However, in some sense the Basel proposals will have failed in their purpose unless the pricing of bank credit better reflects the riskiness of borrowers. By removing perverse incentives for banks, we also wish to establish better incentives for borrowers. Greater risk sensitivity does, however, carry with it a possible danger, and that is the introduction of potential 'procyclicality' into the capital framework. I have touched on this concern more than once in the past, and make no apology for doing so again. To counteract this danger, regulators should not allow banks' internal ratings to reflect the optimistic prospects of borrowers during an economic upswing: rather, ratings need to be genuinely forward-looking, and to factor in borrowers' likely performance during economic stress. Long runs of performance records will be invaluable in establishing how robust borrowers are to different economic circumstances. In this way, economic downturns when they come should not prove too much of a shock to the ratings scales. Of course, I do not wish to sound complacent regarding the avoidance of 'procyclicality'. Capital is after all meant to be a cushion against volatility, also referred to as 'unexpected' loss, but measuring the unexpected is something of an oxymoron. Some of our researchers at the Bank of England recently reviewed the usefulness of various predictive models of banking problems, but unfortunately our conclusion at the moment is that banking crises are each unique in its own way.
Indirectly, in the same way that the change in banks' behaviour in response to the original Basel Accord had a profound effect in shaping developments in securities markets in the last decade. Directly to the extent that EU investment firms, under the Capital Adequacy Directive, are subject to the same capital requirements as banks. One of the principal goals of the new Basel framework is, of course, greater risk sensitivity. The lack of sensitivity of the existing Accord has been one of the drivers of increased capital market activity: both through disintermediation, as companies have accessed the capital markets for funding directly instead of relatively more expensive bank loans, and through securitisation, as banks themselves have sought to continue originating credit but not incur the capital costs of holding it on their balance sheet. The new Basel proposals to the extent they succeed in aligning capital more closely with the underlying risk, will we hope significantly reduce incentives for pure regulatory arbitrage. While the original Accord created an incentive to securitise or, by other means, move exposures off balance sheet, it is too simplistic to assume that adoption of the new proposals will result in a swing back to more traditional bank lending. The wider use of internal ratings, coupled with greater transparency regarding their compilation and some assurance of quality control by the regulators, may in fact contribute to further 'commoditisation' of bank loans. It is conceivable that this development could reduce the cost of due diligence on loan portfolios by rating agencies and buyers.