By requiring strong internal standards as an entry criterion, the Basel II approach will ensure that these banks adopt structured, formal, empirically based methods of managing credit risk, which will lead to significantly improved risk-management capabilities at the very largest banks and other adopters. Capital requirements themselves will become more risk sensitive and less prone to artificial distortions.
The poor incentive structure of Basel I will be removed for A-IRB banks. Supervisory practices will also become more consistent with evolving risk-management practices. Risk-based capital ratios will become more reliable as an indicator of financial strength. I turn now to another aspect of Basel II: its three pillars.