International Regulations of Banks - Basel II, Pillar III - Essay Example

BASEL II – PILLAR III INTRODUCTION Pillar III addresses the issue of market disciple through effective public disclosures. Specifically it representsa set of disclosure requirements that should improve market participants ability to assess the bank’s capital structure, risk exposures, risk management processes and hence their overall capital adequacy. The proposed disclosure requirements consist of qualitative as well as quantitative information in three general areas i.e. corporate structure, Capital Structure and adequacy and risk management. Corporate structure refers to how a banking group is recognized, what is the top entity of the group and how its subsidiaries are 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 banks 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. This essay will explore the above mentioned Pillar III of the BASEL II and its various elements however before discussing the Pillar III; I would be touching on some of the historical context of BASEL II in order to get a comprehensive view of the accord before elaborating on the Pillar III. BASEL II and Risk Management The advent of BASEL II is the turning point in the field of Banking as it demands complete transparency and rational approach towards making banking more risk sensitive. BASEL II prompted me to look for this new and exciting avenue of Financial Risk Management as it not only involved a more prudent approach towards banking but it also demands a transparent and flexible banking structure to be in place to effectively manage the interests of various stakeholders in the banking sector. Bank of international Settlements was established in Basel, Switzerland in 1930 and is considered as the world’s oldest international financial institution. It remains the principal center of international central bank corporations around the world. The BIS was formed as a result of the treaty of Versailles which ended the First World War and BIS was basically established for repatriation of funds from the Germany to allied forces. However after the Breton Woods Agreement the scope of BIS was greatly increased as a result of the growing emphasis being placed on the role of central banks in managing the financial system of the banks and a need for a regulating the internationally active banks were felt. It was because of this reason that a Basel Committee on Banking Supervision was first established in 1974 as the committee for banking regulations and supervisory practices. This committee was established by the central bank governors of the G210 countries mainly due to the failure of the Herstatt Bank.(Compliance LLC,2006). The first serious effort towards developing the Capital accords took place in 1980s and resulted in the implementation of minimum capital standards of 8% was implemented by the end of 1992. However as the process evolved over the period of time, The Basel Committee issued a proposal for a new framework to replace the 1988 accord and after lengthy discussions, a new capital accord was introduced in June 2004 known as BASEL II.. The new BASEL II accord was aimed at being implemented in G10 countries and was released also to Spain and Luxemburg besides the G10 countries to adapt the new accord by their own individual rule making process. The principals of risk management suggest that the credit providing institutions must maintain a minimum level of financial capital in order to sustain the various risk shocks to which they are exposed to. The basic aim of this approach is to ensure that the banks and financial institutions must maintain financial soundness and retain the consumer confidence in order to ensure the stability of the financial system and protect the interests of the deposit holders. With these perspectives in mind, Bank of International Settlement formed a Basel Committee on Banking Supervision in 1974 to provide a comprehensive forum for dealing with banking matters of such magnitude. The Basel Committee is made up of senior officials responsible for banking supervision or financial stability issues in central banks and other authorities in charge of the prudential supervision of banking businesses. Members of the Basel Committee come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK and the US. (GARP, 2006). Pillar III- Market Discipline Disclosure is the public dissemination of information that is material to the evaluation of a company’s business. (GARP, 2006). Traditionally disclosures whether within the context of the accounting and other regulatory requirements, they have often been considered as important because they can provide existing and potential investors an opportunity to sift through the information to make more prudent decisions. It is believed that the minimum capital requirements and the supervisory review are being re-enforced with the introduction of the Pillar III.. The Pillar 3 is designed to facilitate the use of market mechanism for the prudential purposes. “This is based on the assumption that well informed market participants will reward a risk-conscious management strategy and effective risk control by credit institutions in their investment and credit decisions and will correspondingly penalise riskier behaviour. This gives credit institutions a greater incentive to monitor and efficiently manage their risks.”(Bundesbank, 2008). The basic aim behind the Market discipline is to ensure that the organizations must show transparency in their disclosure requirements and in doing so provide accurately and timely information to all the stakeholders. The Pillar 3 addresses the issue of the improving market discipline through effective market discipline. To be more specific, the market discipline approach defines it according to three different variables. In risk management approach, the focus in on managing the credit, market and operational risks of the bank. In order to effectively manage the credit risk, banks are required to disclose the information completely in the shape of discussion on the qualitative aspects of as what policies and procedures have been adapted to effectively manage this kind of risk. This further extends to the definition of the key policies, statistical methods to use and the information regarding the acceptance of the credit risk models by the Supervisors of the country.(FRBSF,2003). In its essence, Pillar 3 applies to the disclosure requirement only to the consolidated group entities of the banks until and unless bank includes a separate large and significant bank as its subsidiary. In these kinds of cases, each subsidiary is required to its own disclosure requirement and the group on the consolidated basis would only report the Tier I capital ratios. However in order to complete or rather fulfill the disclosure requirements, following requirements need to be fulfilled: Qualitative Requirements includes the inclusion of the top corporate entity within the group to which the Pillar III applies a complete description along with details of the group accounting and regulatory purposes and disclosure of any differences between the two and finally fulfilling the requirement of disclosing the any restrictions on the transfer of capital around the banking group. Qualitative requirements include the disclosure of the any surplus capital held in insurance subsidiaries which are the part of the banking group besides disclosing the value of the investments made by the group into insurance subsidiaries. When it comes to the disclosure requirements of the capital structures, banks are required to disclose the full description and details of the structure of their capital. When disclosing the qualitative information about the capital structure, banks are required to describe the main features of all its capital instruments whereas on the quantitative front, the bank need to disclose information on the amount of TIER I capital, by class of instruments, the amount of Tier 2 capital and Tier 3 Capital, deductions made from the capital and finally the disclosure of the total regulatory capital. While disclosing Capital Adequacy Disclosure, the Pillar 3 requires that banks to disclose information on their regulatory capital. Capital Adequacy disclosure requires that the bank describes its approach of the bank to assessing its capital adequacy whereas the capital requirements for the credit risk, by portfolio under the standardized and internal ratings based approach. It is also customary that the capital requirements for the equity exposures, market risk as well as operational risk are to be disclosed properly. Pillar 3 on the risk exposure and assessment requires that the Banks disclose their information on credit risk, market risk, operational risk, the interest rate risk in the banking book as well as the equity risk in the banking book. Apart from disclosing the information regarding the above risks, there are also some general requirements for risk disclosures to fulfill. For each risk category, banks are required to outline their strategies and process, the structure and organization of the relevant risk management structure and function within the organization, outlining the scope and nature of the risk reporting mechanism in the organization besides disclosing the policies for hedging and mitigating these risks. (GARP, 2006). REFERENCES 1. Compliance LLC. (2006). BASEL II. Available: http://www.capital-requirements-directive-training.com/Title2.htm. Last accessed 06 April 2008. 2. GARP. (2006). BASEL II and the International Regulations of Banks. In: GARP Banking Risks- Measurements, Supervision and Disclosure. New Jersey: GARP. P37-40. 3. Bundesbank. (2008). Pillar 3: Enhanced disclosure (discipline of market). Available: http://www.bundesbank.de/bankenaufsicht/bankenaufsicht_basel_saeule3.en.php. Last accessed 07 April 2008 4. Federal Reserve Bank of San Francisco. (2003). Disclosure as a Supervisory Tool: Pillar 3 of Basel II. Available: http://www.frbsf.org/publications/economics/letter/2003/el2003-22.html. Last accessed 07 April 2008. Read More