4  BIS Review 15/2003  While there is much work still to be done at many institutions, those banks that have obtained senior management buy-in to embark on this approach have been able to move ahead fairly rapidly. In addition, these institutions have found significant value in the process of rolling out such a framework. The benefits include greater risk transparency within the firm, greater cost efficiency, and ultimately, less exposure to large losses, both in terms of dollars and additional reputational knock-on effects. Challenges for supervisors I've focused on the challenges banks will confront in implementing the new Accord. Let me now spend a few moments discussing how our supervisory approach is also likely to evolve over time. Naturally, allowing banks to rely on internal models in determining their capital requirements has led, and will continue to lead, to changes in our supervisory process. Fortunately, we do have some experience on which to draw. In 1996, under the "market risk amendment" to the original Basel Accord, qualifying banks with large market risk positions were first permitted to incorporate internal estimates of the associated risk in their regulatory capital requirements. When determining whether a bank may rely on its market risk model for capital purposes, our examiners have had to evaluate the technical underpinnings of the model, as well as the risk management and control processes surrounding its implementation and use.
This means that a credit expansion process is likely to lead to some credit quality problems in roughly that time horizon. The average duration of the economic cycle (from boom to bust) is similar. This implies that if banks only look at contemporary bad loans to determine their credit risk policies, they will restrain credit and increase risk premia in the downturn. The higher cost of funding for bank-dependent borrowers will feed back to activity, reinforcing recessionary forces. I turn now to provisions. In Spain, until year 2000, loan loss provisions were strongly pro-cyclical (as in many other countries), because they were largely linked to the volume of contemporaneous problem assets. This static provisions are backward-looking, they are based on past events. Only are accounted for loan by loan when borrowers fail to repay or in some cases when the situation of the borrower deteriorates significantly. As a consequence, the ratio of provisions to total loans fell therefore during periods of economic growth and tended to rise considerably during downturns (see lower part of Graph 3). As a result of this, the latent risk of loan portfolios was not properly recognised in the profit and loss account under the old system. In periods of economic expansion the fall in doubtful loans went hand in hand with the decrease in provisions, which in turn allowed bank managers to improve bottom-line profits.