to go beyond simple compliance with minimum standards and perform for themselves a comprehensive assessment of whether they have sufficient capital to support their risks. in addition, supervisors should be in a position to provide constructive feedback to bank management on these internal assessments, or " economic capital ", based on their knowledge of industry practices at a range of institutions. finally, pillar iii seeks to complement these activities with market discipline by requiring banks publicly to disclose key measures related to their risk and capital positions. the concept of these three mutually reinforcing pillars has been key to the basel ii effort. pillar i : minimum regulatory capital requirements the minimum capital requirements for credit risk under the a - irb approach are built around the same concepts that underlie all modern portfolio - based methods for systematically measuring credit risk. the first, and perhaps most important, input to this approach is an estimate of the likelihood or probability that a borrower will default. second, lenders need a sense of the size of the loss in the event of a default because they are often able to recover something from a defaulted borrower's assets or from collateral or a guarantee. third, the lender, who often has an undrawn credit line or loan commitment to a borrower, needs to estimate what the amount borrowed is likely to be at the time a default occurs. these key inputs - probability of default ( pd ), loss given default ( lgd ), and exposure at default ( ead ) - are the building blocks of the a - irb approach to estimating capital requirements. many banks are currently working to improve their ability to estimate these quantities, using a wide variety of techniques from expert judgment methodologies to quantitative statistical models. a - irb permits banks to use any or all of these, requiring only that the procedure for estimating these three key parameters be based on empirical information, that it be rigorous, that it be reproducible by third parties, that the process be subject to strong internal controls, and that the results be shown to measure risk accurately. the supervisor must, in fact, validate the estimation procedures and the controls that support them before a bank can use a - irb. as part of the validation process, a bank must demonstrate that these risk measures are in fact used in credit - granting decisions, as well as for other management purposes such as reserving and pricing. the intention is for the supervisor and the manager to focus on the same issues. these estimated risk variables are inputs to regulatory

diversification and / or limited alternative funding sources, the market continues to force most banks to carry capital positions considerably in excess of regulatory minimums under basel i. for these reasons, u. s. supervisors do not believe the benefits would exceed the costs of requiring most banks to shift to basel ii. however, for the small number of large, complex, internationally active banking organizations, basel i has serious shortcomings, which are becoming more evident with time. developing a replacement to supply to these banking organizations is imperative. first, basel i is too simplistic to adequately address the activities of our most complex banking institutions. basel i categorizes each bank's assets into one of only four categories, each of which represents a certain risk class. each risk class has its own risk weight that is multiplied by 8 percent to get the minimum capital charge : zero for most sovereign debt, 20 percent of 8 percent for most intra - bank exposures and for agency securities, 50 percent of 8 percent for residential mortgages, and 100 percent of 8 percent for all other exposures. these " all other " credits include essentially all corporate and consumer loans, meaning that the whole spectrum of credit quality over which banks do much of their lending - from aaa to the most speculative credits - receives the same regulatory capital charge. the lack of differentiation among the degrees of risk means that the resultant capital ratios are too often uninformative and might well provide misleading information for banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans. moreover, the limited number of risk classes not only limits the value of the capital requirement but also creates a regulatory loophole that creates incentives for banks to game the system by capital arbitrage. capital arbitrage, in this case, is the avoidance of certain minimum capital charges through sale or securitization of those assets for which the capital requirement that the market would impose is less than the regulatory capital charge. clearly, the market believes that the 4 percent capital charge on most residential mortgages ( 50 percent of 8 percent ) and the 8 percent on most credit cards ( 100 percent of 8 percent ) is higher than the real risk, facilitating the securitization and sale of a large volume of such loans to other holders. this behavior is perfectly understandable, even desirable in an economic efficiency sense. but it means that banks that engage in such arbitrage retain the higher - risk assets for which the regulatory capital