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.

BIS Review 75/2000  2  The difference today is that the timeframe for answering these fundamental questions is dramatically shortened. As supervisors, we must be able to look at rapidly changing financial institutions and assess whether their strategies make sense and whether they are effectively evaluating the risks associated with executing those strategies. Technology and innovation have also rendered geographic boundaries all but meaningless, and undermined the power and control of financial authorities. As you know, one of the principal means of supervising internationally active banks has been the process whereby the host supervisor approves the establishment of a brick-and-mortar presence in its country or jurisdiction. By way of a web-based platform, banks can now target customers far beyond the reach of a typical branch, and even cross borders into countries where they have no local offices and may never have conducted business before. We’ve already seen a few cases in which a bank is chartered in one country, handles its data processing in another, and targets customers in still others. Such situations will surely challenge traditional notions of “home” and “host” supervisor, and raise difficult issues regarding international coordination and cooperation, information sharing, law enforcement and privacy. In a world of instantaneous communication, interconnected markets, and more complex instruments and risks, effective supervision is more important than ever to maintaining financial stability, both locally and globally. To remain effective and relevant, supervisors must understand how and to what extent the “wired” economy and other technologies are changing banking and finance.