But before I get into the details, let me say that I believe the LTCM episode and the supervisory response to it is fundamentally about two things: leverage and good judgment. Leverage is a fact of life in our financial world, and is a key part of the risk-taking necessary for the creation of wealth. But sometimes banks go too far in extending credit to their customers and counterparties. That’ s where good judgment comes in. I know - - I’ ve been there. I was a commercial banker for 22 years before becoming President of the New York Fed, and I can tell you that the most important decisions a banker makes are how to lend and to whom. Those decisions are not easy, and often involve many shades of gray. One of our aims as supervisors should be to see that banks are using the right tools to make those judgments. The importance of these issues extends beyond banks and their supervisors. Sound credit policies and procedures are essential not only for the stability of individual banks, but also – and more importantly – for the health of the financial system and the economy as a whole. This is because banks play a pivotal role in our economy as providers of credit. If banks make poor credit decisions with respect to a borrower, including a hedge fund like LTCM, the financial system and our economy will suffer.
In the case of LTCM, stress testing could have given banks at least some warning of the types of exposures they could have faced last fall. The critical importance of stress testing is noted very explicitly in our new supervisory guidance. Sound Practice Guidance The sound practices document accompanying the Basle report presents an important set of standards that will guide both banks and their supervisors. It appears that banks generally have tightened the credit risk management standards for their HLI exposures since the collapse of LTCM. However, it is important that supervisors try to ensure that progress continues. Memories tend to be short, and we want to make sure that as markets calm down, as they have in the past months, banks do not return to the old ways of doing business. The adoption and rigorous enforcement of enhanced risk management practices should contribute substantially to limiting excessive risk-taking and leverage at HLIs. This is the case because HLIs cannot trade without access to financing and liquidity from banks and securities  3  BIS Review 27/1999  firms. If each counterparty manages its risks appropriately, the chance of contagion to other institutions and the financial markets more broadly would be reduced substantially. It is this risk of contagion and financial market instability that is the principal concern of central banks and supervisors. Along with other federal banking supervisors, the Federal Reserve has moved quickly to implement the recommendations of the Basle Committee’ s report.