Sarbanes-Oxley Act and Basel Accord II - Research Paper Example

Sarbanes-Oxley and Basel Accord II Contents Abstract 3 Chapter 1 – Introduction 4 Chapter 2 – Sarbanes-Oxley Act 2002 6 Chapter 3 - Basel II 14 Chapter 4 – Conclusion 22 Bibliography 24 Abstract Corporation operating in the larger publicly listed arena operate in the area of public trust afforded by their size and or status. The preceding is true whether they are engaged in manufacturing, services, financial, and or banking, to name a few areas. As the complexities, and demands of conducting business, appeasing shareholders, meeting profit targets, and competing in the increased competitive atmosphere of globalisation weigh on corporate decision making, the potential risks cannot be ignored. The temptations of potentially dubious courses of action as represented by more risky investment vehicles, new market entries, and other considerations to generate increased performance, revenues, earnings and a heightened stock price are real world variables that have manifested themselves in a rash of corporate scandals and banking failures. The preceding represents the historical foundations that preceding the enactments of the Sarbanes-Oxley Act, and Basel II. This examination shall delve into these two pieces of regulatory legislation to uncover the ramifications of there use as well as identify any potential similarities. Chapter 1 – Introduction Globalisation is often utilised, whose meaning has relevance in terms of the implications of the Sarbanes-Oxley and Basel Accord II. Lewellen (2002) defines globalisation as: “…the increasing flow of trade, finance, culture, ideas, and people brought about by the sophisticated technology of communications and travel and by the worldwide spread of neoliberal capitalism, and it is the local and regional adaptations to and resistances against these flows. Beck et al (2003) advise that globalisation “…involves the simultaneity and the interpenetration of what are conventionally called the global and the local”, which provides too broad a context to be useful in understanding its overall ramifications. Bhagwati (2004) offers a definition that enhances the one stated by Lewellen (2002), and provides a realm from with the understanding of the circumstantial environment impacting banking can be understood. He states (Bhagwati, 2004) that globalisation “…constitutes integration of national economies into the international economy through trade, direct foreign investment (by corporations and multinationals), short-term capital flows, international flows of workers and humanity generally, and flows of technology”. The borderless world, trade and economically speaking, means that capital flows more freely into as well as out of countries, and regions encountering differing financial, accounting, and legal systems. The preceding compounds the complexities of translating financial reporting, risk management, and analysis as well as capital requirements as posed by the preceding. While the terms bank, and banking are well known to us all, exactly what they are, and do might not be as easily called to mind. Banks represent the core of our economic systems as they hold, transfer, invest, and utilize money on a customer, client, and institutional basis to generate a return (Cranston, 1997). “The essential characteristics of the business of banking are “. . the collection of money by receiving deposits upon loan, repayable when and as expressly or impliedly agreed upon, and the utilization of the money so collected by lending it again in such sums as are required”, The foregoing represent “…the essential functions of a bank as an instrument of society” (Cranston, 1997, p. 5). The core activity of banks is the taking of deposits, and lending that have evolved into “…multifunctional institutions, engaged not only in core banking but in a range of other activities” (Cranston, 1997, p. 3). He further explains that “…individual customers have become wealthier, and more sophisticated. Money has been drawn away from deposit accounts to unit trusts, life assurance, and pension plans. Banks have thus become involved in the distribution, and provision of these services as their captive deposit base has been eroded” (Cranston, 1997, p. 3). The foregoing has thus lead to “…banks themselves choosing higher risk, higher return activities … as banks have become players in foreign exchange, securities, and derivatives markets, on their own account, as well as on behalf of customers … (with their) … Trading profile, as well as fee income, as the goal” (Cranston, 1997, p. 3). In terms of finance, “…banks are not the sole providers of capital, and therefore are not alone in suffering periodic losses, falls in asset prices are generally thought to have more serious consequences if they occur in the banking system rather than elsewhere in the economy” (Brealey et al, 2001). Bank regulation is an important facet in that it “…first arises from banks’ role in the payments system” in addition to the fact that a “banking crises may restrict credit and accentuate the fall in economic activity” (Brealey et al, 2001, p. 5). Lastly, “… the fragility of bank deposits and the costs of monitoring bank solvency” form the reasons as well as justification for banking regulation. The Sarbanes-Oxley Act of 2002 represented the United States Congress introduction of “…a series of corporate governance initiatives into the federal securities