Speech

New York, December 11, 2007

1. It is a great pleasure for me to be at this event. On previous IIB seminars, I have been representing the Basel Committee on Banking Supervision. This time, I am going to talk about Basel II but from the perspective of the IMF, a global institution which has preserving global monetary and financial stability at the heart of its mandate.

2. Let me begin by complimenting our hosts, the Institute of International Bankers, for the important work that they are doing in improving communication and understanding between the foreign banks operating in the US and the regulatory agencies. In a globalized world, effective home-host cooperation between national authorities and dialogue with the industry are critical to underpinning financial stability across jurisdictions.

3. Today I will approach Basel II from a different perspective. The IMF is not a standard setter for the financial sector, but we have an important complementary role in the implementation of Basel II. This will be one of the three topics I would like to address today. I must note here the important role that the Basel Committee's Accord Implementation Group has been playing in this regard together with the industry. I am happy that there is a separate session this afternoon on home-host issues. I am also pleased to see that my old friend and Basel Committee colleague, Danielle Nouy, will be providing a European perspective on Basel II, where significant progress had been made through the CEBS and can also provide the perspective of the Basel Committee.

4. As I said, the main focus of the IMF is global macroeconomic and financial stability and from this perspective there are two additional issues. The full implementation of Basel II is happening or it is going to happen, in the midst of financial turmoil where credit quality is deteriorating rapidly, at least in some segments of the market. This is the time to implement Basel II, but this is no time to take measures that can amplify the cycle and this raises an interesting point about the transition to Basel II in complex times. I continue to think that the discussion about the procyclicality of Basel II has been exaggerated, but I also think that it is important that the different elements built in the framework to mitigate procyclicality are properly used. This will be my third point.

Basel II and the recent market turbulence.

5. But first I would like to give my personal thoughts on another issue. There has been some discussion in the financial press on the impact that Basel II had or could have had on the way the current events in the credit markets have unfolded.

6. Earlier speakers today have provided us with an excellent insight into the turmoil originating in the sub-prime mortgage markets in the US, which has had—and may continue to have—global repercussions.

7. One of the questions that is often raised in discussions is whether Basel II could have prevented the chain of events. I have clear views on the positive contribution that Basel II is already making to address the risks faced by banks in today's financial markets. Basel II is about capital, but it is also about risk management, incentives and risk based disclosure. The new framework is a vast improvement on the less risk sensitive approach of Basel I.

8. Let me tell you a brief story. I attended, some time ago, a seminar on risk management. One of the speakers was from the industry, a clever risk manager from a large international bank. He was using a PowerPoint presentation, and his first slide showed a picture of a Ferrari. He announced that this car represented the industry, racing ahead at full speed with advances in risk management practices. The next slide showed a picture of a tortoise. This tortoise—he announced—represented the supervisors, making only agonizingly slow progress to take account of the advances made by the industry, always behind and with no hope of catching up. The big question, he said, was how to redress this imbalance, so that the supervisors were not holding back industry advances. His next slide provided the answer—it showed the tortoise climbing onto the Ferrari.

9. With Basel II, I like to think that the tortoise has climbed aboard the Ferrari, that supervisors and the banking industry, have increased their mutual understanding and enriched the dialog, maintaining their different perspectives. Certainly, supervisors should not be telling banks how to manage their business. In other words, the tortoise should never drive the car. That was the spirit of the intensive consultation and dialog between the industry and supervisors during the Basel II process.

10. At that time, listening to the presentation, I thought that this was a somewhat unkind description of the supervisors, but there certainly was some truth in the analogy. Today, looking to this crisis, with the benefit of the hindsight, it seems to me that the car was too fast not only for supervisors but also for many market participants.

11. In the context of recent events, it seems to me that the incentive structure in the three pillars of Basel II could have mitigated some of the problems we have seen. An obvious example is the treatment of securitization, the risks of which were simply not captured in Basel I. Had Basel II been in place and requiring banks to hold capital against the risks associated with securitization exposures, whether as originators, sponsors, investors or liquidity providers, it is likely that the loss exposures would have been at least contained. Further, it also provides stiff disincentives for inappropriate behavior linked to securitization. For example, in cases of provision of implicit or non-contractual support which undermines the clean break criteria and signals to the market that the risk has in effect not been transferred, supervisors are required to take strong action which could include denial of capital relief in the case of originated assets or an increase in capital required against acquired securitizations.

12. However, I should emphasize two points. First, Basel II is a regulatory capital framework - not an overall guide to how banks should run their businesses. Capital requirements can, and should, contribute to create the right incentives for risk takers and support good risk management generally. But capital requirements cannot prevent banks from making mistakes—or substitute for banks' own responsibilities for assessing risk and managing it appropriately. Second, the current problems in the market in any event clearly go beyond the objectives of a capital adequacy framework. The issues range from loose underwriting standards, opacity in complex financial products, lax investor due-diligence to inadequacies in liquidity management Basel II is not the panacea for all the financial market troubles, but is part of the remedy. In particular it is not a liquidity standard, and as you may know, the Basel Committee is now working on developing improved guidance for liquidity supervision. I should add here that Pillar II steps up to the plate even in this context. It recognizes that banks' capital positions can affect their ability to obtain liquidity, especially in a crisis, and requires banks to evaluate the adequacy of their capital in the context of their liquidity profile and the liquidity of the markets in which they operate. It also requires that an assessment of illiquidity under stressful market scenarios should be built into bank's assessments of capital adequacy for market risk.

