Its adoption by over 100 countries has helped to strengthen the safety and soundness of the international banking system and has contributed to the achievement of competitive equality. However, the financial world has changed dramatically over the past dozen years, to the point that the Accord’s efficacy has eroded considerably. Its broad brush approach to differentiating credit risk encouraged banks to undertake regulatory arbitrage transactions. Furthermore, as banks have developed innovative techniques for managing and mitigating risk, credit risk now exists in more complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently calculated, less useful to banking supervisors. Today’s marketplace also provides an imperative for revising the 1988 Accord. The rapid pace of technological change places information that was once largely the domain of analysts and institutional investors into the hands of millions of individual investors and consumers. Market participants, armed with timely and meaningful information, reward sound risk management practices and penalize those banks that are found deficient in this area. A bank’s regulatory capital position can be a strong indicator of how it supports its risk, and if markets are to impose an optimal level of discipline on banks, we must ensure that regulatory capital measures reflect risk as precisely as possible. I believe that reform of the Basel Accord is thus clearly in the markets’ best interests. As the Committee continues to develop a more risk-sensitive capital adequacy framework, we cannot lose sight of the need to keep the Accord up to date.

Many in the industry noted that a capital regime based on banks’ internal ratings, which reflect a wide range of information about borrowers, can prove to be quite sensitive to the level of risk in a bank’s portfolio. Our analysis indicates that a wider range of institutions could be eligible to use the internal ratings approach, than the narrower set of large and sophisticated institutions, as implied in the Consultative Paper issued in June. We now envision extending the applicability of the internal ratings method approach to banks of varying sizes, including small and medium-sized institutions provided such ratings systems are accompanied by strong internal controls, supervisory oversight and ample disclosure. With this in mind, the Committee is working on how to link banks’ internal ratings to a regulatory capital scheme. We are seeking to develop flexible approaches, since all banks wishing to use internal ratings may not yet be able to generate the full amount of information necessary to tie their ratings to capital requirements. Thus, for at least some banks, we are considering the possibility that some information would be supplied by the supervisor, although the core elements would be generated by a bank’s internal ratings scheme. There would be a parallel track for the more sophisticated institutions, which would rely fully on internal information. In practice, the two approaches are part of a single evolutionary framework, in which banks can rely increasingly on internal processes for regulatory capital allocation as their risk measurement and management practices improve.