The Committee seeks to align minimum capital requirements more closely with the best industry risk management practices available. This goal is accomplished by giving banks a range of increasingly sophisticated options for calculating capital charges. Banks will be expected to employ the capital adequacy method most appropriate to the sophistication and complexity of their operations and risk profiles. For credit risk, the range of options begins with the standardized approach and extends to the internal ratings-based (“IRB”) approach. The standardized approach is similar to the current Accord. Banks will be expected to allocate capital to their assets based on the risk weights assigned to various exposures. It improves on the original Accord by weighting those exposures based on each borrower’s external credit risk rating. Without question, the IRB approach is a major innovation of the New Accord. For the first time, banks will be permitted to rely on their own assessments of a borrower’s credit risk. The close alignment between the inputs to the regulatory capital calculations and banks’ internal risk assessments will facilitate a more risk-sensitive approach to minimum capital. Changes in a borrower’s credit quality will be directly reflected in the amount of capital held by banks. How will the New Basel Accord promote better corporate governance and strengthened risk management practices? Here, I will limit myself to emphasizing two key points. First, the Basel Committee has expressly designed the New Accord to provide tangible economic incentives for banks to adopt increasingly sophisticated risk management practices.
The rotation from net asset purchases towards our conventional monetary policy instruments, together with our stock of assets and the related reinvestment policy, ensure an ample degree of monetary policy accommodation. In particular, our enhanced rate forward guidance provides a strong anchor for policy rate expectations. And the reinvestment policy will ensure that the favourable liquidity conditions and duration extraction associated with the large stock of assets on our balance sheet remain in place for a long period and thereby exert downward pressures on term premia. The mechanisms underlying the combination of instruments are duration extraction, liquidity creation and expectation management. Starting with duration extraction, our reinvestment policy implies that the bonds we have purchased will remain on our balance sheet for an extended period of time after the end of net purchases. Asset purchases affect interest rates mainly through the market price of duration risk, which is the interest rate risk borne by price-sensitive investors holding long-term bonds. If the central bank wants to exert downward pressures on long-term interest rates, then it can absorb duration risk from the market by purchasing securities with a relatively longer maturity. This frees up more risk-bearing capacity for investors, which they can re-allocate towards other types of risk, including investment in productive capacity. For a central bank to set this mechanism in motion, it needs to hold a large portfolio of long-dated securities embodying duration risk. Chart 5 shows that we have built a sizeable portfolio estimated at around 20% of the duration-equivalent stock of public debt.