FRBSF Economic Letter
2003-22; August 1, 2003
Disclosure as a Supervisory Tool: Pillar 3 of Basel II
International efforts are underway to improve the regulation
and supervision of banking institutions to reflect advances in financial
risk management
techniques. In April 2003, the Basel Committee on Banking Supervision
(BCBS 2003a), headquartered at the Bank for International Settlements
in Switzerland, released for public comment the new Basel Capital Accord,
which will replace the 1988 Capital Accord. These international agreements
among banking regulators attempt to set regulatory capital requirements
that are comparable across countries. On July 11, the Federal Reserve
issued an interagency advance notice of proposed rulemaking, seeking
public comment on the implementation of the new Basel Capital Accord
in the U.S.
The new Accord, popularly known as Basel II, rests on three "pillars":
Pillar 1 focuses on making bank regulatory capital requirements more
risk sensitive, while Pillar 2 emphasizes refinements of current bank
supervisory processes regarding capital adequacy issues. The purpose
of Pillar 3 is to complement the other pillars by presenting an enhanced
set of public disclosure requirements focusing on capital adequacy. Banking
institutions, like all firms, are monitored by their customers, trade
counterparties, and investors in their securities. This type of monitoring
is part of what is generally known as "market discipline," which
is increasingly viewed as complementary to the monitoring efforts of
government supervisors; see Kwan (2002) for further discussion. The principle
underlying Pillar 3 is that improved public disclosure of relevant information
should enhance market discipline and hence its potential usefulness to
bank supervisors. This Economic Letter reviews recent policy developments
regarding disclosure by banking institutions, focusing on the disclosure
requirements in the proposed Basel Accord.
Market discipline and public
disclosure
In order for market discipline of banking institutions to
be effective, banks must be sufficiently transparent; that is banks
must provide
a sufficient amount of accurate and timely information regarding
their conditions and operations to the public. Improved public disclosures
of such information lead to increased transparency and should lead
directly
to more effective market discipline.
As described in a study by the
Board of Governors of the Federal Reserve System (BGFRS, 2000), bank
disclosure standards in the United
States
are a byproduct of the demands of market participants and regulatory
agencies as well as of the choices made by bank management. The
core disclosure requirements for banks with publicly traded equity are
set by the Securities and Exchange Commission (SEC) as well as
the
Financial
Accounting Standards Board. These banks must meet the standards
set for all publicly traded firms. For example, SEC disclosure rules
require publicly traded firms to file the annual Form 10-K, which
includes
audited
financial statements, and the quarterly 10-Q financial statements
that are unaudited. In addition, SEC filings must be made in connection
with special circumstances that can affect the reporting firm,
such as the
intention to issue new debt or equity securities.
In addition, all
banks, whether publicly or privately owned, are required to file quarterly
regulatory reports, such as the bank-level
Call Reports,
and much of this information is made publicly available. The
reports contain detailed information regarding bank balance sheets and
earnings. Also, agreements between banks and their supervisors,
such as formal
enforcement actions and cease-and-desist orders, are public documents
that disclose specific steps bank management must take.
Although
this overall regulatory reporting structure leads to a great deal of
public disclosure, banks have a large degree
of flexibility
in meeting SEC disclosure requirements and thus maintain some
control over
what information is disclosed. A clear example is the case
study reported in BGFRS (2000) regarding SEC requirements for disclosure
of market
risk exposures, defined as potential financial losses due to
adverse movements
in securities market prices. The most commonly used tool for
reporting such risks are value-at-risk (VaR) estimates that
summarize
the
potential
losses that might occur with a specified probability over a
given time horizon. In the case study, bank VaR disclosures were found
to vary
in detail across banks and to have an unclear connection with
actual trading
performance during the turbulent third quarter of 1998. Even
though such heterogeneity is present in these types of public
disclosures,
the academic
literature still suggests that market participants can assess
bank risks accurately. For the case of VaR disclosures, Jorion
(2003)
found that
VaR numbers in quarterly and annual reports of publicly traded
commercial banks provide reasonable predictions of the variability
of their
trading revenues.
