Better information about the credit risk profiles of the largest, internationally active banks, including the composition of their portfolio by internal ratings, would also be useful. A commitment to the use of advanced analytical tools, stress testing, and improved disclosure comes under the widely discussed rubric of seeking out and adopting industry-wide best practices. It is, perhaps, most important to note that the development of best practices is a dynamic, not a static, process that can only be enhanced by consistent risk management efforts over a long time horizon. In sum, I am led to conclude that diligent market discipline using techniques such as those I suggest here is in the long run the essential element needed to achieve both public and private goals. All market participants bear the difficult responsibility of determining and exacting adequate compensation for risk. While the public sector has a responsibility to increase the effectiveness of its overall regulatory and supervisory framework, it is the private sector’s continuous reassessment of risk and advancement of risk management techniques that ultimately will serve to preserve a safe and sound financial system while simultaneously rewarding individual institutions with long-term profitability. In the public sector, we can help markets work more effectively by ensuring that regulated financial institutions support the trading process by making sound credit decisions. We can also work to improve bank supervision by our ongoing examinations of bank risk measurement and management processes, a major focus of the examination process.

The development of credit models by a number of banks has led to a deeper understanding and analysis of the relationship between risk and return in credit activities at the portfolio level. In addition, some banks are exploring the possibility of validating their internal ratings using information from the equities markets. BIS Review 8/1999  –4–  With respect to securities financing, several institutions have discussed and, in certain cases, already have implemented instrument specific collateral haircuts. Many institutions also have acted to ensure the adequacy of their current collateral holdings and developed procedures for accessing additional collateral when necessary. Finally, I applaud recent efforts by the securities lending community in the U.S. to begin publishing aggregated cash-collateral reinvestment data that reflect reinvestment return, interest-rate sensitivity, and liquidity and credit tiering. These are all positive developments. However, along with many of my colleagues in the private sector, I believe there still is a need for the market to develop and implement additional risk management techniques. Let me give you some examples of what I am thinking about. First, financial institutions must have the discipline to consistently apply robust risk management techniques through all phases of the business cycle. A concern for supervisors is the tendency of credit markets to steadily bid down spreads in the optimistic phase of the cycle, often to the point where returns no longer seem commensurate with risk. Then, as problems emerge, lenders in the credit markets pull back, causing spreads to reverse sharply.