the strongest management teams. trust and reputation are valuable competitive assets for financial institutions, and the desire to preserve those assets creates a powerful incentive for firms to manage conflicts and compliance with exceptional care. supervision and regulation, and the enforcement response to management failures, should help strengthen the incentives for a stronger compliance infrastructure, but they cannot insulate firms from the consequences of reputational damage. financial innovation has made it possible for the market to assign values to a broader range of financial activities. and this, combined with improved disclosure, has increased the potential power of market discipline. but the increased complexity that comes with innovation also creates challenges for investor and counterparty risk assessment. although the overall quality of disclosure has improved in recent years, along with accounting and auditing processes that underpin the integrity of disclosure, the complexity of public financial reporting can make it very difficult to discern the true picture of a firm ’ s financial condition and its exposure to risk. financial innovation has also made it possible for risk to migrate to - and for leverage to accumulate in - parts of the financial system with less strong, or simply different, supervision, capital requirements, or disclosure norms. risk today, on balance, seems to be allocated more effectively to those institutions better able to manage and hold it, resulting in reduced risk to banks and to the financial system as a whole. however, limitations in the extent of public disclosure over institutions that hold large amounts of risk make it hard to develop a comprehensive picture. 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

the skill with which we manage the challenges that come with them. among these challenges are those that relate to the complexity of financial and operational risk management, concentration in critical markets, internal governance to manage conflicts, the quality of public disclosure, opportunities for regulatory and capital arbitrage, and trend amplifying market dynamics in times of stress. the financial innovations that have made risk transfer and hedging possible have increased the complexity of risk management, both financial and operational. the seemingly simple structure of a loan or bond issue can now involve a complex series of additional transactions that seek to allocate risks and responsibilities along specialized lines. this increased number of transactions that need to be separately settled and tracked by themselves create new risks that must be managed. the economies of scale inherent in certain activities have led to a significant degree of concentration in some markets. a relatively small number of dealers account for a very large share of the over - the - counter derivatives business, with higher degrees of concentration in specific markets such as interest - rate options. two institutions dominate the government securities clearing business. the growth in the size of government - sponsored mortgage entities creates a high degree of concentration in a market with very large systemic implications. 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 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