Supervisory review of capital Supervisory review and market discipline are two other elements that can create incentives for responsible behavior, and are of such importance to contemporary supervisory thinking that they have also been adopted as two of the three "pillars" of the Basel Committee’s proposal to revise the international standards on bank capital requirements. There’s been a good deal of public discussion about the first pillar, in which the Committee recommended changes to the guidelines that set minimum capital requirements for banks. Tonight I will concentrate on the importance of the other two in promoting financial stability. Adequate capital is, of course, the foundation of a safe banking system, as it provides banks with a "cushion" against unexpected losses. Supervisors aim to ensure that banks set aside sufficient capital relative to the underlying risks that each institution faces, including whether the banks are addressing the relationship between different kinds of risk. This will be no easy task, as banks under the new Capital Accord will increasingly rely on their own internal models to determine the kinds of risk they face and to what degree. The Basel Committee proposed that supervisors review the methodologies through which banks set their capital levels to ensure that banks have an incentive to develop effective processes for aligning their capital levels with their risks.
In the United States, the risk-focused approach that the Federal Reserve and other bank supervisors have adopted over the past five years allows us to tailor a supervisory plan appropriate for each bank. This marks a radical shift in the way that we evaluate a bank’s condition in the United States. Rather than reviewing mainly the quality of individual loans and other items on a bank’s balance sheet, for example, our bank examiners now try to identify the most important risks to which each bank is exposed – and then determine whether bank management employs robust processes to control those risks. This is a much more "top-down" approach to supervision, as we are evaluating the integrity of the managerial process in a bank rather than only testing the strength and quality of individual transactions. This helps us to determine whether a bank that is healthy today will continue to be so in  2  BIS Review 35/2001  the future. I’m pleased to note that banks have welcomed this change in approach, as we have enhanced our ability to compare the quality of one bank’s control structure to those of other banks that face similar risks. We thus are better able to share our views of the "best practices" we see in industry risk management.