of their relationship with the borrower and the availability of collateral - despite the fact that collateral was often hard to seize in the event of default. the result was that loans - including, i might add, loans by foreign banks - expanded faster than the ability of the borrowers to repay. additionally, because many banks did not have or did not abide by limits on concentrations of lending to individual firms or business sectors, loans to overextended borrowers were often large relative to bank capital, so that when economic conditions worsened, these banks were weakened the most. the asian crisis also illustrates the potential benefit of more sophisticated risk management practices. many asian banks did not adequately assess their exposures to exchange rate risk. although some banks matched their foreign currency liabilities with foreign currency assets, doing so merely transformed exchange rate risk into credit risk, because their foreign currency borrowers did not have assured sources of foreign currency revenues. similarly, foreign banks underestimated country risk in asia. in both cases, institutions seemed to have assumed that stability would continue in the region and failed to consider what might happen if that were not the case. a greater willingness and ability of banks to subject their exposures to stress testing could have highlighted the risks and emphasized the importance of key assumptions. had they conducted stress tests, some lenders might have seen how exposed they were to changes in exchange rates or to an interruption of steady economic growth. although avoiding failure is a principal reason for managing risk, global financial institutions also have the broader objective of maximizing their risk - adjusted rate of return on capital, or raroc. this means not just avoiding excessive risk exposures, but measuring and managing risks relative to returns and to capital. by focusing on risk - adjusted returns on capital, global institutions avoid putting too much emphasis on activities and investments that have high expected returns but equally high or higher risk. this has led to better management decisions and more efficient allocation of capital and other resources. indeed, bank shareholders and creditors expect to receive an appropriate risk - adjusted rate of return, with the result that banks that do not focus on risk - adjusted returns will not be rewarded by the market. risk management is clearly not free. in fact, as i will discuss, it ’ s expensive in both resources and in institutional disruption. but the cost of delaying or avoiding proper risk management can be extreme : failure of a bank and possibly failure of a banking system. a point too often overlooked, however, is that, by focusing

to lend ; and the expected loss given default, taking into account any collateral or other loss - mitigating features of the credit agreement. combined, these measures reveal the expected loss, which a bank must know to underwrite and price a credit correctly, as well as to establish adequate loss reserves. however, it is the volatility of this loss and the contribution of the credit to the volatility of the bank ’ s cash flow on a firm - wide, portfolio basis that is crucial to evaluating capital adequacy. as you can imagine, the process of modeling credit risk is still as much art as science for most banks, requiring many assumptions and subjective judgments as well as substantial amounts of data. testing the sensitivity of a model ’ s results to these decisions and maintaining the integrity of the process from start to finish will be a constant challenge. nevertheless, leading institutions around the world have made substantial progress in measuring risk in recent years, and we expect much more progress in the years ahead as both the regulatory and banking communities devote more attention and resources to the topic. the continually declining cost of technology for storing and analyzing data will help greatly to encourage firms to create the databases necessary to understand credit risk better. this decade may see a watershed for risk management as institutions make far greater use of information. indeed, i fully anticipate that the revised basel capital accord now under development will link capital requirements more closely to a bank ’ s own internal evaluation of risk. for most institutions, though, success in risk management does not require sophisticated models, nor will models alone suffice. clearly, all banks must take advantage of new technologies and keep pace with market innovations to remain competitive and to survive. that need points to ever more sophisticated risk measurement and management practices. nevertheless, adhering to the fundamental principles of risk management and adapting sound practices to one ’ s own situation will remain key. as i indicated earlier, the experience throughout the world with bank failures and other financial crises demonstrates time and again that violations of traditional and long - known management principles produce the largest losses. i gave some examples of this earlier. technology and financial innovation facilitate risk management and accommodate more sophisticated risk exposures. financial models are tools and the environment around them must still be properly managed and controlled. i cannot overstate that point. the most sophisticated risk management techniques are useless if the operating environment and management incentives are deficient or if fundamental risk management principles are ignored. fundamental elements of sound risk management the fundamental elements