management practices and standards under the more sophisticated approaches of basel ii will be useful for all institutions. admittedly, not all aspects of basel ii will be of use to every bank. for example, some of the quantification tools used in large complex institutions may not be necessary for the smaller and less sophisticated institutions. but, common tenets of good risk management embodied in basel ii - such as good processes to identify risks, the exercise of sound judgment to assess the extent of threats to solvency posed by the risks, and the discipline to control risks if they are disproportionately high - are equally applicable to all institutions, large or small. basel ii and financial stability one of the criticisms of basel ii is that capital cushions required under pillar 1 will tend to become more cyclical, dropping at the peak of economic cycles and increasing at the bottom of cycles when capital can be more scarce and expensive. if not addressed, this pro - cyclicality could erode the solvency cushions that banks should be holding against the effects of economic downturns. addressing this is one of the most important remaining challenges of basel ii and is particularly associated with the implementation of the more sophisticated approaches of the new capital framework. despite reassuring noises from the basel committee, this is not going to be an easy problem to address. few people, and definitely not banking supervisors, can foresee the peaks and troughs of economic cycles. but our inability to perfectly foretell the future should not be a pretext for inaction. an effective supervisory review process will be critical to create a counter - weight to the cyclical tendencies of the new capital framework, in order to prevent increased incidences of failures and financial instability. managers of banks and bank directors have an even more important role to play. they have the primary responsibility for identifying and assessing various threats to solvency of their own bank, including the risks that are partially covered or not covered at all under pillar 1 of the framework. they also need to be cognizant of the cyclicality arising from their quantitative tools and should have sufficient compensatory mechanisms against the cyclicality of regulatory capital requirements. these issues are referred to in pillar 2 of basel ii. this is what we refer to as “ supervisory car ”, to address risks not covered or not fully covered by the formulae in pillar 1. one of the biggest challenges to supervisors now is to develop more detailed guidance for the implementation of pillar 2 and to follow that guidance in a consistent

- managed institutions, with less work for supervisors and less supervisory intrusion for those deserving banks. but, idea and reality do not always coincide. so far, an immense amount of work has gone into development of pillar 1 of the framework, which contains the nuts and bolts of basel ii ’ s risk sensitive capital requirements. the result is a far more complex system than we ever dreamed we would be putting in place. but in the end, we have met the objective of creating a more risk - sensitive supervisory system for measuring capital adequacy of banks, that is better aligned with the way in which banks manage their own risks. good risk management as a competitive advantage the importance of basel ii lies not just in aligning capital adequacy requirements more closely with the way banks measure economic capital. the real payoff will be the positive impact it will almost certainly have - indeed is already having - on the risk management practices of institutions. improvement in risk management will tend to enhance the competitiveness and financial success of banks. as suggested earlier, good risk management practices allow a bank to take more risks and improve profitability. such practices foster better understanding of risks and allow the managers of banks to establish proper tolerances for the risks they assume. good risk management allows banks to weather the unexpected shocks that occur from time to time. the danger, of course, is that as risk management practices improve, a bank ’ s risk appetite may increase disproportionately. bank directors and supervisors must be vigilant against this possibility. basel i was officially implemented in 1992. main benefits of implementing basel ii improvement in risk management will materialise the risk management standards and practices embodied in the more sophisticated approaches under basel ii are real and are drawn from the best practices of large internationally active banks. they reflect many insights gathered through practical experience, including both successes and failures in risk management. even for institutions at the forefront of risk management capabilities, we think the basel ii standards will be useful. because the standards represent a comprehensive compendium of best practices, even the best - managed institutions will have to improve in some areas to take full advantage of the various approaches offered by basel ii. for institutions whose risk management practices are not leading edge, the benefits of basel ii implementation will be even more obvious. the basel ii framework contains many useful lessons and can serve as a good roadmap on how to improve internal risk management. with the exception of small banks with relatively simple business models, the risk