BIS Review 130/2007  1  While lending and deposit-taking remain the mainstay of commercial banking, the profile of credit markets has changed significantly. Today, conventional credit products are being offered alongside the growing significance of asset securitisation and credit derivative activities. This has had a profound impact on the nature of banking. The rapid development of these synthetic credit markets, coupled with an extended period of ample liquidity in the global financial system, has expanded the avenues for banks to engage in more aggressive lending practices that are funded by borrowing from the wholesale money markets, and by repackaging and selling loans to other investors in the form of asset-backed securities. This represents a significant shift from the more traditional banking models where loans are predominantly funded by deposits. The increasing complexity in the way that debt is created and distributed in the financial system raises important implications for financial stability. The “originate and distribute” strategy that has been adopted by some institutions warrants addressing more comprehensively the full range of risks to which the banks are exposed. This includes the liquidity, foreign exchange and moral hazard risks in banking institutions. Credit risk exposures have also taken on more complicated forms, including counterparty risks on derivatives and foreign exchange transactions. The valuation of such financial transactions and instruments are also often difficult to measure particularly under distressed market conditions. In addition, the correlations between credit and market risk, both within and across national borders, have become more complex.
As a consequence, the bank capital framework de facto becomes a partial substitute means of achieving more forwardlooking provisioning, through the internal models regime for credit risk which requires the deduction from capital of expected losses in excess of provisions. A forward-looking approach to provisioning based on expected losses would help move to a more appropriate position where the accounting standard requires a prudent valuation of banking book assets and the capital regime can focus on unexpected loss. I hope that implementation of the new accounting standard for provisioning, IFRS 9, is a step in this direction. I now want to turn to the issues around risk-weighted assets in the capital framework. Basel I was a simple framework, as I described earlier. In my view, that was its strength and weakness. The strength was that it was quite easy (certainly by today’s standards) to see the balance sheets even of the largest banks laid out and broken down by broad risk weights. The weaknesses were two-fold. First, it provided little insight into how firms measured and managed risk. As a supervisor in the late 1980s and early 1990s, I remember well meetings with firms which would start by the firm reminding that while they had filled in the risk weighted assets form faithfully, it bore no resemblance to how they assessed and managed risk in the business – what is often called “economic” as opposed to “regulatory” capital.