jaime caruana : the basel ii initiative remarks by mr jaime caruana, governor of the bank of spain and chairman of the basel committee on banking supervision, at the iif spring membership meeting, madrid, 31 march - 1 april 2005. * * * i would like to begin first by thanking for his kind introduction. it is an honour for me to participate once again in an event sponsored by the institute for international finance. it is doubly a pleasure for me to do so here in the city of madrid. although the title of this session is “ regulation and consolidation in the financial industry ”, i will not speak about consolidation in my intervention, because i believe that the role of the banking supervisor in such issues is minor compared to the role of the market. structural changes in the financial sector, such as consolidation, should, in my opinion, be market - driven phenomena that respond to market needs - such as economies of scale, it synergies, the benefits of diversification, gaining access to a larger client base, etc. this is particularly relevant in the eu context, where we are aiming for a truly single market. in this respect, i support all the steps the commission is taking to remove remaining internal barriers and restrictions in pursuit of this goal. the banking supervisor ’ s role in issues related to consolidation is tightly defined by both the letter and spirit of eu banking legislation. our task is confined to ensuring that structural changes do not undermine the soundness and “ supervisability ” of banking institutions, and that bank shareholders are suitable. so, with this in mind, let me turn to the main topic that i would like to discuss, which is the basel ii initiative. when the iif met in madrid last july, the basel committee had just released the text of the revised capital framework. the publication of basel ii marked a critical milestone in our efforts to improve the risk - sensitivity of bank capital requirements while providing incentives to strengthen the quality of risk management. i think that on this occasion the meeting of the iif has been preceded by another milestone in our work in relation to the new capital framework. a successful meeting of the basel committee concluded yesterday. among other things, we dealt with the double default and trading book issues, on the basis of the work undertaken in close collaboration with the international organization of securities commissions. i think this teamwork between iosco and bcbs can also be perceived as a landmark in the area of cooperation among supervisors. let me therefore start

individuals, circumstances differ hugely. young people starting out in the housing market probably always will borrow a large proportion of the price of their first house, and a large amount relative to their current income. such loans are risky for the individual borrower if bis central bankers ’ speeches something goes badly wrong. but for a well - managed bank ( and for the economy as a whole ) higher risk loans like those will typically be balanced with other loans which have gradually been being repaid for 20 or 30 years. for whole economies, “ too much ” debt can cause problems. but researchers are not really sure quite what is “ too much ” ( among other things, measurement and institutional differences complicate things ). historically, a much better indicator to watch out for has been large increases in debt ( relative to incomes ) for several years in succession. as reinhart and rogoff have documented, financial crises are often followed by tough economic times. but even without a financial crisis, periods of rapid increases in debt tend to be followed by periods of economic stress – recessions that last longer and prove more troublesome than a “ plain vanilla ” recession, in which any lost output is recovered very quickly ( new zealand ’ s mild 1998 recession might have been an example of that sort of recession ). there are good reasons why a large and rapid increase in debt ( to gdp ) seems to matter. debt is not taken on in a vacuum. people are readier to take on debt when they are relatively more optimistic than usual about the future. banks are keener than usual to lend when times feel good. and people make choices, re - organise their balance sheets and their spending patterns on the basis of that heightened optimism. any number of factors, often at least a couple in combination, can result in a credit boom getting started. countries ’ experiences differ on that score, even in the most recent boom. but, typically, something causes spirits to lift, and with them spending and business activity. people become more willing to take the risk of buying a house or farm, of consuming more of their incomes than previously, or of expanding a business. once credit is growing rapidly, the process tends, for a time at least, to be self - reinforcing. easy credit tends to lift asset prices ( strengthening expectations of further price increases ), and people feel wealthier as a result. experience tends to confirm people ’ s initial heightened sense of optimism. expectations of future incomes are revised up and people make