laws …” (Romano, 2003). The Act, is also known as SOX as well as the Public Company Accounting Reform and Investor Protection Act of 2002 (McCauley-Parles et al, 2007). Enacted to restore public trust in accounting as well as corporate reporting practices after the scandals resulting from the bankrupcies of Enron, Worldcom, Tyco International, Arthur Anederson, Xerox, and others (Patsuris, 2002) the Act “…has been described as the most sweeping and significant change in securities law since the 1930's.” (McCauley-Parles et al, 2007). The fall of Enron represented the event that pushed the creation and passage of the Sarbanes-Oxley Act, even though prior scadals of corporate reporting and misdoings had occurred. It was the scope, and magnitude of Enron’s misconduct, and financial fallout that rocked the United States financial markets with the brazeness of running up of the stock price through deals, and reporting measures that were either non-existant or fraudulent (Longnecker, 2004). The preceding was further compounded by the company’s accounting firm, Arthur Andersen, essentially turning a blind eye to the events, and reporting measures through failing to perform its fiduary duties in a manner consistent with good accounting, and auditing practices (Longnecker, 2004). The fallout did not just end with American based companies. The Italian food giant Parmalat became the subject of investigation by authorities in Italy “…after discrepancies were revealed in its accounting practices to the tune of more than $5,000,000,000”, one of which represented the fact that money being held in a Cayman Island subsidiary was indeed false (Longnecker, 2004). The preceding represent the conceptual underpinnings of the rationales behind the Act. The foregoing has been utilised to provide a foundation to understand the ramifications, and circumstances that led to the passage of the Sarbanes-Oxley and Basel II accord, which shall be further elaborated upon herein Chapter 2 – Sarbanes-Oxley Act 2002 The Sarbanes-Oxley Act represents a broad reaching as well as comprehensive and complex statute that amended U.S. securities laws in many significant ways (McCauley-Parles et al, 2007). The Act (McCauley-Parles et al, 2007): “… established new law, made changes to existing law, and effected Securities and Exchange Commission (hereinafter the "SEC") rule-making and stock market listing standards. SOX's provisions affect accountants, lawyers, and many others who deal with public companies or issuers. SOX included many "reforms aimed at improving and enhancing financial reporting and at regulating the accounting and audit professions". One of the central facets of the Sarbanes-Oxley Act was its revamping of the accounting profession, and system. As brought forth in the Enron scandal, which was just one such instance, but the largest, “The lack of auditor independence is viewed as a significant contributor …” to the fall of this high flying company (McCauley-Parles et al, 2007). Section 201 of the Act clearly sets forth specifications to eliminate this type of occurance (Sarbanes-Oxley.com, 2007). This aspect represents one of the strongest provisions of the Act in that it overrode “…the long-standing objections of the accounting industry to the creation of an independent regulatory body that would set standards and discipline auditors” (Treaster, 2001). The preceding meant that the self-regulation of auditors had come to an end. The new Public Company Accounting Oversight Board would be under the oversight of the United States Securities and Exchange Commission (Treaster, 2001). Under this structure, the chairman as well as four members of the Board are chosen by the SEC (Treaste, 2001). The Act, in summary, covers issues such as: establishing an accounting oversight board, defining the independence of auditors, setting forth provisions of corporate responsibility, and requiring enhanced financial disclosure The legislation updated audit regulations and is one of the most important changes to United States securities laws. The Sarbanes-Oxley Act was named after its sponsors Senator Paul Sarbanes a democrat from the state of Maryland, and republican Representative Michael Oxley from Ohio (Sarbanes-Oxley.com, 2007). The provisions of the Act provide for (Sarbanes-Oxley, 2006): 1. The chief executive as well as financial officers certify financial reports to ensure they are aware of all financial issues conducted by the firm, and thus protect the public trust. 2. That personal loans to executive officers, and directors are not permitted to ensure officers as well as Board members remain impartial, and thus do not have vested interests to protect. 3. The reporting of accelerated trades by insiders reveals any profits that could be unusual. 4. Insider trading is prohibited during blackout periods for pension funds to ensure that shifts, and or material changes to the position of the company as could occur during a sensitive period are not utilized for financial gain that normal shareholders could not participate in. 5. The compensation as well as profits to the CEO, and CFO are reported publicly to keep the public aware of the nature of compensation packages. 6. Auditors are to be independent prohibiting certain types of work to prevent conflicts of interest on the part of the accounting firm. 7. Securities laws violations are punishable criminally as well as civilly through an increase in punitive actions 8. Jail sentences are extended under the Act for significantly longer periods. 