I expect that this dynamic process will accelerate through work within the AIG, with supervisors outside of the Committee, and by banks in the months and years ahead. Risk management and complex products Our response to changes in risks must also be dynamic, and it is to this aspect that I would like to turn now. In recent years, we have seen tremendous growth in the derivative markets, which include a range of quite complex products. In addition, these markets have attracted new participants, in particular hedge funds, whose risk profiles and exposures may not be transparent to regulators or to other market participants. While these developments have had the beneficial effect of diversifying and spreading credit risk, they have also posed new risks. I would like to briefly discuss steps that both supervisors and the industry are taking to promote better management of these risks, and to ensure that supervision keeps track with market developments. Supervisory efforts One important area where we are working within the Basel Committee to promote sound risk management practices is through a review and, if necessary, update of the Committee’s 1999 paper on sound practices for banks’ interactions with highly leveraged institutions. As part of this review, we are looking at emerging best practices related to banks’ interactions with credit derivatives markets and hedge funds. In addition, we have had informal discussions regarding the potential impact on bank safety and soundness of prime brokerage activities.
Lessons learned That brings me to my second broad topic, which is the lessons we have learned over the years as we have developed Basel II. I am not looking back simply for the sake of nostalgia. Rather, in looking to the past, I would like to share some thoughts on how the things we have learned and reflected in the process of developing Basel II will help to make Basel II successful in the future, to stand the test of time and to have the impact that we intended. Focus on risk management First, Basel II is fundamentally about establishing incentive-based approaches to risk and capital within the three-pillar framework. We should never lose sight of the fact that Basel II is built around both qualitative and quantitative risk management elements. Why is this so important? As a bank supervisor and central banker, what most concerns me is financial stability. When I review the various reports on this subject that cross my desk, one thing they almost always have in common is an emphasis on the link between sound risk management and financial stability. It is my hope—indeed, it is my belief—that the incentives for risk management in Basel II will therefore promote greater financial stability in the future. Improved and more formalised risk management, as fostered by Basel II, will bring more awareness of risks and better quantification of these risks. To the extent that risk assessment and control methods become more formalised and rigorous, this will lessen the likelihood of making bad decisions.