4  BIS Review 34//2005  Transparency Fifth, a very important reason why I believe Basel II will contribute to financial stability involves greater transparency. The exercise of market discipline should be considered a vital element of successful prudential policies. In particular, in order to ensure responsible and prudent behaviour by bank managers, supervisory action is not sufficient. Majority and minority shareholders, depositors and debt-holders should also have the capacity to evaluate banks and reward or penalise them according to how prudently they are managed. As mentioned earlier, Basel II, via the third pillar of the framework, provides for greater transparency. This should serve to curb excessive risk-taking in advance, and should reduce surprises that arise from opacity that can result in a shock to the financial system. Risk-based supervision Sixth, the assessment of risk has begun to play a predominant role in supervisory procedures. Banking supervision traditionally sought to ensure the solvency of banks by emphasising an accounting review of their financial and capital position. There is certainly still a role for this type of review, particularly in assessing asset quality and ensuring proper provisioning and risk concentration policies. The traditional approach is no longer sufficient, however. Today it is necessary for supervisors to place a greater emphasis on anticipating problems. It is vital to complement the traditional accounting approach with a greater emphasis on the analysis of the risks that affect banks and the management and control systems that mitigate such risks.

Basel II will not only help banks to measure and allocate the provisions and capital necessary to withstand expected and unexpected losses, but it will also help supervisors and market participants to ensure that banks have done so in a way that will maximise the likelihood that they can continue to operate, even in the most difficult of circumstances. BIS Review 34/2005  3  Sound corporate governance The second reason I believe Basel II will promote financial stability is that it promotes more effective corporate governance. Risk management must be based on a strong foundation of corporate governance. A bank can have the most sophisticated measurement tools in the world, but if it is poorly governed, it will be vulnerable to financial and operational weaknesses. The Basel Committee recognised this when it developed the qualifications that banks must meet in order to adopt the most advanced approaches under Basel II. While much attention has been paid to some of the more complex quantitative aspects of Basel II, I believe the most important qualifying criteria are those that address how the bank’s risk management framework is governed. Banks that adopt Basel II will be expected to have a comprehensive and sound planning and governance system to oversee all aspects of their risk measurement and management process. The board of directors, senior management, and audit and other control functions will be expected to exercise their duties in a rigorous manner. I believe that better managed banks under Basel II will be safer, sounder, and more resilient.