9. Value added services by audit forms is prohibited along with legal, and other services that are unrelated to audit work to prevent conflicts of interest. 10. Annual independent audit reports are required concerning the condition of internal financial reporting controls. The ramifications of the Act are broad as well as sweeping in that it consists of eleven titles (sections) that are summarized as follows (SOX-online.com, 2007): 1. Title I – Public Company Accounting Oversight Board (SOX-online.com, 2007) Under this section of the Act, the key segments are as follows a. Section 101 establishes administrative provisions b. Section 103 spells out the auditing, quality control as well as independence standards of accounting firms, and the rules associated with the preceding. It sets forth that “ registered public accounting firms … prepare, and maintain …” audit papers as well as other information so related in full detail for a period of seven years (AICPA, 2007). Within this section, a standard requiring auditors to evaluate if the internal control structures as well as procedures include records which reflect accurately the issuers transactions, and provide assurances that these are recorded in a way that coincide with the preparation of financial statements that meet with GAAP regulations (AICPA, 2007). In addition, the foregoing requires that any material weaknesses within the internal controls are identified, and brought forward (AICPA, 2007). c. Section 104 deals with the inspections of registered public accounting companies, setting forth that annual inspections are to be conducted for companies auditing more than 100 issues, with those constituting less than this amount to be held every three years (AICPA, 2007). Special inspections can be conducted at anytime. d. Section 105 provides for the investigation of accounting firms, and their clients along with disciplinary proceedings. It states that “Sanctions can be imposed by the Board … (if a) … firm … fails to reasonably supervise and associated person ..” involved with the auditing, and or quality control standards (AICPA, 2007). e. Section 106 entails the rules, and regulations with respect to foreign public accounting forms. This section specifies that foreign accounting firms auditing U.S. companies must register with the Board. 2. Title II – Auditor Independence (SOX-online.com, 2007) a. Section 201 represents services that are outside the scope of the practice of auditors. Specificly it states that it is unlawful that the auditing firm provides other services that are non audit while engaged by the issuer as an auditor (AICPA, 2007). b. Section 203 deals with the rotation of audit partners, and specifies that the lead audit, or coordinating partner, along with the reviewing partner “… must rotate off of the audit every five years” (AICPA, 2007). c. Section 206 represents conflicts of interest whereby the Chief Executive Officer, Controller, Chief Financial officer, Chief Accounting Officer, and or any other person of an equivalent type, and or “… position cannot have been employed by the company’s audit firm …” for a one year period preceding the audit (AICPA, 2007). 3. Title III – Corporate Responsibility (SOX-online.com, 2007) a. Section 301 refers to public company audit committees that shall be independent in terms of not having any type of affiliation with the issuer, and or any of the issuer’s subsidiaries (AICPA, 2007). b. Section 303 represents improper influence in terms of the conduct of audits, and makes it a criminal offence for an officer, and or director of the audited company to undertake any type of action that could in any manner “… fraudulently influence, coerce, manipulate, or misled …” an auditor (AICPA, 2007). c. Section 305 states that “… any action that is brought forth by the SEC in terms of securities laws violations that the federal courts in the United States are “… authorized to grant any equitable relief that my be appropriate …” in terms of investor benefit (AICPA, 2007). d. Section 307 deals with the rules of professional responsibility in terms of attorneys, and requires them to report evidence of securities laws violations to the chief legal counsel, and or CEO of the company involved (AICPA, 2007). It further states that if these individuals do not respond properly to such notification that then the attorney is required to make a report to the audit committee of the company’s board of directors (AICPA, 2007). 4. Title IV – Enhanced Financial Disclosures (SOX-online.com, 2007) a. Section 401 refers to disclosures in periodic reports that in accordance with GAAP standards shall “reflect all material correcting adjustments …” that have been uncovered in all company reports (AICPA, 2007). b. Section 404 entails management’s assessment of internal controls which binds companies to an annual internal control report that (AICPA, 2007): 1). States it is management’s responsibility for the establishment, and maintenance of an internal control structure that is adequate, along with financial reporting procedures (AICPA, 2007), and 2). That such report shall contain an assessment at the end of the issuers fiscal year periods of the internal control structure effectiveness as well as procedures (AICPA, 2007). c. This section also requires that a code of ethics for senior company financial officers is made public (AICPA, 2007). 