the g10 countries for the first time to use a common yardstick for measuring the capital adequacy of banks. while the 1988 accord was a milestone achievement, its simple risk - weighting scheme has had difficulty incorporating innovations in the way banks today manage and mitigate credit risks. more fundamentally, the 1988 accord does not adequately differentiate among degrees of credit risk. as a result, banks have had incentives to take on higher risk exposures within each of the accord ’ s broad risk categories. banks have also tended to engage in transactions that lower capital requirements without reducing economic risk. the effect of these developments has been to erode the significance of the basel ratios as an indicator of a financial institution ’ s capital adequacy, particularly for the large, internationally active institutions which were the original targets of the accord. to address these shortcomings in the 1988 accord, the basel committee proposes two primary approaches : ( 1 ) a standardized approach that ties risk weightings to external credit assessments such as credit ratings, and ( 2 ) an internal ratings - based approach that would begin by mapping internal risk ratings into standardized risk weightings but might eventually evolve into something closer to the full use of credit risk models. each approach treats the trade - off between simplicity versus accuracy somewhat differently and thus one or the other is likely to be relevant to banks with different levels of sophistication. importantly, both proposed approaches attempt to introduce greater risk sensitivity into the minimum capital standards. in my view, it is essential that we move forward in this fashion in order to enhance the responsiveness of required capital to risk and to address the unfortunate incentive problems that have evolved from the 1988 accord. because of the committee ’ s desire to produce a capital adequacy framework with a greater sensitivity to risk, some observers may note that we inevitably introduce a dynamic element into our standards. that is, the capital requirements for loans to troubled borrowers will tend to increase at just the point when such trouble is becoming apparent. i see an important positive aspect to such an outcome. i would argue that the global financial system needs to become better prepared to address potential credit problems pre - emptively, before these problems have time to grow from minor disturbances into major disruptions. implementing capital standards that are more responsive to the dynamics of risk could help move us in this direction and away from a mindset that waits too long to address problems. in particular, the committee is interested in hearing views on how we should think about

these issues. the second pillar in the proposed new capital adequacy framework has to do with the supervisory review of capital, a critical complement to minimum capital requirements. the consultative paper calls on supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks and capital structure, thus moving the accord beyond a ratio - driven minimum capital standard to a comprehensive approach for assessing capital adequacy. in general, supervisors have expected and continue to expect banks to hold more than the regulatory minimum amount of capital. in proposing this supervisory review of capital, the basel committee intends to foster a more active dialogue between banks and their supervisors with respect to the actual level of capital banks choose to hold. i want to stress, however, that this proposed approach to assessing capital adequacy in no way intends to replace the judgment and expertise of bank management. nor is this approach meant to shift ultimate responsibility for the adequacy of bank capital to the supervisors. on the contrary, i believe that managers are the ones with the most complete understanding of the risks that their institutions face and it is they who must have the primary responsibility for overseeing these risks. the task for supervisors in this framework is to evaluate how well banks are assessing their own capital needs relative to their risks, including whether banks are appropriately addressing the relationship between different types of risks. to this end, the basel committee is currently developing guidance to help supervisors evaluate internal capital assessments conducted by banks. in the event that a bank ’ s internal capital adequacy process is lacking, supervisors must have the knowledge and authority to take corrective action. there can be no doubt that implementing the supervisory review of capital will require considerable insight and flexibility on the part of supervisors because they will have to tailor their efforts to the unique risk profiles of particular institutions. at the same time, this approach should allow supervisors to draw on their cross - institutional knowledge as they assess the strengths and weaknesses of a bank ’ s risk management and capital allocation processes relative to those of its peers. the g10 supervisors recognize the obvious implications that this approach will have for supervisory resources. in order to keep pace with industry innovation, it is clear that we will have to step up our training and consider effective ways for making the most use of our limited resources. the basel committee also recognizes the importance of these issues for the non - g10 countries and is working toward providing the training and other types