and lending growth, and that the impact of higher capital levels on lending may be especially significant during a stress period6. imf analysis indicates that banks with stronger core capital are less likely to reduce certain types of lending when impacted by an adverse funding shock7. and our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements. these banks are less likely to cut lending aggressively in response to a shock8. these empirical results are intuitive and accord with our supervisory experience, namely that a weakly capitalised bank is not in a position to expand its lending. higher quality capital and larger capital buffers are critical to bank resilience – delivering a more stable system both through lower sensitivity of lending behaviour to shocks and reducing the probability of failure and with it the risk of dramatic shifts in lending behaviour. the capital adequacy framework has made much needed progress in recent years. the framework is now being designed to be fit for purpose both for the micro - prudential purpose of each firm ’ s safety and soundness, and for the macro - prudential purposes of addressing the risk certain major firms individually present to financial stability and the risk that imbalances building up in the sector as a whole, or part of it, may threaten financial stability. the key elements of the framework are : - first, a common definition of capital resources focussed on genuine loss absorbency in a going concern – common equity tier 1. in doing so, we must define robustly the boundary between going and gone concern loss absorbency ; - second, a framework for capital which comprises minimum capital requirements and capital buffers, with the buffers varying in size depending on a bank ’ s size and the nature of its activity and risk, and varying through the cycle ; - third, using a combination of different approaches to assessing capital adequacy – risk - based approaches, stress tests, and a leverage ratio ; - fourth, within the risk - based approach, striking a balance which recognises the potential benefits of firms ’ internal models while guarding against their weaknesses and the incentive problems they create. a major principle of the new framework is that there is no single “ right ” approach to assessing capital adequacy. the very important role that is now given to stress tests illustrates the point. this year the pra and fpc are running their first concurrent stress tests for the major uk banks, building on the past development by the fsa

is hugely important. the leverage ratio is simple and that is its appeal, but on its own it could encourage banks to take more risk per unit of assets. in contrast, internal models and stress tests are complicated, and therefore carry the risk of opacity and model error. there is now a growing debate on the use of models and stress tests. in many respects, the debate has common ground, since models are intrinsic to stress tests. my view is that this is not a debate about whether or not supervisors should use models. that question was answered a long time ago in the reasoning for the switch away from basel i. the design and implementation of basel ii was not done well, and a substantial charge has been required. a major lesson is that to use models and stress tests effectively requires intensive development and maintenance by firms and a highly skilled body of supervisors and a regime where judgement can be used. it also requires the supervisor to have a credible capacity to withdraw the permission given to a firm to use a particular model if the model is considered to be inadequate or the firm has not demonstrated the capacity to use it safely. in another case, the supervisor could withdraw permission for whole types of models, as the fsa / pra did for the commercial property models of uk banks by requiring a substitute “ simple slotting approach ” to be used – which is still a model, but a very simple one. then i think the debate becomes more around whether the relevant risks can be modelled, how easy it is for supervisors and firms to observe the performance of models, and the ability of supervisors to police the performance of models. none of this is easy. there is also a very good question around whether supervisors should supplement the use of firms ’ models by developing their own models. in the us, the federal reserve has gone down this road, and in doing so advanced their use of stress testing. so far, we have gone down the road of pushing banks to improve their models, and to be more realistic about what the models can and cannot do. my guess is that we may eventually end up with greater international convergence of supervisory approaches on the use of models, and that would be a good thing in terms of more efficient supervision and use of our scarce resources. but i would note that today i have an open mind as to where that convergence will lead to in terms of the capital adequacy regime. much of this speech has been about the incentives in the regime of capital adequacy