5. Title V – Analyst Conflicts of Interest (SOX-online.com, 2007) a. Section 501 refers to the treatment of securities analysts in terms of registered securities associations as well as national exchanges. 6. Title VI – Commission Resources and Authority (SOX-online.com, 2007) 7. Title VII – Studies and Reports (SOX-online.com, 2007) 8. Title VII – Corporate and Criminal Fraud Accountability (SOX-online.com, 2007) The sections under this Title make it a felony “… to knowingly destroy or create documents to impede, obstruct or influence …” any federal investigation (AICPA, 2007). The Title further requires that auditors must maintain “all audit or review work papers for five years” (AICPA, 2007). This Title also provides what is termed as “whistleblower protection” that prohibits companies from taking actions against those employees who under the law disclose information concerning their employer, and or others, private or public, that may constitute a fraud or violation of any of the rules and or statues under the Act (AICPA, 2007). 9. Title IX – While Collar Crime Penalty Enhancements (SOX-online.com, 2007) This segment of the Act increased the maximum penalty to 10 years for mail, and wire fraud form five years, and also made it a crime to tamper with records, and or impede any investigation (AICPA, 2007).. The SEC is also provided with the ability to seek the freezing in court of extraordinary payments to officers, and or directors, partners, other individuals, and or agents that lie outside of what is deemed within normal compensation bounds (AICPA, 2007). It further states that all financial statements as “… filed with the SEC must be certified by the CEO, and CFO”, and that knowing violations of the stipulations under this Title can result in fines, and or sanctions of up to $500,000 and or imprisonment ranging up to five years (AICPA, 2007). 10. Title X – Corporate Tax Returns (SOX-online.com, 2007) a. Section 1101, states that the Federal income tax return must be signed by the company’s chief executive officer. 11. Title XI – Corporate Fraud and Accountability (SOX-online.com, 2007) a. Section 1102, refers to the fact that it is a crime to tamper with a record and or impeding an official investigation or proceeding (AICPA, 2007). A study of the effects of the Sarbanes-Oxley Act in terms of its ramifications on the marketplace was conducted by Coustan et al (2004) among professionals in the industry to gain insights of the aftermath of the Act. The Act that deals with the “Assessment of Internal Controls”, under Section 404, makes it a requirement that issuer’s publish an “internal control report” in their annual report that contains an assessment “…of the effectiveness of the internal control structure, and procedures of the issuer for financial reporting” (Coustan et al 2004). Said section, 404, also requires the auditor to attest to as well as report on the internal control assessment as set up by management (Coustan et al, 2004). All of the interviewees agreed that the foregoing represented a good idea in that it increased management’s working knowledge as well as concern on the quality of this area (Coustan et al 2004). It was noted that while many large firms already had these type of controls in place, the Act will result in more emphasis (Coustan et al, 2004). On the negative side of the requirement it was noted that “It may be harder to go public, but the real challenge to smaller companies will be the costs, which will be incredibly prohibitive” as the company is going to have to be a certain size, and really want to go public. New companies that come out are probably going to be a lot bigger" (Coustan et al, 2004). The study conducted by Coustan et al (2004) also uncovered that the people within the profession agreed that the Act contained many good areas. They commented "The dumb CEO is no excuse any more. There will be zero tolerance. Companies must find CEOs who understand financial statements” (Coustan et al, 2004). The Act responded directly to the malfeasance of prior scandals, most noteably Enron, and Arthur Andersen, the largest as well as most broadly known of the aforementioned corporate failures in terms of damages, and reach (cpa-cfa.com, 2007). The Enron scandal prompted certain reforms that manifested themselves under Section 404 of the Act which: entails management’s assessment of internal controls which binds companies to an annual internal control report that (AICPA, 2007): 1). States management’s responsibility to the establishment and maintenance of an internal control structure that is adequate, along with financial reporting procedures (AICPA, 2007), and 2). That such report shall contain an assessment at the end of the issuers fiscal year periods of the internal control structure effectiveness as well as procedures (AICPA, 2007). Interestingly the bad investments as well as debt that were hidden within Enron’s intricate accounting system were not addressed (cpa-cfa.com, 2007). However, these areas were strengthened under the Financial Accounting Board Standards (FASB) rule 46, and 46 that tightened the guidelines for financial sheet consolidations to prevent the hiding of intricate deals as occurred under Enron (cpa-cfa.com, 2007). The accounting firm of Arthur Andersen was also involved in a number of other accounting scandals, including Enron (cpa-cfa.com, 2007). The company also was the firm handling the auditing for “WorldCom, Sunbeam, Waste