Undercapitalised banks will tend to make abrupt decisions to cut lending when there is news of a downturn, and banks which have not assessed risks properly may likewise be forced to react abruptly. Pillar 2 of Basel II requires banks to have a capital strategy that takes into consideration the fluctuations of capital through the cycle and to hold additional buffers of capital that will help to offset potential problems. Basel II’s more forward-looking approach to granting credit introduces “risk awareness” and “early detection” factors that will provide additional defence against credit disruptions and procyclicality. I also believe that when banks have the right incentives to manage their risks appropriately, to hold sufficient capital and to improve transparency, the banking system will become more resilient, more stable and better able to serve as a source for credit and growth Nonetheless, the Committee recognises that any risk-sensitive capital framework will cause the minimum capital requirement to fluctuate for the same exposure if a borrower’s creditworthiness strengthens or weakens. To mitigate excessively wide swings in capital requirements, the new framework incorporates a number of elements such as the requirement to use longer time horizons in the design of internal rating systems and in the average calculations of key variables, and also the need to carry out stress tests and conduct calculations in downturn conditions. All these elements will ensure that bank managers are conscious of how risk-drivers change through the cycle and in stress conditions, and that they incorporate these elements into their decision-taking processes and capital strategies.

The policy mix must be well-balanced at the international as well as the domestic levels. Placing too heavy a burden on monetary policy in terms of achieving the main economic and financial balances is detrimental to its effectiveness. In particular, it diminishes its ability to maintain and consolidate financial market stability. This concern underlies the implementation of the Growth and Stability Pact in Economic and Monetary Union. By obliging fiscal policies to commit to stability, the pact allows the fiscal buffers to fulfil their role as stabilisers. Indeed, by their information and expectations, investors can penalise  4  BIS Review 41/2001  imbalances affecting the main world economies or diverging developments in different countries. To reduce this constraint, economic and monetary policies must be harmonised at the international level in order to achieve more balanced international financial relations. B. Financial authorities have to soften as much as possible some of the side-effects of the new financial market features. Let us first consider a few possible improvements as regards credit cycles: •  Provisioning standards should allow banks’ lending to be less pro-cyclical. As a general rule, provisioning standards require improvements so that provisions better reflect the actual inherent credit risk of loan portfolios. They should also be improved for macroeconomic purposes, so that banks’ lending behaviour becomes less pro-cyclical. These objectives could be achieved through a more forward-looking provisioning, whereby provisions are set up earlier – that is to say, in a perfect world, as soon as a loan is granted.