jaime caruana : what ’ s next for basel? remarks by mr jaime caruana, governor of the bank of spain and chairman of the basel committee on banking supervision, at the “ basel ii : reality check ” conference, sponsored by financial times business and the banker magazine, london, 10 november 2004. * * * 1. introduction and overview i would like to thank the banker magazine and the financial times business for inviting me to join this important discussion today on the practical implications of the new capital framework for banking organisations. it is an honour to represent the basel committee on banking supervision at this event. the organisers have selected a provocative and highly appropriate title for this conference. as i will discuss this morning, the “ real ” reality checks for basel ii lie just ahead. basel ii ’ s effectiveness in encouraging improvements in risk management, and in motivating banks to hold adequate levels of capital, will depend principally on the degree to which it reflects the true risks and rewards facing banks. that is the focus for banks and supervisors now as we work toward the implementation of the new framework. will basel ii be effective in promoting sound risk management? i am confident that the answer is yes on at least two levels. on the microeconomic level, i believe that basel ii will help to increase the rigour and comprehensiveness of an individual bank ’ s decision - making. as i will explain in the first part of my remarks, the three pillars of basel ii introduce a coherent system of checks and balances - or perhaps reality checks - into the supervision of capital. basel ii will likewise contribute to the resilience of the banking system on a macro level. in the second part of my remarks, i will discuss some of the factors that suggest that basel ii will more broadly become an effective tool of public policy. of course, for basel ii to be effective at the micro and macro levels, we will need to undertake considerable work in the months ahead to prepare for its consistent implementation. in the third and final part of my presentation today, i ’ d like to share an update on what supervisors are doing currently to prepare for the implementation of the new capital framework. i ’ ll include as well some thoughts on additional things that banks can do to promote a smoother transition to the new framework. 2. will basel ii promote sound risk management within individual banks? to begin, i would like to discuss why i believe that basel ii will promote reasonable and realistic decision - making on a microeconomic

to make decisions for the uncertainty of the future. likewise, some banks may engage in unique activities that are not captured in the minimum standards. to guard against overdependence on quantitative models, we have included qualitative provisions to ensure that strong risk management and internal controls are adopted throughout the organisation and to ensure the involvement of boards and senior management. the new accord also stresses the importance of independent assessments and audits. on top of that, and to ensure that banks are evaluating all of the risks they face, the basel committee has incorporated two other reality checks into the new framework, namely pillars 2 and 3. pillar 2, supervisory review, requires each bank to apply its best human judgement to capital planning. every bank is responsible for assessing its own capital needs, including whether any activities or exposures may incorporate more risk - and hence may require more capital - than is assumed in pillar 1. supervisors, in turn, must evaluate the bank ’ s judgement and processes ; moreover, they must respond if any bank ’ s capital planning seems unrealistic. similarly, pillar 3 - market discipline - provides another external check by offering greater insight into a bank ’ s risk profile to investors, counterparties, rating agencies, and others. marketplace participants are then better able to assess whether a bank ’ s management is engaging in the reasonable and responsible pursuit of opportunity and profit. they are better able to reward companies that are well managed and to penalise those that are not. that, in turn, encourages all banks to consider their current risk exposures carefully and to make appropriate plans for risks that may be on the horizon. let me also briefly take this opportunity to recall that the new framework also imposes principles of transparency on supervisors as well as on banks. pillar 2 requires supervisors to carry out their obligations in a transparent and accountable manner, for example making publicly available the criteria they use in the review of banks ’ internal capital assessments, and explaining to banks why any remedial actions are considered necessary. so we see transparency as an effective tool and reality check for ourselves too. the three pillars together can thus be seen as a series of checks and balances that seek to promote reasonable and realistic approaches to risk management and to capital management in banking organisations. the efforts that banks take to identify and assess their risks rigorously, and to evaluate and implement measures necessary to protect themselves effectively, represent not just good steps toward maintaining capital adequacy, but also important steps toward improved corporate governance on a