Management as well as Global Crossings” (cpa-cfa.com, 2007). Arthur Andersen collapsed under the weight of these scandals as its reputation was tarnished (cpa-cfa.com, 2007). Chapter 3 - Basel II “The international standard for bank capital was set by the Basel Accord” (Brealey et al 5). A key factor in the Basel Accord is that “…in computing capital ratios, the Accord made formal allowance for risk” (Brealey et a, 2001). Padoa-Schioppa (2004) advise that “The Capital Accord adopted by the Basel Committee in 1988 constitutes a milestone in the field of banking supervision and a major success of international economic cooperation in general”. It “…introduced a minimum capital requirement for the international banks of the G10 countries set in relation to their credit risks” (Padoa-Schioppa, 2004). In addressing credit, and country risk, the Capital Accord represents a system whereby banks in the European Union all operate under the same rules in these areas. An understanding of the Basel Accord that preceded Basel II is necessary in order to be able to equate the changes, and impact of Basel II, what it addressed as well as why. The Basel Accord of 1988 represented a major step in accomplishing the following (Mikdashi, 2001): 1. The Basel Capital Requirements were the “…basis for strengthening the international banking system by raising the amounts of capital banks were required to hold. In so doing they contributed to a more level playing field for internationally active banks” (Mikdashi, 2001). 2. The Basel Accord was “…the first time that national regulators had agreed on the application of a set of international minimum standards for bank supervision – a first step towards global regulation” (Mikdashi, 2001). As such, the Basel Accord represented the initial step towards global regulation of the banking sector. The 1988 capital accord established “…capital requirements for banks by assigning loans and off-balance-sheet commitments to four risk-weighted categories based on perceived credit risk” (Gup, 2002, 108). Criticism of the Basel Accord was based upon the fact that it had “…types of assets with different degrees of credit risk” (Gup 2002, 108). To illustrate the foregoing Gup (108) cites the example of a blue chip company loan that has a triple A credit rating. He states that this “…carries the same 100 percent risk weight … as a loan to a speculative company with a below-investment grade rating” (Gup, 2002, 108). The problem that resulted was that because of the preceding unsophisticated credit risk treatment, Large Complex Banking Organizations (LCBOs) were able (Gup, 2002): “to engage in “capital arbitrage” by 1) using complex derivatives, whose embedded risks are difficult to value, as substitutes for conventional financing arrangements, and 2) structuring methodologies that transfer low-risk assets out of the bank while retaining more risky assets. The weakness of the Basel Accord is that is did not take into account the risks in the market resulting from derivatives, securities as well as the other banking trading assets of banks (Gup, 2002, p108). The key component that the Basel Accord was devised to rectify was the fact that capital represents what is termed as “… a lagging indicator of bank problems …” as a result of the fact that capital declines are generally not reported, and recognised until after a bank is in serious trouble (Gup, 2002, p. 109). The lag time is due to the fact that many banking assets such as loans, OTC derivatives as well as residual interests in securitisations are not traded in organised markets, and thus make it extremely difficult to evaluate (Gup, 2002, p. 109). The result of the preceding is that the problem as represented by the depreciation of these types of assets is not seen until after a significant capital reduction has happened (Gup, 2002, p. 109). In addition to the foregoing, the officers of banks getting involved in this type of problematic situation often postponed write downs in terms of capital as well as assets in the hope that the situation would rectify itself prior to the next supervisory examination, or the requirement to make public disclosure (Gup 109). Basel II addresses the foregoing weaknesses of the Basel Accord, and adds additional important regulations, and requirements to prevent bank failures. The highlights of these revisions and changes are as follows (Accenture, 2003): 1. to ensure that the capital allocation of banks is more sensitive to risk, 2. to separate the bank’s operational risk form its credit risk as well as providing for separate capital charges, 3. to bring a convergence of regulatory, and economic capital, 4. to vary the bank capital requirements of banks with different types of business, and 5. to encourage the use of internal systems to arrive at levels of capital to met regulations. It, Basel II, was designed as well as intended to mitigate risks affecting today’s financial markets (Stein, 2004). The framework of Basel II is founded on a more comprehensive standard in terms of capital adequacy regarding minimum standards. This is accomplished through the improvement of the rules via the alignment of regulatory capital requirements so they are closer to the risks faced by banks (Bank for International Settlements, 2007a). In reviewing Basel II it is important to understand the importance of risk, and thus risk management in the banking perspective. Under Basel II, risk management is more