to base ratings and capital on a borrower ’ s position at the top of an economic cycle. operational risk use of internal ratings will of course raise many of the sorts of difficulties for testing and validation that were identified for credit risk modelling. however, we are at least talking about a reasonably well - defined type of risk and one which is quantifiable in statistical terms. we are in much more difficult territory when it comes to operational risk. the term operational risk covers a wide range of types and sources of risk, and banks ’ data bases of loss are generally patchy. there are numerous questions not only about the appropriate design of the charge, but also about the appropriate level. it is clear that some types of operational risk, such as fraud, can result in huge spikes of loss, as we saw in the case of barings and morgan grenfell. even though we are concerned with protecting the system, i feel it would be inappropriate to expect most banks to hold an additional cushion of capital to cover these sorts of very rare events : it would either be grossly excessive for most of the time, or alternatively seriously inadequate if a major problem arose. so the focus here must be on systems and controls, and on using variable target capital ratios under pillar 2 to encourage improvements in these. moreover, the appropriate level of capital will depend in part on how far we think operational losses are correlated with other types of loss which are already covered by capital. probably there are some types of operational loss - processing errors, settlement delays - which do not exhibit a high correlation with either credit or market risk. but in practice, there is clear evidence that credit or market losses put pressure on the firm, which can push managers into fraud or result in operationally - risky cost cutting. there have certainly been occasions when operational losses have only been revealed because of a market downturn or similar event. as i heard it graphically expressed the other day : “ it is only when the tide goes out that you discover who is not wearing a bathing costume ”! i am optimistic that, over time, operational risk will become more measurable and that, as was the case for market risk models, a consensus on methods of quantifying it will emerge. the basel committee ’ s framework will certainly have to be flexible in the face of this evolution. however, we should also not lose sight of the fact that the committee ’ s announced aim is not just coverage of operational risks, but “ other ”

mr clementi comments on the systemic aspects of the basel proposals speech given by mr david clementi, deputy governor of the bank of england, at a financial services authority conference, held in london on 2 december 1999. * * * ladies and gentlemen, i am delighted to be given this opportunity to address you today. i must first express my admiration for the pro - active and thorough way that the fsa is seeking views from the industry on these important proposals. i know that as well as this conference, their efforts have encompassed briefing sessions, circulars to banks, advisory group meetings, and a dedicated website. there will no doubt be a few focus groups springing up in due course! the bank of england is in turn holding regular meetings with the main trade bodies, while various of the basel committees involved in developing the proposals have conducted surveys and received presentations from banks and others. i hope that, at the end of the process, if differences of opinion remain between the authorities and the banking industry, this will be the result of rational divergence between our different perspectives, and certainly not through any failure of communication. i intend to direct my comments to the systemic aspects of the basel proposals. the bank has a close interest in this subject and i will start by outlining the relationship between the design of the regulatory system and the bank ’ s core purposes. in promoting the stability and efficiency of the financial system, we favour capital charges based on more sensitive risk measures. some argue that such measures are procyclical and add to the vulnerability of the system as a whole. i will deal with this issue before going on to discuss some features of the new proposals. in particular i will consider the pros and cons of more complex rules, the use of internal ratings and the measurement of operational risks. i will end by looking beyond the current proposals at potential new chapters for the basel accord, including the harmonisation of provisioning policies and the development of capital charges for financial conglomerates. the role of the bank of england in financial stability as many of you may know, the bank of england has three core purposes : first, to maintain the integrity and value of the currency, generally referred to as our monetary policy objective ; second, to maintain the stability of the financial system, both domestic and international ; and third, to ensure the effectiveness of the uk ’ s financial services. the bank ’ s monetary policy role is well known through the minutes of monetary policy committee meetings and the quarterly publication of the