The New Basel Capital Accord (Basel II) released in 2004 improved the capital adequacy ratio framework, shifting from singular requirement on capital adequacy to highlighting the importance of risk-based banking supervision, and including minimum capital as one of the three pillars of banking supervision (regulatory capital requirement, regulatory responses, disclosure and market discipline). Under Basel II, the minimum capital requirement of 8 percent was unchanged, but the notion of risk weighted asset was improved to reflect not only credit risks, but also market risks and operational risks. Following the release of the Basel II, major economies have outlined steps and the timetable for its implementations, and major European countries have basically implemented the new Accord. China is also making preparations for implementing it.

The Basel II framework allows financial institutions to apply internal rating-based approach in pricing and assessing risk of complex products. Risk weights for purpose of capital adequacy calculation are derived from internal modeling. Such weights are generally low and lead to high capital adequacy ratio (CAR) during economic upswing, and are high and lead to low CAR during cyclical downturn, everything else equal. As a result, financial institutions tend to have high leverage ratios during good times and have to deleverage during bad times. This amplifies bubble buildup during upswings and leads to credit squeeze and asset dumping during downturns, thus increase cyclical volatilities. This reflects a strong pro-cyclicality. We took notice that FSF has formed working groups to cooperate with BCBS in studying ways to strengthen Basel II framework, and to address its weaknesses revealed during the crisis including its pro-cyclicality.

2. Give full play to the professional role of authorities of overall financial stability and establish a counter-cyclical mechanism for capital requirement

Among the supervisory requirements on financial institutions, banking institutions in particular, capital adequacy ratio is one of the most important prudential requirements. The current financial crisis suggests that a sound capital buffer is critical for banks' resilience to risks and financial stability in a broader sense. Effectively addressing the pro-cyclicality elements in the existing capital requirement framework is essential for avoiding a repetition of serious financial crisis. The ongoing crisis has exposed much vulnerability in capital adequacy framework of banks in the following areas: inadequate capture of risks by the Basel II framework for complex credit products; the minimum capital requirement and the quality of capital did not provide adequate buffer during the crisis; the pro-cyclicality of capital adequacy amplified economic oscillations; the differences in capital requirements among different types of financial institutions. Efforts are being made in some countries to widen 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 capital, and enhancing the global consistency of minimum capital requirements. In addition, as a complement to capital adequacy ratio requirement, a notion is under discussion that 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 amplification of cyclical fluctuations.

In addressing the vulnerability of the existing capital adequacy ratio framework, particularly the pro-cyclicality of capital buffer, national authorities responsible for overall financial stability can actively play their professional role. If economic cycle comes into an unusual phase, or economic system needs an unusual counter-cyclical adjustment or special stabilization measure, it can be considered to let authorities of overall financial stability issue quarterly indicators of prosperity and stability, which can then be used by financial institutions and regulatory supervisors by multiplying into risk weights for capital adequacy ratio calculation. Thus the risk weighted capital adequacy requirement and other control criteria (like internal rating-based approach), can reflect counter-cyclicality preference of the stability authorities.