Concentration has benefits, but it necessarily increases the vulnerability of the system to an operational or financial disruption in a single institution, or the decision by a single institution to exit a particular business. Moreover, to the extent that the  2  BIS Review 18/2004  same set of firms play dominant roles in multiple markets, this concentration can also give rise to linkages between markets that are not apparent in normal circumstances and that could potentially affect how the financial system functions in conditions of acute stress. Increased opportunities for diversification offer the prospect - though not the assurance - of lower overall volatility in earnings, but they also bring much more complicated management challenges in controlling conflicts, reputational risks, and operational risks. The actual gains achieved from diversification depend on the correlation of movements in different sources of earnings and in economic growth among different regions as well as the relative volatility of the new business lines into which the institution is diversifying. To the extent that diversification achieves lower overall volatility in earnings for the major financial institutions, it is clearly good for the stability of the system. But to fully exploit these potential gains requires careful attention to the design of the control and compliance infrastructure, to monitoring and managing credit risk and concentration across diverse types of financial activities, and to managing conflicts of interest. These are formidable challenges even for the strongest management teams.

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.