pricing – something that has not been proven in any research. in fact, research and the committee ’ s own discussions with banks suggest that something else drives loan pricing. when determining the price of a loan, banks consider all of the economic risks associated with a particular borrower. it is factors such as “ economic capital ” and the level of competition that drive loan pricing, rather than regulatory capital. research on the pricing of international syndicated loans has confirmed that “ pricing clearly varies positively with credit risk. ” that finding should be no surprise to any banker or supervisor – banks that do not price their loans based on a borrower ’ s credit risk probably will not be in business very long. when applied in the context of sovereign or bank borrowers, this finding suggests that loan pricing already takes into account the credit quality of the borrowers. studies such as this one have concluded that, consequently, even those countries that have the lowest credit quality will not likely experience a marked contraction in capital flows. why would that be true? it is because banks that are managing their risks appropriately are already considering all of the risks that they face when they lend to higher risk borrowers – and thus a country ’ s lower credit quality is already priced into a loan, even under the existing capital rules today. furthermore, there are additional elements in basel ii that can contribute to alleviate concerns about the impact on capital flows. let me mention the reduction in capital charges for retail lending, residential mortgages, small and medium enterprises ( exposures below € 1 million ) and well - provisioned past - due loans. 1 also, the recognition of credit risk mitigants such as collateral and guarantees is significantly better in the new framework of basel ii. in a similar vein, i would like to address a related comment that i have often heard. some observers argue that basel ii will have a detrimental effect on capital flows to emerging market economies because the new framework does not recognise the diversification benefits that characterise investments in such markets. it is true that basel ii falls short of recognising the diversification benefits of full credit risk models, although the internal - ratings based approach recognises the benefits of diversification to some degree by assuming that a bank ’ s assets benefit from the same degree of diversification as that of an in the standardised approach the risk - weight of residential mortgage is 35 % instead of 50 % in basel i. for sme ’ s and other retail the new risk weight is 75 % versus 100

, the basel committee is blending several policy approaches to replace the existing capital framework. as i have mentioned, basel ii consists of three mutually reinforcing pillars. the first pillar aligns the minimum capital requirements more closely to banks ’ actual underlying risks. qualifying banks will rely partly on their own measures of those risks, a rule that helps to create economic incentives for banks to improve those measures. the second pillar – supervisory review – allows supervisors to evaluate each bank ’ s assessments of its own risks and to determine whether those assessments seem reasonable. the third pillar, market discipline, strengthens external incentives for prudent management. it strengthens the ability of marketplace participants to reward well managed banks and to penalise poorly managed ones by enhancing transparency in banks ’ financial reporting. one might say that basel ii seeks an “ efficient frontier ” of policy objectives through the three pillars. each pillar provides something that the other two cannot. each is essential to achieving our overall objective of financial stability. the three pillars represent a far more sophisticated view of risk and a far more comprehensive approach to supervising bank capital than the “ one - pillar ” approach contained in the 1988 basel accord. as a result, the committee has engaged in an exhaustive – and sometimes exhausting – public dialogue with bankers, supervisors, and other observers on basel ii ’ s structure and merits. that dialogue was critical to improving the quality of the new framework, and i would like to express my gratitude to all who took great pains to share their views and concerns. you provided us with the perspective of other markets and countries. you shared detailed comments on the proposals. you encouraged your banks to participate in our consultations. the improvements that the committee made to basel ii would have been impossible without your contributions. indeed, it was during those public discussions that policymakers in emerging market countries raised three sensitive questions. i would like to turn now to address those questions and help explain my belief that basel ii represents an opportunity for banks and supervisors in many countries. 1. will basel ii harm the international flow of capital? the first key question in the discussion about the new framework and emerging markets is whether basel ii will harm the flow of capital across borders and especially to emerging markets. in this context, some observers suggest that the new capital framework ’ s heightened sensitivity to risk may reduce the flow of foreign investment in developing economies, since exposures to those economies might typically be considered of higher risk. as i will explain, i believe that basel ii will not have a