For these reasons, I believe the most practical approach is to focus on financial institutions’ lending activities, because such an approach offers a near-term and cost-effective remedy to the systemic risks posed by HLIs. Challenges for the Banking Industry I strongly believe that both the official and private sectors have important roles to play in addressing the challenges arising from an increasingly complex and dynamic financial services industry. First and foremost, we hold banks accountable for ensuring that sound credit risk management standards are upheld and that these keep pace with financial market innovation. If competitive pressures lead to bad practices in one bank or the industry as a whole, our job as supervisors is to raise standards and ensure that sound practices are restored. In my remarks today, I highlighted a number of areas where progress has been made. Of course, there is more work to be done by banks and supervisors. High on the agenda should be the development of more meaningful measurement of risk exposure and the implementation of effective stress-testing techniques. Another important area that requires further industry attention is the measurement of leverage. Finally, I believe that the industry should devote more thought to the appropriate valuation of positions during periods of market stress and illiquidity – which is particularly relevant to the use of collateral to protect against credit risk. These are just some of the broader issues arising from the LTCM experience and the market turbulence last fall.

As I mentioned earlier, we recently issued guidance to the institutions we supervise detailing sound risk management practices for the credit risk management of trading and derivatives activities. This document identifies the areas that our examiners will review during their examination of trading activities. It is important to note that the Federal Reserve’ s guidance to banks and examiners covers not only HLI and hedge fund counterparties, but all other counterparty relationships. We want to ensure that banks carry forward the lessons of the LTCM experience to all potentially high-risk trading activities. In this regard, our examiners will devote particular attention to the risks associated with rapidly growing, highly profitable and potentially high-risk activities and product lines. They will assess the adequacy of banks’ reviews of counterparty creditworthiness, exposure measurement and monitoring techniques, stress testing, limit setting, and the appropriate use of collateral and other credit enhancements. Our examiners will also look at internal policies and the degree to which behavior conforms to stated policies. We have already conducted meetings with the major banks to reinforce these messages and our examiners will conduct follow-up reviews in the course of this year. Other Possible Policy Responses Over the past few months, there has been significant debate about other measures that could be taken to limit the potential risks to the financial system arising from the activities of large, highly leveraged, unregulated financial institutions. The Basle Committee carefully considered all the ideas that have surfaced.