Banks are increasingly providing technology services, such as account reconciliation software and “web-enabling” assistance, while technology firms are making inroads into services once the domain of banks and brokerage firms, such as financial planning and bill payment. Indeed, many banks are beginning to think of technology firms as competitors – or are contemplating ways to partner with them. I’d guess that most of us, perhaps even all of us, consider the advancement of computing and information technologies, and their role in the development of ever-more sophisticated financial instruments and techniques, to be decidedly positive developments. Such technologies, and the innovation they enable, have reduced the costs of financial transactions, improved the allocation of financial resources, increased the competitiveness and efficiency of financial institutions and markets, and opened new avenues through which individuals and institutions can better diversify and hedge their risks. But with this progress has also come new and difficult challenges. The rapid pace of technological advancement and financial innovation has introduced new, highly complex elements of risk, increased the speed and volatility of the markets, and blurred the barriers between previously distinct sectors of the financial marketplace. Even as supervisors confront change, the fundamental questions remain the same. Where is the risk in banks’ activities, and how effectively are they managing it? Where are banks extending credit and in what form? Who are banks’ customers, and how are those customers changing? To what extent are credit risks being transformed into liquidity and operational risks?

First, a bank would assign each of its loans or exposures to an internal grade, which reflects the risk associated to lending to each borrower. A bank would do so by using the expert judgment of senior lenders and its own well-defined internal rating scale and criteria. The bank would then assess the likelihood of default of borrowers in each internal grade, based on its own analysis. Many larger banks are doing this now. It is this assessment of the probability of default that is the core of the internal ratings-based approach. The second step is for the bank to assess the severity of loss should a loan default – most often referred to as the Loss Given Default. The Committee currently envisions two internal ratings-based approaches, a foundation approach and an advanced approach with even higher minimum standards. A key distinction is that under the foundation approach, banks would use supervisory estimates of lossgiven-default based on loan characteristics, while under the advanced approach, they could make use of their own analysis. The third step is to derive the bank’s capital requirement. The Committee will set out the risk weights that correspond to different estimated probabilities of default and loss-given-default. These risk weights are being developed by the Committee as a measure of unexpected loss, reflecting the amount of potential credit loss for each loan. A key aspect of the internal ratings-based approach is the development of rigorous supervisory standards for the assignment and quantification of internal ratings.