Basel II, in my view, is fundamentally about better risk management and corporate governance on the part of banks, as well as improved banking supervision and greater transparency. Thereby, it is also about increasing the stability of the global financial system, to the benefit not only of banks, but also consumers and businesses. This is especially critical in markets where banks are the primary source of funding and therefore key drivers of sustainable development. How will Basel II contribute to financial stability? Allow me then to take a few minutes to elaborate on several areas where I believe Basel II will foster financial stability. First, I believe that Basel II is a major step forward in strengthening the incentives for the ongoing improvement of banks’ risk measurement and management systems. The new capital framework is both incentive-based and risk-based. It therefore offers us the opportunity to ensure that supervision and regulation takes a forward-looking view on risk, that it remains up-to-date with sound practices in the industry and that our supervisory framework motivates responsible risk-taking and prudent behaviour in our markets. Improved and more formalised risk management will bring better assessment, better quantification and greater awareness of risks. To the extent that risk assessment and control methods become more formalised and rigorous, this will lessen the likelihood of making bad decisions and will improve riskadjusted pricing policies. It will also contribute to the prompt detection of errors and deviations from targets, allowing banks to implement corrective measures at an early stage.
This is why the Basel Committee has devoted so much effort to developing the so-called Basel II capital framework, which was released in June 2004. The new capital framework is built on three mutually reinforcing pillars. The first pillar aligns minimum capital requirements more closely with banks’ actual underlying risks. The menu-based approach means that qualifying banks may also rely partly on their own measures of those risks, which will help to create economic incentives to improve those measures. In concept the first pillar is similar to the existing “Basel I” capital framework in that it provides a measure of capital relative to risk. What is new are the second and third pillars. The second pillar – supervisory review – allows supervisors to evaluate a bank’s assessment of its own risks and determine whether that assessment seems reasonable. It is not enough for a bank or its supervisors to rely on the calculation of minimum capital under the first pillar. Supervisors should provide an extra set of eyes to verify that the bank understands its risk profile and is sufficiently capitalised against its risks. BIS Review 45/2006  1  The third pillar – market discipline – ensures that the market provides yet another set of eyes. The third pillar is intended to strengthen incentives for prudent risk management. Greater transparency in banks’ financial reporting should allow marketplace participants to better reward well-managed banks and penalise poorly-managed ones.