I entirely agree with Howard Davies that it is essential that the Basel framework, if it is to remain a global standard, continues to encompass a menu of options which accommodate different needs. I also do not wish to gloss over the fact that there are some very knotty areas in the proposals that have to be tackled before the Basel Committee can deliver on its objectives of greater risk sensitivity and comprehensiveness. The FSA is today going to tackle four of the most difficult, namely credit risk mitigation, operational risk, internal ratings, and interest rate risk in the banking book. I would like to take this opportunity to make a few observations on those areas that are of particular interest to us. Use of internal credit ratings The Bank has, as some of you may know, been devoting considerable thought to development of the internal ratings based approach to setting capital for credit risk. This is in part because we have been able to utilise the expertise we have built up in the course of our work on credit risk modelling, on which the Bank and the FSA held a joint conference last year. But more importantly, it is also because we consider this part of the Basel proposals to be of the utmost importance to achieving a balanced and stable framework. In particular, the availability of this approach is a very important safety valve for the market pressures and distortions that could otherwise arise from the use of external ratings.
Several options need to be explored, including the possibility of offering a choice of approaches to supervisors, or an evolutionary framework whereby the system could develop in sophistication over time. In principle, we would certainly like to see a system that a reasonably large number of banks could sensibly aspire to. There are only two caveats that I would make. First, of course, there are the implications for supervisory resources if a very large population of banks have to have their internal ratings systems approved. And secondly, even a simple framework has to observe certain minimum requirements. This means the ability to relate an internal rating to a quantifiable concept, such as loss-given-default or default probability; the ability to demonstrate that this relationship is historically valid, or - in the likely absence of long runs of data - at least plausible; and third, as I said before, a forward-looking dimension to the rating. Whilst the Bank of England is doing its best - I hope with some success - to help the economy avoid the booms and busts of previous decades, banking is likely to remain a cyclical industry, and to my mind it would be simply imprudent to base ratings and capital on a borrower’s position at the top of an economic cycle. Operational risk Use of internal ratings will of course raise many of the sorts of difficulties for testing and validation that were identified for credit risk modelling.