Basel II, the new capital standard, is expected to be released by June 2004, for implementation starting in January 2007 in G-10 countries. The drafting and public consultation process has been thorough and has led to many revisions of the draft. In its contacts with member countries and with the media, Fund staff has been confronted with a number of issues related to the new Accord. These relate primarily to the scope of the Accord, its implementation date, the consideration of Basel II in Fund/Bank Basel Core Principle assessments, assistance in assessing pre-Basel II readiness, and follow-up technical assistance to countries that decide to implement Basel II. This note seeks to provide guidance to Fund staff with regard to a number of these issues.

1. The revised Capital Accord (Basel II) represents a significant improvement over the 1988 Capital Accord, and its implementation should lead to enhanced financial stability through better risk management systems in banks, better banking supervision in member countries, and improved market discipline. In its comments (see www.bis.org), Fund staff has broadly endorsed the objectives of the new Accord, and recorded its appreciation for the wide consultative process in the course of which many of the concerns expressed by commentators, including those of Fund staff, have been addressed.

2. For many countries, meeting the planned G-10 starting date for implementation of January 1, 2007 should not take precedence over the quality of the implementation, based on a high level of baseline supervision and readiness. Basel II was designed in the context of internationally active banks in G-10 jurisdictions, which are already largely in compliance with Basel I and the Basel Core Principles. Basel II, however, may not be the priority objective in banking supervision, at this stage, for more resource-constrained and less advanced banking systems in many developing countries. There may be short-term risks in the transition and implementation of the new standard. A supervisory focus on meeting the specific requirements of Basel II, with the associated reallocation of resources, may distract supervisors from more immediate concerns, such as building a strong system for day-to-day risk-based supervision.

3. As the supervisory review process is key to the successful implementation of Basel II, staff believes a baseline compliance reflecting a system fully or largely compliant with the BCP, which incorporates Basel I as the capital adequacy standard, should form a base for moving to the New Accord. In the course of 71 assessments conducted as part of the FSAP covering 12 advanced, 15 transition, and 44 developing economies, staff has noted many deficiencies in the areas of risk management, consolidated supervision, and corrective action for undercapitalized institutions-all of which are crucial to sound supervision and the proper implementation of Basel II. In particular, about half the developing countries were assessed as noncompliant, with BCP 6 dealing with capital regulation, BCP 11 dealing with country risk, BCP 22 dealing with formal powers of supervisors for corrective action, and BCP 20 dealing with consolidated supervision. More than two thirds were noncompliant with BCPs 12 and 13 dealing with market and other risk management, while over one third did not comply with BCP 8 dealing with loan evaluation and provisioning, and BCP 21 dealing with accounting and information requirements (Table 1).

Table 1. Noncompliance* with Core Principles Relevant to Basel II

	Noncompliant by Country Grouping (in percent)
Basel Core Principle	Developing	Transition	Advanced
CP 6 - Capital Adequacy	48	27	8
CP 8 - Loan Evaluation and Provisioning	39	27	25
CP 11 - Country Risk	55	60	25
CP 12 - Market Risk	66	53	0
CP 13 - Comprehensive/Other Risk Management	66	53	0
CP 20 - Consolidated Supervision	57	67	0
CP 21 - Information/Accounting Requirements	36	40	0
CP 22 - Remedial Powers	52	33	17
* = Assessed as Materially Noncompliant or Noncompliant.

4. In their assessments of a country's compliance with Basel Core Principle 6, which relates to the adequacy of a country's capital regulation, the Fund and the Bank will not assess compliance based on whether or not a country has implemented Basel II. Bank/Fund assessments of supervision will be against the capital standard (either Basel I or Basel II) chosen by the country. The ultimate choice of what capital standard to adopt must be made by national authorities. Neither the Fund nor the Bank intends to push countries toward implementation of Basel II, nor toward specific country options under the Basel II framework. The assessments made by staff would judge compliance against the standard chosen in the context of the country's capacity and sound international practice.¹

5. Countries will also need to put in place effective structures for cooperation between home and host supervisors, in particular, when the parents of foreign banks and their overseas establishments operate under different regulatory capital systems than domestic banks. Issues that may arise include competitive inequities between banks with different capital requirements and high-risk assets migrating toward institutions with lower capital requirements.

6. Basel II has stimulated substantial interest on the part of member countries to upgrade banking supervision systems and banks' risk management. Countries that wish to strengthen their supervisory system (as well as those that would like to prepare for the implementation of Basel II) may require assistance in diagnosing the adequacy of their present systems, training supervisors, issuing policy guidance to banks, and building credit information, data pooling, and IT systems. The Fund and the Bank, the Basel Committee, and the Financial Stability Institute will work together in exploring TA opportunities that can help countries deal with these issues, including addressing deficiencies in the existing supervisory framework and the capital adequacy framework. If a country so decides, the Fund, in collaboration with the Bank, may help develop a roadmap for Basel II implementation. Thus, interest in Basel II implementation can be used to stimulate diagnosis of, and improvements in, banking regulation and supervision.

¹ In the case of a country which has not chosen to adopt Basel II, so long as the applied standard is appropriate to the circumstances and reflective of international practice-such as Basel I-staff should not judge the system as noncompliant. Conversely, if a country has chosen the Basel II standard, but does not implement this properly, staff could find the country noncompliant.