Jaime Caruana: Basel II - a new approach to banking supervision Remarks of Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee on Banking Supervision, at the Fourth Annual International Seminar on Policy Challenges for the Financial Sector: “Basel II - the international banking system at the crossroads”, Washington DC, 1 June 2004. *  *  *  It is an honour to be invited to join you, the members of the global supervisory community, at this seminar on the future of banking supervision. I would like to thank our host, Chairman Greenspan, for his warm welcome into the hallowed halls of the Federal Reserve. Likewise, all of us express our gratitude to the World Bank, the International Monetary Fund, and the Federal Reserve for organising this seminar. To ensure rich, lively, and informed discussions, our sponsors have assembled an impressive array of speakers and participants, including senior supervisors, central bankers, and others from over 50 countries, an achievement that demonstrates, for the fourth time, excellence in international and inter-organisational cooperation. Overview of remarks The new capital adequacy framework, or “Basel II,” figures into virtually every discussion today on the outlook for international banking tomorrow. This seminar will tackle its policy implications. They include the new framework’s potential effects on risk management within an individual firm; on competition between firms; on the stability of the financial sector and the future of supervision; and, most broadly, on the long-term growth of the economy.

I believe that banks adopting especially the advanced approaches to credit risk will increasingly take longer-term views of their international investments, as stress testing and other requirements will ensure that they consider how their risks would react to certain changes in the market environment. When banking systems are adequately capitalised, well-managed and risks are correctly assessed within the appropriate time horizon, the financial system becomes more stable, less procyclical, better able to promote sustainable growth, and more resilient during periods of distress. Risk assessment process that are more formalised and disciplined may facilitate early detections of deviations or mistakes, and that may facilitate making smoother corrections at an early stage, reducing the probability of sudden changes in investment decisions. This, in turn, should benefit emerging market economies by improving the degree of confidence that they can have in the future level of capital inflows. Procyclicality This is very much related to the discussion about procyclicality, an important issue that we at the Committee have taken up and addressed seriously. In particular, some have suggested that the internal ratings-based approaches will drive up the cost of credit for borrowers precisely at times when its supply is falling, namely during downturns in the business cycle. This has led to concerns that Basel II may exacerbate fragility in emerging markets. There is some degree of procyclicality inherent in banking behaviour. The question that we should consider is whether Basel II will unduly exacerbate this behaviour.