analysis. ensuring that risk management permeates an entire organization may require some fundamental changes for certain firms. and this lesson applies not just to the prominent organizations mentioned in the headlines of late, but also to smaller firms. even if smaller firms have been less affected by the recent turmoil ( and perhaps have even won back some market share as customers seek more " traditional " places to put their money ), their managements must understand that the financial landscape has changed and needs to be surveyed anew because events outside of their control in market - wide flight to liquidity, for example, can have direct impacts on them. of vital importance will be incorporating into strategic risk management the lesson that funding and liquidity will be a major determinant of institutions'success going forward. building a rigorous strategic risk management framework requires an institution to reexamine both its internal practices and its external environment, and to understand how closely the two are connected. in other words, external factors have an impact on internal practices, but those internal practices, because financial markets are so interconnected, can in turn have an impact on how the institution is viewed externally – and even have an impact on the marketplace more broadly. we have witnessed several such examples of late, in which an institution encountered severe liquidity needs, which then affected funding for other institutions. institutions need to understand better that a number of factors affecting their business are beyond their control, and that events can have secondary or tertiary " knock - on " effects. the real art is to realize that while all institutions may be affected by external factors, each is affected in its own way. now that i have laid out a general framework for strategic risk management, i would like to offer a few examples of its application. funding and liquidity as i noted, the clear driver of the fundamental transformation in financial services is the increased importance of funding and liquidity. the ability to secure funding is a fundamental task in banking, and banks have been managing expected liquidity demands since the beginning of banking itself. in times of stress, such as now, having a solid and reliable funding structure becomes much more important, in some cases so much so that it affects most other banking activities. the current turmoil has brought about substantial deleveraging in financial services. managing this process is an immediate challenge for banking institutions, as they must consider the need to reduce leverage at their own institution as well as understand the consequences of deleveraging at other firms. this is clearly an example of external factors

doubtless is a factor in the significant gain in the overall finance industry ’ s share of american corporate output during the past decade. in short, the value added of derivatives themselves derives from their ability to enhance the process of wealth creation. while the value of risk unbundling has been known for decades, the ability to create sophisticated instruments that could be effective in a dynamic market had to await the last decade ’ s development of computer and telecommunications technologies. the ability to create and employ sophisticated financial products also galvanized the academic community to develop increasingly complex models of risk management. while recent history suggests that such models are useful, they are doubtless in need of much improvement – an issue to which i will return shortly. yet beneath all of the evidence of the value of derivatives to a market economy, there remains a deep - seated fear that while individual risks seem clearly to have been reduced through derivative - facilitated diversification, systemic risk has become enlarged, as a consequence. without question, derivatives facilitate the implementation of leveraged trading strategies, though the very technology that has made derivatives feasible has also improved the ability to leverage without derivatives. nonetheless, the possibility of increased systemic risk does appear to be an issue that requires fuller understanding. we should point out, first, the obvious. overall, derivatives are mainly a zero sum game : one counterparty ’ s market loss is the other counterparty ’ s market gain. counterparty credit exposures on otc derivatives are a different issue and the source of much of the systemic concerns. such losses rose to record levels in the third quarter of 1998. nonetheless, the rate of loss remained well below that on banks ’ loan portfolios. moreover, the counterparty credit losses in the third quarter can be traced primarily to the extraordinary events in russia, which produced many defaults on ruble forward contracts. in the fourth quarter such losses dropped sharply, albeit not to the very low pre - crisis rate. the bulk of the losses reported by the major derivative houses for the financially turbulent third quarter of last year reflected declines in the market values of their underlying trading positions, especially in equities, commodities and emerging market debt. derivative instruments were bystanders. they may well have intensified the losses in underlying markets, but they were scarcely the major players. yet, through the past decades ’ phenomenal growth of the derivative market, there has not been a significant downturn in the economy overall that has tested the resilience of derivative markets. ( i operate on