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.

In summary, even though the framework for financial stability is not as comprehensive as in the case of price stability, significant progress has been made in all of these areas in recent years. There is a fourth lesson that is particularly relevant for this presentation, and it is a lesson that we have learned from periods of bank resilience in times of stress. During the past few years, financial markets have experienced a series of significant shocks. However, the banking system has been able to cope with them successfully. Financial innovation, the existence of deeper financial markets with a great variety and availability of instruments to transfer risks, and the improvement of the capacity of financial institutions to understand and manage their risks are key ingredients in explaining the resilience of the financial system during the period of shocks. And that leads me to my next point: important trends in risk management. 4. Recent trends in risk management  Financial stability is a key precondition for sustained growth. It is crucial, therefore, to find reliable ways of identifying risks to financial stability and, in particular, to banking stability, and to try to manage these risks in the most effective way. Indeed, as experience has repeatedly shown, both inside Asia and elsewhere, having a solid and well-run banking system not only greatly reduces the likelihood of shocks originating inside the banking system but also makes it less likely that shocks arising elsewhere in the economy are amplified through the banking system.