. changes introduced by basel ii how will basel ii do a better job delivering on the four capital objectives i have described to you? it does so by moving capital regulation to a better point on a spectrum of two extremes. on one end of the spectrum, we have basel i - like regimes, which rely on rigid, externally imposed regulatory ratios which collapse under their own weight as rapid financial innovation and capital arbitrage proceed. the result is a breakdown in the link between risk and capital ( as we have seen in the example of structured credit exposures ). on the other end of the spectrum, we have full reliance on banks ’ internal credit models. here we run the risk of regulatory capital not putting appropriate constraints on banks ’ risk taking, and as we all know, the role of regulatory capital is to impose limits on banks that do not manage themselves in a prudent way. basel ii falls in the middle of this spectrum by leveraging off and reinforcing the basic building blocks of sound credit risk management, but filtering these elements through a rigorous regulatory framework. in particular, i am talking about requiring banks to have sound internal ratings classification systems that decompose any exposure into its probability of default, loss given default and exposure at default, subject to stringent supervisory standards and internal controls. moreover, these inputs are filtered through a regulatory framework where supervisors conservatively specify correlations within asset classes. let me elaborate a bit more on how basel ii does a better job of capturing the types of risk that banks increasingly face. some of the most important areas relevant to the current crisis are the following : • first, basel ii delivers greater risk differentiation. banks that move from prime into subprime mortgage lending or that move from traditional corporate lending into leveraged lending will see an increase in their capital commensurate with the changing business strategy and risk profile. under basel i, all such exposures receive the same charge. • second, off - balance sheet contractual exposures to sivs and conduits will be brought into the fold and subject to regulatory capital, whatever the accounting treatment. • third, there will be a much more risk sensitive treatment for securitisation exposures. this will create more neutral incentives between retaining an exposure on the balance sheet or distributing it in the market through securitisation. • fourth, banks will have to develop more rigorous approaches to measure and manage their operational risk exposures and hold commensurate capital. • fifth, banks will

have to develop more rigorous methodologies for capturing counterparty credit exposures, including so - called wrong way risk. this is the risk that the exposure increases as the counterparty ’ s credit quality deteriorates, as we saw in the monoline sector. in addition, basel ii has in place a variety of safeguards, which also have the benefit of reinforcing supervisors ’ objectives to strengthen risk management and market discipline. let me say a few words about some of basel ii ’ s safeguards. • for example, banks will have to continuously improve the quality of their internal loss data. basel ii requires that banks have at least five years of data, including a downturn. our quantitative impact study work showed that this will raise the bar from current practice at many banking institutions. • another safety measure is the requirement for banks to estimate their recovery rates assuming a downturn in the credit cycle. this will reflect up front in capital that losses on liquidated collateral will be greater during stressful periods. • in order to use basel ii ’ s advanced approaches, banks will have to demonstrate robust data management and firm - wide aggregation capabilities. • the requirement for banks to perform stress tests of their on - and off - balance sheet exposures is an additional safeguard. based in part on these stress tests, banks will need to demonstrate to supervisors that they have adequate capital cushions to manage through a down cycle. • finally, banks will have to provide much better transparency to the market about the range of exposures they hold, including to securitisations and conduits. taken together, these measures will introduce a more rigorous, forward looking perspective on the types of risks that banks could face in a downturn. they will require banks to factor these risks into minimum regulatory capital, internal capital planning and disclosures to the market. supervisors will reinforce these disciplines by assessing banks ’ risk management, measurement and capital before capital ratios fall below the minimum requirements. this will help change incentives to anticipate risks and potential losses and to hold commensurate capital ex ante. in sum, all these efforts recognise the fact that banks ’ business models and associated risks have gotten increasingly complex, and that there is no longer one simple measure that can capture them and stand the test of financial innovation. indeed, the framework, through its three pillars and various safeguards, provides multiple perspectives on a banks ’ risk taking, ensuring that there is no over reliance on any one measure. lessons from the recent turmoil