In other words, if we want to see if policy works or not, or if the economy has become less sensitive to changes in interest rates, then we should examine the slope of the IS curve, and not only of the Phillips curve.11 Empirical research on the IS curve is scarce, however. And the few studies available are generally not encouraging from a monetary policy perspective. They typically find that output does not respond, in a statistically significant way, to the real interest rate. 12 Often they even find a positive relationship between real interest rates and output. These findings are at best disturbing given that much of mainstream monetary thinking is built on the idea that firms and households take the level of the interest rate into account when making economic decisions. 8 / 14  BIS central bankers' speeches  To illustrate the empirical failure of the IS curve, slide 7, column 1, shows the estimated coefficients of a regression of the euro area output gap on its own lag and a measure of the real “interest rate gap”, i.e. the difference between the real ex ante interest rate and the time-varying natural rate.
Therefore, the Basle Committee has quite rightly advised that regulators and banks should approach it with caution even with regard to the simplest approach to Basel II. We commenced our journey one year ago, together with the industry, and we will move slowly, but steadily, towards full implementation of the basic approach, hopefully in 2008. We will, however commence our test runs in parallel with Basle I in 2006, fine tuning our systems for full compliance as we go along. This would be in line with the widely accepted policy that countries should adopt the options and approaches that are most appropriate for the state of their markets, their banking systems, and their supervisory structures. In Sri Lanka, as in most countries, the banking sector enjoys predominance in our financial system. As is to be expected, the financial environment, domestically, is becoming more innovative and competitive to meet the sophistication of peer foreign banks and the needs of investors and consumers. This naturally increases their risk profile. Increasingly, therefore, our remit as regulators is to ensure an efficient risk management framework and the adequacy of resources to mitigate risk. Against this background, therefore, Basle II is synonymous with good risk management, not only of the core risk of credit default, but of a wider range of risks such as market risk and operational risk in Pillar I .