Overall, bank disclosure appears to be improving
over time, guided by public and private sector efforts. A recent survey
of the
disclosure practices of internationally active banks by the
BCBS (2003b) found
that
they have expanded the nature of their disclosures. Using
a set of 104 questions addressing qualitative and quantitative
disclosures,
the survey
indicated that banks disclosed 63% of the survey items in
2001, compared
to 57% in 1999. The most commonly disclosed items were on
banks' capital structures, accounting policies, and market risk models.
In
the United States, the private sector Working Group on Public Disclosure
proposed enhancements to the public disclosure
of
market and credit
risk information by large banking institutions. For example,
the Group recommended
that disclosures should explain how such risks within a
firm change over time and how they evolve with innovations in
a firm's risk
management practices; see Supervisory Letter 01-06 issued
by the BGFRS (2001)
for
further details.
In an effort to continue this trend and
to improve the ability of bank supervisors to use market discipline
for their own
monitoring purposes,
the BCBS has made financial disclosure a key component
of the newly proposed Basel Capital Accord.
Details of
Pillar 3
Pillar 3 addresses the issue of improving market discipline
through effective public disclosure. Specifically,
it presents a set
of disclosure requirements
that should improve market participants' ability
to assess banks' capital structures, risk exposures, risk management
processes,
and, hence,
their overall capital adequacy.
The proposed disclosure
requirements consist of qualitative and quantitative information in
three general areas:
corporate structure,
capital
structure and adequacy, and risk management. Corporate
structure refers to how
a banking group is organized; for example, what
is the top corporate entity of the group and how are
its subsidiaries
consolidated
for accounting and regulatory purposes. Capital
structure corresponds to how much
capital is held and in what forms, such as common
stock. The disclosure
requirements
for capital adequacy focus on a summary discussion
of the bank's approach to assessing its current
and future
capital
adequacy.
In the risk management area, the focus
is on bank exposures to credit risk, market risk, risk from
equity positions,
and operational
risk.
For credit risk, which is defined as the potential
losses arising from borrowers not repaying their
debts, banks
must provide
a qualitative discussion of their risk management
policies, the
key definitions
and
statistical methods used in their risk analysis,
and information on their supervisor's acceptance
of their
approach. The
quantitative disclosures
include total gross credit risk exposures after
accounting for offsets and without taking account
of credit
risk mitigation efforts. These
exposures
also must be reported in disaggregated form by
exposure type (such as loans or off-balance-sheet
exposures),
by geographic
region,
by industry
or counterparty type, and by residual contractual
maturity. Impaired
loans and past-due loans also must be reported
by geographic region and industry type.
A key
element of the new Accord is banks' ability to use their own credit
risk models and internal
rating
systems
to set regulatory
capital requirements.
Credit risk models are tools for assessing
the potential losses from
aggregate fluctuations in loan repayments by
borrowers, and internal rating systems provide
these models
with indicators of how likely
different borrowers are to repay their loans.
Given the Accord's
increased reliance
on these internal components for setting regulatory
capital requirements, the proposed disclosure
requirements focus
on a number of related
informational areas. For example, banks must
provide a description of their internal
rating systems and the amount of credit exposure
in each rating category. Banks that opt to
use the most
sophisticated
capital
methods based
on their own models also must report key model
parameters, such as default
probabilities, credit exposures in case of
default, and losses given default; see Lopez (2001) for
further discussion.
Furthermore,
banks
must report historical results regarding actual
losses.
For market risk, banks must provide
a general qualitative disclosure of their
management policies, the statistical
methods used
in their models, and their model validation
and stress-testing procedures.
The quantitative
disclosures include capital requirements
for interest rate risk, equity risk, foreign exchange
risk,
and commodity risk, as well
as various
VaR measures and a comparison of these measures
with actual
outcomes. For
the interest rate risk arising from loan
portfolios, banks must report its nature qualitatively,
their models' key
assumptions, and their
earnings sensitivities to upward and downward
movements in interest
rates. For
risk from equity positions, banks must disclose
the types, amounts and nature of investments
in public
and private
firms, as well
as their total
gains or losses, whether realized or not.
Finally,
banks must disclose various elements of their operational risk exposures.
