For anyone interested, the details of these reports are available on the website of the BIS. Before turning to capital adequacy issues, I would like to highlight some key elements from two recent papers on sound practice. In July, the Basel Committee issued for comment a report on the management of credit risk. This is a particularly important topic since the major cause of serious banking problems continues to be directly related to poor practices regarding credit risk management. A key focus of the report is on the need for banking organizations to develop an overall business strategy for credit risk that incorporates the tolerance for risk and the level of profitability the bank expects to achieve from incurring various credit risks. A strategic approach to credit risk provides a coherent framework for practices in such areas as credit-granting criteria, credit limits, and credit risk monitoring. The Basel Committee issued a second paper in September that addresses the subject of corporate governance in banking organizations. As you know, corporate governance, especially the role of boards of directors, is of particular interest in this country. More intense competition, rapid change, and increased complexity in many business activities mean that responsible and independent oversight by boards of directors plays a more crucial role in ensuring that the firm’s business strategy is sound and its leadership effective. I am convinced that the need for strong corporate governance is equally great in emerging market countries, where banks and other financial institutions face comparable pressures.
While the 1988 Accord was a milestone achievement, its simple risk-weighting scheme has had difficulty incorporating innovations in the way banks today manage and mitigate credit risks. More fundamentally, the 1988 Accord does not adequately differentiate among degrees of credit risk. As a result, banks have had incentives to take on higher risk exposures within each of the Accord’s broad risk categories. Banks have also tended to engage in transactions that lower capital requirements without reducing economic risk. The effect of these developments has been to erode the significance of the Basel ratios as an indicator of a financial institution’s capital adequacy, particularly for the large, internationally active institutions which were the original targets of the Accord. To address these shortcomings in the 1988 Accord, the Basel Committee proposes two primary approaches: (1) a standardized approach that ties risk weightings to external credit assessments such as credit ratings, and (2) an internal ratings-based approach that would begin by mapping internal risk ratings into standardized risk weightings but might eventually evolve into something closer to the full use of credit risk models. Each approach treats the trade-off between simplicity versus accuracy somewhat differently and thus one or the other is likely to be relevant to banks with different levels of sophistication. Importantly, both proposed approaches attempt to introduce greater risk sensitivity into the minimum capital standards.