BASEL II PILLAR III MARKET DISCIPLINE

1. BASEL II PILLAR III MARKET DISCIPLINE Dilip Nachane Senior Professor Indira Gandhi Institute of Development Research Mumbai, India nachane@igidr.ac.in CRO ANNUAL SUMMIT MUMBAI 9th March 2007

2. The Three Pillars

3. Outline of the New Basel Capital Accord PILLAR IMinimum capital requirements PILLAR IISupervisoryreview process PILLAR IIIMarketdiscipline Weighted risk Definition of Capital Interest rate risk Liquidity risk Credit risk Market risk (amendments 1996) Operational risk Asset securitization Standard approach Event risk Business risk Internal rating-based approach Basic Indicator approach Standardized approach Foundations Advanced Internal rating-based approach Standard approach Advanced measurement approach

4. Market discipline is sought to be achieved via • Disclosure Requirements • Remedial action in case of non-disclosure • Complementarity between Pillars I, II and III • Disclosure of information in regulatory reports, which may or may not be made public at the discretion of the supervisor/regulator.

5. Overview of some of the disclosure requirements under Pillar III

6. Disclosure Overlap There could be several overlaps between disclosures made under accounting requirements, under listing requirements made by securities regulators and those under Pillar III. In such situations the banks are expected to provide an explanation of material differences (if any) between the disclosure requirements in the 3 categories. The BCBS (Basel Committee on Banking Supervision, BIS) is also studying the issues of consistency between disclosures under Pillar 3 and norms for accounting disclosures IASB (International Accounting Standards for Banks) 30.

7. Materiality The guiding principle for Pillar III disclosures is materiality. An information is regarded as material if its omission or misstatement could affect the decisions of a user of that information. In particular, market participants should be able to reach a view on the risk profile of the bank, based on the disclosures (under Pillar III). For judging the materiality of a particular piece of information, the norm introduced is what a “reasonable investor” would consider as material.

8. Proprietary and Confidential Information • There is need to strike a balance between the disclosure requirements and information of a proprietary or confidential nature. • Proprietary information relates to information (on products, procedures, systems, etc.) which if shared with competitors could render a bank’s investment in these products etc. less valuable and undermine its competitive position. • Confidential information usually relates to customers, relationship with whom may be bound by a legal agreement or counterparty relationship.

9. Frequency • By and large it is felt that annual disclosure is insufficiently frequent for allowing market discipline to operate with full effect. By and large, most of the disclosures under Pillar 3 are envisaged as being collated on a semi-annual basis, with two important exceptions. • Qualitative disclosures providing a general summary of a bank’s risk management objectives and policies, reporting systems and definitions may be made on an annual basis. • Large internationally active banks should disclose their Tier I and total capital adequacy ratios along with their components on a quarterly basis.

10. Scope Pillar 3 requirements are generally expected to apply at the tope consolidated level, with the exception of disclosures of capital adequacy which are expected to operate also at the levels of subsidiaries and foreign branches. However, in order to avoid confusion among market participants the following disclosures are however mandated.

11. Disclosures for Capital

12. Disclosures for Capital Adequacy

13. Disclosures for Credit Risk

14. Disclosures for Market Risk (Standardised Approach)

15. Disclosures for Market Risk (Internal risk based approach)

16. Disclosures for Operational Risk

17. Is Market Discipline Effective? • Empirically if market discipline is effective in improving bank governance, then we must have that publicly listed banks (with constantly available market signals from their equity and bond prices) should take less risk than similarly placed non-publicly traded banks. • This has been done by regressing measures of bank risk taking e.g. credit risk, earnings volatility, capitalizations, etc. on a vector of firm characteristics (firm size portfolio mix, funding mix, etc.) and a dummy variable for publicly traded banks. • No significant difference in the risk profile between publicly traded and non-traded bank. • Very often publicly traded banks tend to have worse supervisory ratings than non-publicly traded banks.

18. Is Market Discipline Effective? The above empirical studies demonstrate that market discipline may not really come from the stock and bond holders but more likely from counterparties (including depositions) borrowers and regulators. The information content under Pillar III should thus be of greater relevance to the latter group. Greenspan (2001) “… we need to adopt policies that promote private counterparty supervision as the first line of defence for a safe and sound banking system. Uninsured counterparties must price higher or simply not deal with banking organizations that take on excessive risk”. This statement has strong implications for cross border flows. Representatives of countries with imperfect market systems fear that public disclosure under Pillar III could seriously undermine the flow of global deposits and other capital inflows.

19. Basel II : Second & Third Pillars • Second Pillar (Supervisory Review Process • Supervisors should be able to prescribe higher capital adequacy ratios for specific banks. • Banks should develop internal procedures for assessing overall capital adequacy in relation to their risk profiles. • Strategies and procedures adopted in (ii) should be open to supervisory review. • Prompt corrective action by supervisors. • Third Pillar (Market Discipline) Stress disclosures by banks to enable counterparties (to bank transactions) make well-founded risk. Salient components of disclosure information • Structure and components of bank capital • Accounting policies used for valuation of assets and liabilities • Risk exposures and risk management strategies • Capital ratio and main features of its capital instruments.

20. Macroeconomic Implications of Basel II • Capital adequacy and the aggregate economy • Possibility of increased capital adequacy leading to a credit crunch (Jackson et al (1999)), which may affect real output if many firms are bank-dependent. • Monetary transmission affected via the emergence of a financial accelerator (van den Heuvel (2002)). • Differential effects of monetary policy on poorly capitalized and adequately capitalized banks (Tanaka (2002)). • Pro-cyclicality (Ghosh & Nachane (2003)). • Cross-sectional Implications • Restriction of credit supply to high-rated borrowers • Special problems for SMEs (Basel directive of July 2002) • Basel II may curtail credit supply to borrowers based in LDCs (Ferri et al (1999) • Impact on Capital Flows to EMEs.

21. Basel II and India Likely Implications • Basel II may lead to increased capital requirements in all banks across the board. • Likely pressures on interest rate spreads. • Unsolicited ratings and low penetration of ratings. • High-risk assets may flow to weaker banks who are more likely to be adopting a standardized approach. • Anomaly between prescribed risk weights for unrated entities and entities with lowest rating. • Success of Basel II contingent upon good corporate governance.