that my remarks on derivatives end with a discussion of risk - based capital. this, to me, illustrates the unexpected effects of financial innovation. a decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital - - but that ’ s the very nature of innovation. those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed. taking risk is unavoidable in banking, indeed bankers must do so to survive. the key is to identify, manage, and control the risks that are inherent in the business. the intelligent use of derivatives is one way to accomplish that. one should focus not on derivatives in and of themselves, but on their role and effect on a bank ’ s overall portfolio.

instruments, including derivatives. the risk management principles under examination applied whether or not the institution used derivatives. we addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end - user activities. more recently, the federal reserve issued examiner guidance on the risks relating to banks ’ management of secondary credit market activities, including securitization activities, the extension of various types of off - balance - sheet credit enhancements, and the use of credit derivatives. the guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions. a second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively. that is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. however, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities. most dealer banks now routinely employ value - at - risk ( var ) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk. the move to a portfolio - based approach to managing risk has influenced bank supervisory efforts in several other ways. all three of the u. s. banking agencies now take a more risk - focused approach to supervision. this is simply allocating more supervisory resources to a bank ’ s activities that pose greater risk. for example, bank examiners no longer exhaustively review all of a bank ’ s activities. instead, the examination approach is now to identify and review the sources of risk within a bank ’ s various lines of business. the need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements. beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal var measures. this approach allows banks to make use of empirical correlations among risk factors when computing the var. a third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance