In addition to the most recent cycle, examples of such behavior include high-yield bond and leveraged buyout lending in the 1980s, and Latin American investment and lending in the mid1980s. Too often, management edicts to reduce risk occur during the latter phase of the credit cycle, after substantial losses have already occurred. Second, I would argue that targeting returns commensurate with risk over an appropriately long time horizon probably is the single most important defense against violent swings in the credit cycle. Individual banks can protect themselves if they recognize when margins become too thin to cover risk by restraining their credit activities at those rates. They can benefit by expanding their credit activities when returns have risen enough to cover risk once again. To limit credit cycle volatility, appropriate risk and return analysis must be practiced widely and consistently throughout the financial system. Third, more attention must be directed at stress testing, the leading technique in assessing the direct and indirect effects of unusual market and economic events. Stress testing is a fundamentally qualitative and judgmental process, typically used in conjunction with more formal, statistical approaches to risk measurement, such as risk modeling. The primary goal of stress testing is to identify scenarios, usually low probability, high-stress events, that could jeopardize the health of a financial institution. Stress testing of market risk exposures is not a recent development. However, the analysis of distinct classes of fixed-income securities all too often occurs in isolation.
Mr McDonough focuses on the importance of risk management techniques and the enhancement of market discipline Remarks by the President of the Federal Reserve Bank of New York, Mr William J McDonough, before the Bond Market Association in New York on 21/1/99. Good morning. It is a pleasure to be here today and I thank the Bond Market Association for giving me this opportunity to share some of my thoughts about supporting the resiliency and liquidity of our capital markets. As you recall, last August the Russian government announced an effective devaluation of the ruble and declared a debt moratorium, shocking investor confidence all over the world. Against the backdrop of weakened economies and financial markets in many developing countries, global equity and debt markets became increasingly volatile. In the U.S., a number of market observers had anticipated a correction in stock prices. However, the simultaneous and abrupt widening of credit spreads went far beyond the expectations of investors and financial intermediaries. We are all familiar with the immediate consequences of these dramatic events. What is most important, it seems to me, is to try to understand what public and private entities can potentially do to prevent, mitigate, and manage financial uncertainty in the future. In the face of the recent events in Brazil, the launch of the euro, the countdown to Y2K, and the extraordinary market volatility of the last 18 months, all of us are obliged to think carefully about our responsibility to support the functioning of liquid and efficient financial markets.