sound risk - management systems the foremost challenge facing the banks in implementation of basel ii is to develop well - functioning, efficient and integrated risk - management systems. while the treatment of market risk remains the same under basel ii, banks need to strengthen their risk - management systems to properly define and assess credit and operational risks and to recognize the inherent interdependence of such risk. to capture credit risk under irb, banks will have to generate exposure data and calibrate it properly to differentiate between borrowers ’ default risks – a complex task in developing countries given the level of industry expertise, lack of historical data and absence of adequate technology. most challenging is estimation of operational risks since most banks do not have required systems and technology to calculate operational risk or determination of capital standards. by increasing the sophistication of the operational risk assessment and management processes, banks can save on capital charge for operational risk. to strengthen risk - management systems, banks and supervisors invariably require capacity building both in terms of human and technology resources to enable them to properly assess the risk - profile and associated capital requirements. supervisors and banks will have to achieve synergies in their operations to meet the high demands of pillar ii. asymmetry in supervision when different market participants are regulated by separate supervisors, it is difficult to maintain comparable quality of policy formulation and vigilance. the asymmetry of regulatory regime can arise within one country e. g. between banks and securities firms, as well as on cross - border level. the basel accord provides an opportunity for developing common standards ; yet it requires a much closer cooperation, information sharing and coordination of policies. in many developing countries, only the banks are coming under the ambit of basel ii and not other financial services providers, thus creating some scope of regulatory arbitrage. 6 the presence of a large number of internationally active banks in the region requires close cooperation among supervisors across the globe to resolve the home - host issues. it would become all the more important for the jurisdictions where the approaches for basel ii would differ. imperfect markets the functioning of risk assessments system of banks is affected by distortions in markets namely dominance of large players, high asymmetry of information, and lack of market depth. the price manipulation by significant market players can distort the true market value of securities ’ portfolio. to make any meaningful assessment of market risk and encourage market discipline, the imperfections have to be removed from the financial markets. the regulator should have the capability to assess

loss resulting from inadequate or failed internal processes, people and systems or from external events ” risk. this definition includes legal risk, but excludes strategic and reputational risk. three approaches underlie measurement of capital against operational risk : ( i ) basic indicator approach ( bia ) – capital for operational risk should be equal to the average over the previous three years of a fixed percentage ( denoted alpha = 15 % ) of positive annual gross income, ( ii ) standardized approach capital charge for each business line is calculated by multiplying gross income by a factor ( denoted beta ) assigned to that business line. beta ( ranging between 12 - 18 % ) serves as a proxy for the industry - wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line ; and ( iii ) advanced measurement approach - the regulatory capital requirement will equal the risk measure generated by the bank ’ s internal operational risk measurement system using the quantitative and qualitative criteria for the ama. overall the approaches for operational risk assessment are not as nuanced as for credit risk, however the ama approach does allow for more fine tuning. once again the banks with better risk assessment would opt for the advance approaches. market discipline pillar underscores need for transparency and disclosure of data and technicalities. the evaluation of banks ’ risks and its systems and capital adequacy by the market will help ensure integrity and validation of other pillars. for this pillar to work, it needs to be supported by proper accounting rules and more elaborate disclosure of bank ’ s strategies and approaches adopted, risk profile and capital strategy through economic and credit cycle, information of the stress tests, and pd / lgd data. fourth, within the pillars, the accord offers a range of options and incentivizes banks to move from vanilla sa which assigns high risk weights and capital standards to adopting irb and within it further having the option to choose either the foundation versus advanced irb. these options have clear trade offs but most importantly, irb offers greater capital relief relative to sa. nevertheless, irb systems will only be feasible if they are supported by databases and history on credit losses, rating models and risk management systems etc. and their soundness and integrity has been validated by supervisors. banks operating in less developed countries, having limited in - house expertise, and small to medium size are in general opting for sa. the advantage of sa is its relative ease of implementation by even small and