the alternatives to strengthening risk management are limited and not very attractive : prohibitions on activities or very intrusive supervision and regulation. bank managers and stakeholders, as well as those who believe in the market process, have an important stake in making basel ii work because the alternatives to it are so unappetizing. pro - cyclicality some observers grant the desirability of better risk management but have voiced concern that a set of rules for risk - sensitive capital requirements still will be excessively pro - cyclical. they argue that as banks re - evaluate the probabilities of default and loss over a business cycle, regulatory capital requirements will fall in booms, as risks are perceived to be low, and increase in recessions, when pessimism replaces optimism, aggravating the underlying real economic cyclical pattern. better risk management, these critics seem to be saying, will make the world less stable. let me stipulate that a regulatory structure based on formal risk - management techniques will imply, to some degree, a cyclical pattern of minimum regulatory capital requirements, exactly like the internal pattern of economic capital needs at a bank using modern risk - management techniques on its own. the question is : is that a bad or good thing? to begin to address that question we first have to recognize that risk itself is not constant over time but, in fact, varies cyclically and in other ways. regardless of how we construct our capital requirements, at times the same portfolio of loans will face more or less risk over the relevant planning period than at other times. we have a choice : we can decide to ignore that reality or recognize it. the current capital regime chooses the former option by default - risk categories are insufficient to recognize changing risk ; less information about reality is conveyed by the capital requirements, facilitating both the banks'and the supervisor's failure to respond to the underlying changes. the proposed basel ii, in contrast, conveys to managers, to supervisors, and importantly, to the public how risk changes as capital requirements respond to changes in the real underlying risk. a sufficiently risk sensitive capital regime will impart timely information regarding risk. that, in turn, will allow adjustments in lending policies sufficiently early to limit excessive swings in lending behavior. risk sensitivity in capital requirements can damp swings in credit availability, reducing both credit sprees and credit crunches. from a supervisory perspective, it seems clear that we prefer - or at least, ought to prefer - the regulatory capital ratios that convey more

requirements that would otherwise occur without the better risk - management techniques required under the proposed basel ii. the response to more formal risk management thus creates the reasonable prospect of reducing concerns about the pro - cyclicality of capital ratios under basel ii. in the past, problems have arisen when banks have been too complacent in their judgments of risks during good times, too slow to react when the situation turns, and too risk - adverse once their losses have turned out larger than anticipated. a process that encourages banks to think more carefully and more pro - actively about all of these possibilities offers the hope of a significant improvement in the way that they manage themselves over the course of the business cycle. along these lines, basel ii emphasizes the importance of stress testing credit - risk measurements. stress testing as a means for considering how risk assessments and capital requirements can change as the economic environment weakens is a necessary part of the broader shift toward a more proactive approach to risk management. bank managers should consider the results of their stress testing when determining how much capital they need to hold above the regulatory minimum requirement, which is after all only a portion of the total capital held. indeed, to facilitate flexibility and to enhance their competitive positions with counterparties, banks will continue, even after the basel ii proposal becomes effective, to carry a buffer stock of capital - an amount above their regulatory minimum. however, under the proposal, the supervisor will incorporate stress testing as a factor in the assessment of how much buffer capital should be held. as part of the second pillar of basel ii, supervisors will discuss the results of the stress test with bank management to ensure that the banks take seriously their need to consider the dynamic management of their capital over the economic cycle. operational risks my comments have focused on risk management and the cyclicality of a risk - sensitive capital regime. but thus far i have emphasized the major risk that most banks face - credit risk. at times, however, other risks have proven to be quite costly - sometimes fatal - to banks. in my view, therefore, a discussion of risk management is incomplete without a consideration of operational risk. from a bank's and a supervisor's viewpoint, no matter how real and serious operational risk may be, it is, with the current state of the art, not easy to measure. thus, the basel committee's proposal to apply an explicit capital requirement under pillar i to operational risk has been controversial. against that background, reviewing the committee's thinking that led to