Lastly, it introduces a requirement for regulatory capital to be tailored for certain off-balance sheet exposures, particularly liquidity facilities associated with these transactions, which under Basel I were generally exempted of any capital charge. Second, by reinforcing the link between the capital base and the risks actually incurred, Basel II encourages banks to improve their systems for managing these risks as well as their due diligence procedures. Beyond reminding banks of the basic caution required when extending credit, this encouragement is all the more useful in that banks now often play a role in securitisation transactions for which the underlying assets, for example housing loans, may be initiated by unregulated entities, that are not always  BIS Review 11/2008  3  accountable for their risk analysis and pricing. In other words, the weaker the discipline surrounding the granting of a loan the stronger banks’ diligence procedures needs to be. Thirdly, Basel II gives banks and supervisors a vital tool, Pillar 2, with which to assess the risk profile of institutions and in particular to take account of certain risks that are sometimes difficult to quantify but whose impact can be great. By way of example, I shall merely mention refinancing risk and reputational risk. Pillar 2 thus enables banks, through the determination of the level of economic capital and supervisors, via for example an increase in capital requirements, to ensure that all of the risks incurred are appropriately covered.

As the scope for differentiation between institutions increases under the risk-based regime, it will become more critical for insurers to attract, develop and retain the right human capital resources. With the liberalisation of financial markets and the rapid pace of financial convergence, the investment management function within insurers needs to be flexible, risk-focused, and equipped with professionals who are able to respond to the exigencies of the marketplace. An important component of the new risk-based capital and supervisory framework is the notion of supervisory target capital levels which insurers will be required to maintain under the risk-based framework. This is new to our environment, and has been a matter of some concern to insurers which may view it as an additional capital burden. Although the risk-based capital regime will more closely align economic capital with regulatory capital, it is important to recognize that it necessarily derives its application from industry-wide tests which cannot fully address risks that are specific to an individual institution. The supervisory capital target therefore serves to provide an early signal of emerging difficulties so that appropriate intervention measures can be taken to prevent a further deterioration of conditions which would warrant more drastic and costly actions. For insurers that already adopt robust internal approaches to capital management, the introduction of the supervisory target level in itself should not significantly alter existing capital management strategies. Insurers that do not yet have such systems in place, will be encouraged to develop them, and thereby enhance their own resilience to adverse changes in business conditions.