We  BIS Review 68/2004  1  believe that improving risk management helps to increase the stability of the global financial system - a goal that would benefit not just banks, but more broadly businesses and consumers. To foster greater financial stability, the Basel Committee blended several policy approaches to replace the existing capital framework. Basel II consists of three mutually reinforcing pillars. The first pillar aligns the minimum capital requirements more closely to banks’ actual underlying risks. Many banks will rely on external measures of those risks to determine their capital requirements. These might include drawing on credit ratings issued by external rating agencies or on supervisors’ assessments of the degree of operational risk inherent in various businesses. More sophisticated institutions, in comparison, may qualify to rely partly on their own measures of those risks when determining their capital requirements, an innovation that will help to create economic incentives for banks to improve those measures. The second pillar - supervisory review - allows supervisors to evaluate each bank’s assessments of its own risks and to determine whether those assessments seem reasonable. Ultimately each bank’s own management is responsible for assessing and responding prudently to all of the risks that a bank faces, including those risks that might not be captured entirely in the first pillar. The second pillar will therefore foster a dialogue between banks and their supervisors on the nature of the risks that banks face and the measures they take to control them, including holding aside sufficient levels of capital.
That dialogue creates great implicit incentives for management to undertake careful evaluations of the bank’s capital needs. Finally, the third pillar, market discipline, recognises the power of marketplace participants to motivate prudent risk management. By enhancing transparency in banks’ financial reporting, the third pillar provides counterparties, investors, and other participants with greater insight into a bank’s risk profile; that increases their ability to distinguish and reward banks that are well managed, while penalising those that are not. One might say that Basel II seeks an “efficient frontier” of policy objectives through the three pillars. Each pillar provides something that the other two cannot. Each is essential to achieving our overall objective of financial stability - an objective that would benefit all countries in all stages of development. Of course, some of the advanced approaches offered in Basel II are intended for large and/or sophisticated banking organisations; this has sometimes led bankers and supervisors in particular regions of the world to ask me whether Basel II is relevant to their situations. So I’d like to turn now to address some of the questions that I have heard frequently from bankers and supervisors especially in emerging market countries. Issues in emerging market countries Is Basel II appropriate for emerging market countries generally? Let me address the question that I just mentioned, namely whether Basel II is relevant to the banking system of an emerging market country. Let me begin by emphasising that I cannot answer the question of when or how any country should adopt Basel II.