Promoting financial resilience.

• Author: McDonough, William J.

Despite the fact that periodic surges in volatility are a fact of life in financial markets, I think there is general acknowledgment that recent years have been extraordinary in this regard. This has been a period of historic change and remarkable volatility in markets, going well beyond the emerging markets, and carrying with it important implications for political, social, and institutional stability in significant segments of the globe.

Strengthening the Institutional Framework

The experiences of recent years have reinforced old lessons and brought home new insights about maintaining financial stability and sustained growth. In particular, a broad consensus continues to develop on ways of strengthening the institutional framework at the national and international level to create more robust, and thus more crisis-resistant, economies. There is general agreement that in order for countries to enjoy sustained and stable growth, the following are crucial:

* a sound and stable macroeconomic environment, and

* well-functioning and robust financial systems in both capital-exporting and capital-importing countries.

Moreover, both of these are most effective when supported by a dynamic and adaptive policy regime.

The simple reality is that countries with robust financial systems, strong fiscal accounts, low inflation, credible and coherent monetary and exchange rate policies, moderate external and internal indebtedness, reasonable current accounts, and adequate domestic savings rates are less likely to be buffeted by financial and economic turbulence. Moreover, when shocks do occur, such countries tend to be far more resilient.

There is also considerable agreement on many of the elements needed to achieve these goals. This agreement has been reflected, in part, in the development and promulgation of globally accepted standards and codes for best practices in areas ranging from transparency in fiscal, monetary, and financial policies, to public debt management, and core principles for bank supervision. Guiding themes across these various standards have included the importance of consistent disclosure practices and of building stability up from the firm and sector level. The latter is accomplished by encouraging sound risk management and stronger balance sheets, and creating efficient systems of market, legal, and regulatory discipline.

But the learning process continues. For example, in the United States, recent experiences have brought to light the need to do more to strengthen corporate accounting and disclosure standards, particularly with regard to guarantees and complex financial arrangements, such as those funded offshore or through special-purpose entities.

The Basel Capital Accord

Our ongoing efforts to revise the Basel Capital Accord also reflect a learning process. We embarked on this voyage in the late 1990s because we realized that the original 1988 Basel Accord (Basel I) had been overtaken by advances in the financial sector--and in the broader economy. Although Basel I represented an important advance, new technology, the globalization of financial markets, and innovative financial products and services have changed the way that banks monitor and manage credit risk, market risk, and operational risk in a manner that the 1988 Accord could not anticipate and does not address.

To ensure that the new accord (Basel II) remains flexible, forward-looking, and appropriate for the risks and capital needs of internationally active banks of the 21st century, the Basel Committee established several goals for its work, goals that the industry has embraced.

* First, we intended to develop a framework that encompasses the "three pillars" necessary to support an effective system of regulatory capital: the appropriate measurement and minimum requirements, supervisory review, and market discipline.

* Second, we wanted to align the minimum requirements more closely with the actual underlying economic risks to which banks are exposed, which should help 'allocate capital resources effectively.

* Third, we sought to encourage banks to refine their measurement and management of risk over time. By creating incentives in the New Accord for banks to reevaluate and enhance their tools constantly, we expect that banks themselves will adopt a forward-looking perspective on risk.

I am pleased to say that, through the Committee's efforts and the cooperation and support of other supervisors and the industry, it appears that the proposed framework will attain each goal. We can now count them among the milestones we have achieved.

However, though we have covered quite a bit of territory over the past several years, the last miles of any marathon are the toughest to finish. I would like to turn now to the status of the new accord and of the issues we are still resolving.

Basel II

Since the Second Consultative Document's release in January 2001, the members of the Basel Committee have worked collaboratively and publicly with supervisors, banks, and others to revise the proposals so that they best serve the needs of modern banking. We have published and discussed thousands of pages of proposals and studies with the industry and the public. I would like to share with you the latest news on how we are resolving the key challenges and concerns that have surfaced in this process.

One general issue raised is that Basel II's increased sensitivity toward risk will reinforce procyclical behavior by banks, leading to increased cost of credit during...