integrated response by irb banks. focusing irb efforts in a compliance unit that seeks to meet the letter but not the spirit of the irb standards will not be welcome. the details of what we will expect are, of course, still being developed. based on our discussions with banks thus far, areas of special attention may include the breadth and depth of internal audit and loan review and the consistency and timeliness of internal ratings. the overall supervisory review process is likely to be familiar : verification of internal processes and procedures, coupled with some degree of transaction testing. the overarching goal will be to assess the effectiveness of a bank ’ s processes and systems in achieving sound risk management and adherence to irb standards rather than to dictate the particular form that internal checks and balances must take. supervisors will also carefully review the manner in which loss characteristics are estimated and the estimates themselves – such as the probabilities of default, the losses given default, and the exposures at default – that are provided by irb banks. this is an area where supervisors have not tread very often and with many open issues. the issues include the suitability of internal and external data sources, the appropriate historical period to use in producing estimates, and the manner in which historical data and loss estimates should be linked to the bank ’ s current exposures. these and other issues will be challenging and will rightly occupy much of our attention over the coming months and years. in this context, the industry and supervisors must work together to develop and use reasonable standards for irb quantification. neither we nor banks can afford a “ race to the bottom ” in this critical area. the expertise of the rma will be particularly sought and appreciated. supervisors obviously have a lot of work to do. we are at the very beginning of efforts to train our staff to understand all of the issues raised by basel ii and to make sound judgments about banks ’ adherence to the standards. i hope you will be patient with our examiners as they come up to speed, just as we intend to be patient with you. and you should not interpret my earlier remarks as a signal that we intend to be very inflexible. we recognize that many systems, methods, and organizational forms can satisfy the spirit of the irb standard, and that what is appropriate for one bank may not be appropriate for another. we expect and welcome variety, in part because that is necessary to support further innovation. and innovation is absolutely necessary.

##quities of many other industries, and one conventional explanation for this is that banks are quite opaque. it has become increasingly clear that investors cannot easily know the level of risk they are acquiring with any particular bank equity position. when it comes to assessing share values, uncertainty can often breed doubt : it seems reasonable to expect, as a long - run proposition, that more - accurate market valuations of bank equities will follow better disclosure. the three pillars discussed in the basel consultative documents flow directly from this multifaceted view, and the rank - ordering of their importance in the long run is not indicated by the number of pages devoted to each in the consultative documents. in the long run, the supervision pillar remains critical, but the supervision must be even more risk - focused and increasingly concerned with validating systems. line supervisors will evaluate the quality of risk management and examine the adequacy of the risk measures. without good supervision, the other pillars cannot stand. for example, accurate internal risk - based ( irb ) inputs are surely crucial to obtaining reasonably accurate regulatory measures of capital adequacy. and the market will not believe or use risk disclosures unless it believes that the underlying risk measures, like ratings and the probabilities of default, have been validated. thus, supervisors must validate the risk measures to support both capital regulation and market discipline. market discipline will become increasingly important. given informative and comparable disclosures of internal risk measures, the market will react more quickly and appropriately than any regulator to variations in risk postures, and such responses will help banks strike the right balance between risk and reward. formal capital regulation is the most familiar of the three pillars, and the one to which the most pages are devoted – no doubt because it, by definition, contains more “ rules ” that must be explained. capital ratios will serve as a trigger for corrective actions for banks that get into trouble. projecting ahead many years, better risk management may mean that troubled banks will be far fewer than they have been historically. ideally, the three pillars will work in an integrated way to strengthen banking systems. nonetheless, during the transition to a working basel ii, we may have to lean on capital regulation more than we hope to in the long run. in navigating that transition, our overarching goal should be to advance the practice of risk management and encourage its wider adoption. and we all should accept that a lot of work remains both for banks and for supervisors.