13. For these reasons, I believe that had Basel II been implemented effectively in all the affected jurisdictions, the turbulence could have played out less virulently than we are seeing at present, though it would not on its own have prevented it. It should also be noted that Basel II implementation is a process, not an event, and the implementation calendar is spread out over the next few years even in the mature economies.

The IMF and the implementation of Basel II

14. The IMF has all along supported the Basel Committee and individual countries in the implementation of Basel II. We value its increased risk sensitivity and its enhanced focus on risk management and market discipline. Our broad message has been to caution against improper or incomplete implementation, which may create more problems than it leads to solutions. This is a view that I would like to reiterate and it is consistent with the message coming from the Basel Committee.

15. Therefore, we have not pressed for rapid implementation in all countries. Only national authorities can decide when to adopt Basel II. But if a country decides to adopt it and states that it is using Basel II to supervise banks, then we have a keen interest in the way it is implemented and we will need to asses whether Basel II is effectively applied. The different parts of the framework complement each other and need to be implemented together. Adopting only parts of the framework or modifying it unduly could compromise its risk sensitivity and may even lead to a false sense of security.

16. The instruments for the IMF's surveillance are two: The so called FSAPs (Financial Sector Assessment Programs) and a more general instrument, the so called Article IV consultations, which are paying growing attention to financial issues. In addition we also provide Technical Assistance.. Just to give you an idea of this kind of work, MCM (Monetary and Capital Markets) , the department that I head participates every year in about 20 FSAPs, 60 Art IV and more than 400 missions on financial and central banking issues.

17. As I have said, we believe that the successful implementation of Basel II will strengthen the financial system in individual countries and the international financial system. We are in a position to help in achieving consistent implementation across countries—because of our global membership and active engagement with many countries on the issues. Accordingly, we are developing a methodology to support our work with countries and will begin including implementation reviews in our FSAPs late next year.

Implementation of Basel II in complex conditions.

18. In the discussion on the possible effects of Basel II, the issue of procyclicality has often been center stage. Questions have been raised whether the impact of Basel II implementation will be pro-cyclical or anti-cyclical. Several papers have been written on the subject. Of course, it may be too early to reach any definitive conclusions, and will be some time post implementation that more answers based on empirical studies can be provided. I continue to think that this is an important issue, which needs to be monitored but that many times it has been exaggerated.

19. Markets are procyclical, economic capital is procyclical and human behavior tends to be procyclical—our optimism is amplified in good times, and our pessimism is magnified in bad times. What is more important is that supervisors recognize this inherent bias towards pro-cyclicality in the financial system, ensure that banks prepare themselves in good times to meet the rigors of the bad times and do not take measures in bad times that unduly amplify the cycle. Bank managers, too, should be aware of the cyclical profile of their business activity and their risk management systems; of the difficulty of shoring up capital in recessionary phases and of the costs this entails.

20. When Basel II was being designed, this issue was taken seriously, and hence there has been a conscious attempt to build in mitigants and anti-cyclical elements through all three pillars of the framework. Pillar 2, in particular, specifically requires banks to be mindful of the state of the business cycle in which they are operating in their internal assessment of capital adequacy. It also requires supervisors to ensure that they take business cycle effects into account in their review of the adequacy of banks' assessments.

21. Procyclical behavior reflects the tendency to underestimate risk in good times, and overestimate it in bad times. A capital framework which better estimates risk through an economic cycle, is less likely to suffer from under and over estimations, and hence more likely to aid in smoothening procyclical effects. Basel II encourages the appropriate use of capital buffers through the cycle. Let me emphasize here that the idea of building robustness in good times is not only a prudent policy, it is also theoretically consistent because it is in good times when exposures and therefore risks increase, while in bad times these risks materialize.

22. The most abrupt and procyclical behaviour will probably occur in a poorly provisioned and poorly capitalized bank with inadequate risk management. A case in point using the current issues with asset securitizations is that it is more procyclical to be risk-blind than risk-sensitive, as we have observed with some of the conduit structures, because the dampening effect is greater when the risk comes home to roost. The good part is that being risk sensitive and having capital cushions allows you to react rapidly in bad times, while the flip side is that you may need to hold more capital in good times. In our view, the benefits far outweigh the costs. This is even more important now when we see that balance sheets of many large international banks are under pressure.

23. But let me give you a practical example in this context of the importance of using properly the elements of Basel II that mitigate procyclicality. Some banks may approach their Basel II implementation preferring point-in- time (PIT) systems for estimating probabilities of default (PDs). Others may aspire to through-the cycle (TTC) approaches, that contribute less to accentuate credit cycles as their capital buffers are more adequate for the whole cycle. PIT based models have also some advantages—for example, their PD forecasts are more precise estimates for one-year PDs , but they fluctuate more over the cycle and they are more prone to indicate that credit quality is better than reality in good times and worse than reality in bad times. While national supervisors will decide how to accommodate different types of approaches, what seems to me important is that banks, under the guidance of supervisors, address properly capital volatility in their capital allocation and define strategic plans for raising capital that take into account their needs through the cycle. Otherwise, banks scouring for capital when the cycle turns may further exacerbate credit cycles. The need to raise buffers in excess of the regulatory minimum in good times will be more demanding in banks using PIT systems.

24. In ending, I would repeat the main message of my talk today—that Basel II implementation is important, but consistent and correct implementation of the complete framework is critical if we are to take advantage of the enhanced risk sensitivity that it offers—or hold it responsible for not delivering. We in the Fund support the ongoing implementation efforts which would contribute positively to strengthening the stability of the financial system in our member countries.

25. I thank you all for listening patiently to my views. I also thank my hosts for their invitation to this event, and wish you all `bon appetit'.