adequacy is not on favourable or benign economic conditions, or on the " expected " losses that occur as a normal part of banking business those matters should be addressed through provisioning. rather, the focus is on unexpected loss associated with severe downturns in the economy's performance. " stress testing " for such scenarios is required under basel ii, and the scenarios need to account fully for the behaviour of systematic risk. for example, stress scenarios should address the risk of a downturn leading borrowers'risks to correlate more closely, undermining the diversification strategies rightfully adopted by banks to manage risk in normal times. experience shows that downturns in the housing market do happen and can cause significant losses to banks and to the financial system as a whole when they do. the reserve bank will be working to ensure that any internal models used by an accredited bank produce capital estimates that are based on " through the cycle " loss experience - that is, after adjustment for the peaks and troughs in observed losses that occur over the business cycle in new zealand. notwithstanding this emphasis on through - the - cycle loss experience for the purposes of internal modelling, it will also be important to ensure that capital management processes in practice deliver fairly stable capital outcomes through the business cycle. for example, a failure to adjust fully for the business cycle when incorporating loss experience into modelling processes could lead to capital falling during upturns in the cycle and rising during downturns, which would exacerbate the cycle through promoting lending growth during upturns and lending contraction during downturns. capital settings should be for the long haul, and need to be robust over many business cycles and through a range of economic circumstances. an important outcome we will be seeking from our basel ii implementation is that the capital management processes within banks ( both those using internal models and those using standardised approaches ) ensure that adequate " buffer " capital is always held in anticipation of any need to manage any residual " procyclicality " in the outputs of internal modelling processes. as well as making minimum capital requirements more risk - sensitive, basel ii also includes the principle of sharpening the focus of engagement between supervisors and banks on ensuring that a bank's capital management process adequately accounts for the risk of unexpected loss. the quality of this process and the manner in which the outputs from internal models are used within the bank's governance and risk management more generally will be a key part of the assessment for a bank

wishing to be accredited to use the internal models approaches. the bank will need to satisfy the reserve bank both that its internal models and processes are of adequate quality, and that the use of internal models is incorporated into the bank's risk management framework with appropriate knowledge and oversight, to be accredited. our programme of engagement with banks on basel ii is well underway, focusing in particular on the banks intending to apply to use the internal models approaches, because of all the reasons set out earlier. such banks are themselves devoting a large amount of resources to their applications, and to planning for the use of the internal models approaches, should they be accredited to do so. these large resources devoted to basel ii implementation, as well as the significance of the banks applying to use the internal models approaches, both reflect and underscore the need to get it right. this should not be taken to mean that we are leaving aside those banks that expect to be on the standardised approaches. as well as working on the internal models approaches, we are also well underway with proposals for the implementation of the standardised approaches and will be enter into discussions with the industry on these also over this year and next. in this part of the work, a key outcome we will seek is the preservation of competitive neutrality between banks using internal models and those using standardised approaches. because most banks in new zealand are parts of international banking groups, we will be communicating and coordinating the new zealand implementation closely with relevant foreign supervisors. also, it is only natural that banks owned by foreign parent banks should seek to base any internal models for new zealand capital on models developed within their parent banks. however, where this is the approach taken, the new zealand banks will still need to satisfy the reserve bank that those models are appropriate for new zealand circumstances. in our coordination with foreign supervisors, engagement with the australian prudential regulation authority ( apra ) will clearly be particularly important, because of the significant place in new zealand's banking system of banks ( including the four major banks ) owned by australian parent banks. already, we and apra have put in place terms of engagement to ensure that communication flows well between us. for banks with operations in both new zealand and australia, under the terms of engagement we will work with apra to ensure that in meeting our responsibilities to set capital requirements for the new zealand subsidiaries, we will keep compliance costs to the minimum necessary, consistent with new zealand capital requirements being tuned to new zealand conditions. we will do