Operational
risk
is commonly
defined as the
risk of monetary
losses resulting from inadequate or failed
internal processes, people, and systems,
or from external
events. Aside from
a general qualitative
discussion of their approach to managing
such risks and supervisory approval, banks
that
choose to
use the advanced
measurement
approaches permitted
under the new Accord must describe their
modeling approaches as well as the operational
risk
charge before and after
any reductions resulting
from the use of insurance.
Implementation
The public disclosure requirements in Basel
II are far-reaching and are intended
to improve market discipline
and its
usefulness to bank
supervisors.
Yet, how well the requirements might
work in practice depends on how they are implemented.
For example, the disclosures must not
be overly burdensome on the reporting
banks,
but they
must be accurate.
The BCBS has
made an
effort to see
that the relatively narrow focus
of Pillar 3 on bank capital adequacy does not conflict
with
broader
accounting
requirements.
The BCBS
intends to maintain an ongoing relationship
with international accounting authorities
and to promote consistency among
disclosure frameworks. Note that Pillar 3 disclosures
need not be audited
by an external
auditor,
unless otherwise
required by accounting standard setters,
securities regulators, or other authorities,
but management
should ensure that
the information is appropriately
verified.
Another key implementation
issue is the frequency of disclosures. Qualitative
disclosures of
summaries of
bank risk management
policies are to be
reported annually, and that should
be
sufficient since they are not likely
to
change often. However, many variables,
such as regulatory capital ratios,
are to be reported
quarterly. More
frequent disclosures
have not been
proposed and could be overly burdensome
for some
institutions at this point, but given
the nature of certain bank
business lines,
such disclosures
may become commonplace in the future.
Another
important implementation issue is determining whether a specific
piece
of information
is
proprietary. The BCBS
has determined
that
specific items that may prejudice
a bank's proprietary or confidential
information
need not be disclosed. However,
the bank must disclose more general information
about the
subject matter,
together with
an explanation
of why those specific
items were not disclosed.
Along
the same lines, determining whether specific disclosure items
are material
is another challenge.
Under the current
guidelines, banks should
decide which disclosures are
material based on commonly accepted principles;
that is,
information is material
if its omission
might
change or influence
the assessment or decision of
a user relying on that information.
This
definition is
consistent with International
Accounting
Standards and
with many national accounting
frameworks.
In summary, many implementation
details are addressed within
the Pillar 3
disclosure requirements, but
many specific
questions and
additional
issues will arise during the
actual implementation process.
However,
it is reasonable to
assume that as these issues
are worked out,
the improved disclosure by
banks should facilitate
market discipline, contribute
to supervisory monitoring efforts,
and enhance the
stability of the national and
international
banking systems.
Jose A. Lopez
Senior Economist
References
[URLs accessed July 2003.]
Basel Committee on Bank Supervision. 2003a. "Overview of the New
Basel Capital Accord: Consultative Document" (April).
http://www.bis.org/bcbs/cp3ov.pdf
Basel Committee on Bank Supervision. 2003b. "Public Disclosures
by Banks: Results of the 2001 Disclosure Survey." Basel Committee
Publications No. 97 (May).
http://www.bis.org/publ/bcbs97.htm
Board of Governors of the Federal Reserve System. 2000. "Improving
Public Disclosure in Banking." Staff Study #173.
http://www.federalreserve.gov/PUBS/StaffStudies/2000-present/ss173.pdf
Board of Governors of the Federal Reserve System. 2001. Supervisory Letter
01-06: Enhancements to Public Disclosure.
http://www.federalreserve.gov/boarddocs/SRLETTERS/2001/sr0106.htm
Jorion, P. 2003. "How Informative Are Value-at-Risk Disclosures?" The
Accounting Review 77, pp. 911-931.
Kwan, S.H. 2002. "The Promise and Limits of Market Discipline in
Banking." FRBSF Economic Letter 2002-36 (December 13).
http://www.frbsf.org/publications/economics/letter/2002/el2002-36.html
Lopez, J.A. 2001. "Modeling Credit Risk for Commercial Loans." FRBSF
Economic Letter 2001-12 (April 27).
http://www.frbsf.org/publications/economics/letter/2001/el2001-12.html
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