of their risk measurement and management of the complex financial instruments that are typically used in this model. basel ii also establishes benchmarks for recognising risk transfer and mitigation in securitisation and credit derivatives structures. it sets a boundary between the point at which a firm transfers risk and actually retains the risk. these enable supervisors to assess the degree of risk transfer and mitigation under both normal and stressed market conditions. and finally, basel ii requires that firms strengthen their frameworks for assessing appropriate capital for the trading book. this has taken on increasing importance given the rapid growth of trading book assets relative to the banking book. for example – the basel committee – in consultation with the industry – continues to work on developing a framework for better capturing the default risk associated with credit exposures in the trading book. in addition, basel ii permits firms to use their own models to measure counterparty credit risk exposures. this risk arises, for example, in otc derivatives, which are becoming increasingly complex and more difficult to measure. this approach is closely aligned with industry best practice as well as the underlying economic risks of these activities. basel ii has also paved the way for improvements in other, less visible ways. one example is basel ii ’ s greater focus on firms ’ risk management infrastructure. for instance, the framework requires fundamental improvement in the data supporting pd, lgd, and ead estimates that underpin economic and regulatory capital assessments over an economic cycle. this has spurred improvements in areas such as data collection and management information systems. these advances, along with the incentives to improve risk management practices, will support further innovation and improvement in risk management and economic capital modelling. pillar 2 let me now turn to the second pillar – the supervisory review process. pillar 2 really starts with you, the banks. first and foremost, responsibility lies with bank management for developing an internal capital assessment process and setting capital targets that are commensurate with the bank ’ s risk profile and control environment. a sound risk management process is the basis for an effective assessment of the adequacy of a bank ’ s capital. and bank management bears the primary responsibility for ensuring that the bank maintains adequate capital to support the risks beyond the minimum requirements. excessive participation by supervisors in a bank's capital adequacy assessment process or firms'over - reliance on supervisory review of their assessments are both counter to basel ii ’ s objectives and raise the risk of moral hazard. the better banks measure and manage

their risks, the more comfortable supervisors and the market will become with respect to their pillar 1 processes, as well as the amount of overall capital that pillar 2 indicates is appropriate. this is not a compliance exercise! senior management and boards of directors need to lead the process and ensure that their institutions establish robust internal systems that capture all material risks for their institution in a rigorous manner. management should make certain that the economic substance of risk exposures is fully recognised and incorporated into the bank ’ s systems. this is extremely important, particularly in the instance of securitisation and other complex risk transfer arrangements where the risks retained by the firm are more difficult to measure. these estimates of risk must translate into robust capital assessments that can be validated by banks and supervisors. when supervisors assess economic capital, they should leverage off of banks ’ systems. supervisors need to understand the global perspective within which banks operate. local approaches may be warranted, but we need to ensure that local deviations are proportionate and that the costs do not outweigh the prudential benefits. to achieve the full benefits of pillar 2, supervisors need to avoid falling into the trap of establishing a check - list approach to supervision. it is not in anyone ’ s interest to engage in a tick - the - box compliance exercise. let me stress this - basel ii goes beyond merely just meeting the letter of the rules. the framework is more about a risk - focused approach to capital and risk management. i understand that for banks and supervisors to realise the full potential of basel ii, more work must be done on home - host issues. with respect to pillar 1, we have resolved a number of concerns and have come quite a long way. the same vigour and energy needs to be applied to the home - host issues related to pillar 2. i am confident that with the development of the home - host principles, increased use of the supervisory colleges and further dialogue with the industry we will make progress on the outstanding issues. many of these pillar 2 issues, such as diversification, are particularly challenging and supervisors need to work with the industry to resolve them. i expect that over time bankers and supervisors will engage in a dialogue around pillar 2 that ultimately will turn out to be one of the most important benefits coming out of the implementation of basel ii. for instance, i have already heard from a number of banks about the fruitful discussions of how credit risk mitigation is reflected in their risk models and about the robustness of