It is obviously in the interest of institutions that transfer credit risk, interest rate risk, or other risks to understand the performance capabilities of those institutions from which they are purchasing protection. The ability to arrive at informed independent judgments about counterparty risk, however, can be hindered by the gaps that remain in the quality of disclosure. The same developments in financial technology that have improved the sophistication of risk management and the ability to transfer risk can create positive feedback mechanisms that, for at least short periods of time, amplify large moves in asset prices. There have been substantial increases over the past decade in the capacity of the market, meaning the principal dealers, to handle very large increases in hedging-related flows. This dimension of the financial infrastructure is critical to the capacity of our markets to absorb and respond to large shocks. Dynamic hedging of options and other similar strategies, however, depend on the availability of sufficient liquidity to work effectively. Stressful periods, of course, are marked precisely by a material reduction in market liquidity. These changes in the nature of finance have several important implications for the supervisors and those responsible for market oversight. Financial innovation will, in some ways, always move ahead of the evolution in risk management techniques. As supervisors, our challenge is to work to ensure that the sophistication of the supervisory process evolves to keep abreast of the pace of change in financial innovation. This is a formidable challenge, and we need to continue to work hard at it.

Changes in the nature of financial intermediation have also played a role in improving the overall resilience and performance of the U.S. financial system that was evident in this latest period of economic recession and financial stress. Four different types of changes are particularly important. •  Innovation in financial technology continues to expand the opportunities for financial institutions to separate and distribute, and to manage and hedge, different types of risk. •  The increasingly greater role played by the capital markets in the financial intermediation process relative to banks - both relative to the past and compared with most other major economies - has improved the capacity of our system to handle stress. Loans and securities held by commercial banks today account for less than 20 percent of overall U.S. credit market debt, roughly two--thirds of their 1975 levels. •  The increases in the sophistication of risk management techniques and enhancements to risk management processes have delivered substantial improvements in how banks and other financial institutions actually manage risk in practice. Banks, for example, have aligned their pricing of credit products much more closely with credit risk. •  The increased scale of cross-border financial intermediation, the growing role of securitized financial instruments in those overall flows, and the growth in the size and breadth of financial institutions with global operations may also mean that, as shocks are transmitted more rapidly, they are diffused more broadly. These are positive developments, and they are likely to be enduring.