We recognize this, even as we encourage firms to put in place stronger and more sophisticated systems more commensurate with the complexity of the risks they are taking. 2  BIS Review 36/2004  •  Comprehensive aggregation of credit exposure: The most sophisticated among large diversified financial institutions have well-developed systems for aggregating credit exposure, with a common methodology and results available relatively quickly, across the full range of transactions and business lines they engage in with a single entity or groups of entities with correlated risks. •  Stress testing and scenario analysis: Firms at the leading edge have moved well beyond reliance on “value-at-risk” complemented by stress tests of discrete shocks. They employ stress tests built around more exacting, forward-looking scenarios integrating large moves in a number of variables, more tailored to the risk profile of the firm and current market conditions, and the reactions of other market participants and counterparties. •  Counterparty credit risk management: The most sophisticated firms use much more careful and sophisticated approaches for measuring potential future exposure, and they analyze how exposures may respond in conditions of significant market stress. With respect to hedge fund exposure in particular, the leading firms employ comprehensive evaluation of the risk profile of the hedge fund to set credit thresholds and terms and a more disciplined approach to setting sufficiently high levels of initial margin. •  Measuring and managing interest rate risk: Leading institutions assess their exposure to interest rate risk in a comprehensive manner across the firm’s business lines.
•  We are working to encourage firms to proceed with their investments in greater resilience and geographic range called for in the Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System. •  We continue to encourage efforts to strengthen all aspects of our national payments and settlement systems. •  And we are engaged across a number of fronts internationally to provide a more integrated framework of supervision that better matches the integration of national financial systems and the increased global reach of the largest financial institutions. As part of our supervisory process we monitor closely the evolution in risk management practice across a broad array of financial institutions. Through horizontal reviews that focus on specific dimensions of risk management, we have a reasonably good sense of where the frontier in risk management practices is across the industry, and understand where the gap between this frontier and average practice is the greatest. The size of this gap in practice can increase in market conditions where competitive pressures and a search for return works to erode discipline. I thought it might be useful to highlight some of the areas where leading practice is farthest ahead of typical practice. Leading practice does not imply that there is a definitely superior model that we expect all firms to converge to over time. In most of these areas, there is some diversity in what defines the frontier of excellence.