We are particularly interested in creating the right incentives through a set of robust criteria that will enable banks, subject to supervisory approval, to employ increasingly sophisticated approaches for setting capital requirements for other risks. Second and third pillars Let me also briefly touch upon the two other pillars of the revised capital adequacy framework supervisory review and market discipline. These topics are certainly familiar and important ones to all of you. Supervisory review of capital is a critical complement to minimum capital requirements. The Consultative Paper proposes that supervisors should ensure that each bank has sound internal processes in place to assess the adequacy of its capital, based on a thorough evaluation of its risks. I want to stress that this proposed approach in no way intends to replace the judgement and expertise of bank management, or to shift responsibility for capital adequacy to supervisors. On the contrary, it is well understood that bank managers have the most complete understanding of the risks their institutions face, and it is they and the bank’s board of directors who have primary responsibility for managing those risks. The task for supervisors in this framework is to evaluate how well banks are assessing their capital needs relative to their risks, including whether banks are appropriately addressing the relationship between different types of risks. Most importantly, in proposing this second pillar the Committee intends to foster a more active dialogue between banks and their supervisors, such that when deficiencies develop, prompt and decisive action can be taken to restore capital.

Many in the industry noted that a capital regime based on banks’ internal ratings, which reflect a wide range of information about borrowers, can prove to be quite sensitive to the level of risk in a bank’s portfolio. Our analysis indicates that a wider range of institutions could be eligible to use the internal ratings approach, than the narrower set of large and sophisticated institutions, as implied in the Consultative Paper issued in June. We now envision extending the applicability of the internal ratings method approach to banks of varying sizes, including small and medium-sized institutions provided such ratings systems are accompanied by strong internal controls, supervisory oversight and ample disclosure. With this in mind, the Committee is working on how to link banks’ internal ratings to a regulatory capital scheme. We are seeking to develop flexible approaches, since all banks wishing to use internal ratings may not yet be able to generate the full amount of information necessary to tie their ratings to capital requirements. Thus, for at least some banks, we are considering the possibility that some information would be supplied by the supervisor, although the core elements would be generated by a bank’s internal ratings scheme. There would be a parallel track for the more sophisticated institutions, which would rely fully on internal information. In practice, the two approaches are part of a single evolutionary framework, in which banks can rely increasingly on internal processes for regulatory capital allocation as their risk measurement and management practices improve.