Currently, efforts are being made in some countries and by some international organizations to expand the coverage of capital requirements, including setting requirements on asset-backed securities, off-balance sheet risk exposures and trading account activities, improving the quality of tier 1 asset, and enhancing the global consistency of minimum capital requirements. In addition, as a complement to capital adequacy ratio requirement, a properly constructed leverage ratio indicator will play a role in the macro prudential regulation framework as the new indicator can both measure potential excessive risk-taking and dampen the cyclical fluctuations.

In addressing the vulnerability of the exist capital adequacy ratio framework, particularly the cyclicality of capital buffer, authorities responsible for the overall financial stability need to develop counter-cyclical multipliers in an effort to contain pro-cyclical elements. If an economy experiences an unusual change or economic system needs an unusual counter-cyclical adjustment and specific stabilization measures, the authorities may consider issuing quarterly indexes of prosperity and stability. These indexes may then be used by financial institutions and supervisors to multiply into risk weights in calculating capital adequacy ratio. In this way, the risk weighted capital adequacy requirement and other criteria, like IRB, can better reflect counter-cyclicality requirements for financial stability.

Specifically, with a set of prosperity indices in place, counter-cyclical multipliers can be derived. Many existing indicators linking to business cycles, investor and consumer sentiments can serve as a base for such prosperity indexes. During the boom period, asset prices increase, market exuberance prevails, and prosperity indexes are high; and vice versa during economic downturn. In deriving counter-cyclical multipliers from prosperity indexes, we should take into consideration of factors such as product type, industry and country of risk exposures. Then, the multipliers can be applied to contain the pro-cyclical factors including risk-weights, default probabilities for credit rating purposes and discount (haircut) percentages for various collaterals used in financial transactions, as well as other pro-cyclical factors. This will not only help to mitigate the pro-cyclicality elements, but also improve quality of capital by improving management of collaterals and by using multipliers-adjusted default probabilities to manage risks in complex credit products.

(3)Reulatory agencies should be adequately staffed with people with market experiences

Some regulatory agencies do not have enough professionals with practioners' experience and hence are lack of sufficient understanding of the market developments, especially the systemic impacts of financial innovations. As a result, some supervisors turned a blind eye and were not sensitive to problems in structured products such as CDOs and derivatives such as CDS, and the shadow banking system reflected in the off-balance activities, including the critical rating methodologies for structured products. To enhance capacity, regulatory agencies should conduct systematic and frequent staff exchanges with the industry, which will enable regulatory agencies to become attentive to and keep abreast of developments of the industry and do a better job in supervisory oversight.

(4)Strengthen supervision on the use of crediting rating services and on rating agencies

Credit ratings from the major rating agencies have become international financial services products. In many countries, various rules have required investment management decisions and risk management practices to be benchmarked on financial instruments attaining certain ratings by major credit rating agencies. Once these ratings were given, the financial institutions do not need to worry about the inherent risks of the products. However, the ratings are no more than indicators of default probabilities based on historic data, which never meant to be guarantees for the future. The business model of issuer-paying for services has rendered the rating process with conflicts of interest and the major rating agencies irresponsibly gave many structured products high ratings before the crisis. During the crisis, the reversal of market conditions have forced the rating agencies to lower the ratings of many financial products, which led to massive asset markdowns and exacerbated the severity of the crisis.

Our view is that the financial institutions should conduct independent examination of risks, not simply delegate the duty to the rating agencies. To the extent external ratings are needed, internal and independent judgment has to be deployed as a complement. Regulators should encourage financial institutions to enhance internal rating capability to reduce their reliance on external ratings. Moreover, central banks and regulators should limit the use of external ratings within 50 percent of business volume, at least for those systemically important financial institutions. Meanwhile, these institutions should upgrade their internal rating capabilities to exercise independent judgment on credit risks.