But with more autonomous units, an internationally-active and  BIS Review 42/2004  1  complex bank has to expend more effort to identify, measure, and control the risks arising from its diverse and far-flung activities. Traditional rules of thumb used by management and supervisors to assess risks and to ensure the adequacy of capital to buffer risks are no longer adequate. And continuing financial success depends critically on how a bank responds to the risk management challenges. In response to these challenges, the successful banks have developed enhanced tools for measuring risks. These can be grouped into two broad categories. The first category of tools are those that give a bank the ability to discriminate among risks by differentiating the riskiness of customers, and of various banking facilities and products. The second category of tools includes those that give a bank an enhanced capability to quantify risks. The end of the road for Basel I In and of itself, the enhanced capability of institutions to differentiate and measure risks has been a welcome development. But, the increasing sophistication of institutions in risk management meant that the crude system of risk weights under Basel I became less meaningful in ensuring the adequate capitalisation of large, complex banking institutions. By the mid-1990s, less than five years from the official implementation of Basel I,1 it was apparent that Basel I was becoming less relevant for some banking institutions.
And even the banks, despite the fierce criticism from some firms who did not receive the financial support they expected, do not seem to have been as quick to pull the plug on their borrowers as they were during previous downturns. Overall, the fall in output does not appear to have done as much damage to employment and firm survival as one might have expected. At the same time, the implication of business surveys is that the degree of spare capacity in firms is rather less than implied by the fall in output. So estimates of the gap between overall demand and the economy’s capacity to produce goods and services – an indicator of inflationary pressure known as the “output gap” – are extremely uncertain at the current juncture. The “output gap” appears to be much smaller than the fall in demand alone would have suggested, but there is little evidence of widespread destruction of supply capacity. Whatever the balance between demand and supply, it seems that many firms have maintained prices, not cut them, in the face of weak demand. That may have been a rational  BIS Review 91/2010  3  response. In order to survive they needed to maximise their present cash flow and they would only have cut prices if the demand response was likely to outweigh the lost revenue. Comparisons with behaviour in previous post-war recessions are difficult, partly because inflation was much higher during those episodes.