active as it is driven by the access to higher quality as well as more timely risk information in consideration of the differential capital requirements (Ernst & Young, 2006). The proposals under Basel II impact risk pricing in that it makes the practice more proactive, putting those banks with better risk management systems in an advantageous position versus the banks that have not prepared timely for the changes in this area. The ramification of Basel II, along with the preceding new requirements was made known to the banking community in advance of its implementation date, thereby permitting banks the time to upgrade their risk management as well as other systems for the new provision. Basel II was designed to create portfolio management that is more risk management active. Its final version in 2007 ensures that the allocation of capital separates operational risk and credit risk, makes risk management more sensitive, and attempts to align economic and regulatory capital closer, thus reducing regulatory arbitrage ranges. The new Accord utilizes what is termed as a ‘three pillar’ concept that is comprised of minimum capital requirements, supervisory review, along with market discipline representing the basis for increased stability in the financial system (Schneider, 2004). The first pillar contains the three factors of credit, operational, and market risk, representing the manner in which the maintenance of regulatory capital is calculated for the risk aspects. The understanding of this concept is critical in understanding the nuances, and thus purposes of Basel II. 1. The Standardised Approach (Bank for International Settlements, 2007a) Under this framework the techniques for measuring risk management is handled in a standardised manner that is underpinned by the external assessment of credit, with the other method representing internal rating procedures. Banking activities are thus categorized via eight business lines, as follows (Natter, 2004): a. corporate finance, b. agency services, c. asset management, d. trading and sales, e. retail banking, f. commercial banking, g. payment and settlement, h. retail brokerage The methodology represents operational risk calculated as a percentage of income the bank derives from that business line 2. Foundation Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007b) Under this methodology the Foundation IRB is a set of measurements calculating credit risk techniques. Under Basel II banks can develop their own empirical models for the estimation of the incidence relating to default probability for their banking clients. The preceding can be used by the banks after gaining approval for local regulators. Under this approach methodology the LGD, Loss Given Default, as prescribed by the regulators, and other parameters in the calculation of ‘Risk Weighted Asset (RWA) are required 3. Advanced Internal Rating Based Approach (IRB) (Bank for International Settlements, 2007b) This framework permits banks to devise their own empirical models to reach a determination of capital required for credit risk. As under the Foundation Internal Rating Based Approach, this also requires local regulator approval. This measure permits banks to devise quantitative models to estimate facets such as: Probability of Default (PD), Exposure at Default (EAD), Loss Given Default (LGD), and the Risk Weighted Asset (RWA) The preceding summary of risk management aids in understanding the significant changes Basel II has made in aligning risk in banks in a manner that strengthens their capital requirements to minimize problems stemming from this area. Basel II represents a uniform approach that is used internationally, thus making banks subject to less shocks, and surprises due to more comprehensive risk management procedures, and measures. The Basel II Accord has resulted in harmonization of the capital requirements in the banking sector. The new Accord was adopted based upon the approach that is a combination of (Banco de Espana, 2005): effective internal management market discipline, and supervision The underpinning of the new Accord is based on effective internal banking management as set forth under the three pillars provides a more comprehensive foundation for internal risk management under the guidelines. It also requires (Banco de Espana, 2005): 1. Supervisory Review Under this facet of the Accord it seeks to ensure financial services sector companies, banks, and other types set aside the necessary capital for risk, and utilise best practices in the management of risk as well as its monitoring. 2. Market Discipline This facet refers to the disclosure requirements, and recommendations concerning transparency, with the suggestion of the adoption of a disclosure policy that is formalized, approved by directors, and details the strategy concerning performance, and the financial condition of firms. Chart 1 – Basel II Three Pillars (Bank for International Settlements, 2007b) The emphasis placed on describing risk management herein has been undertaken as it constitutes the main area to be addressed in setting capital reserves to cover risk, and thus minimise failures. It thus places limits upon the type as well as amounts of risk a financial services firm should take as a result of using capital reserves as the limiter. Thus firms that take on higher risk are required to take on higher capital reserves thereby leaving less capital on hand for investments, and return generated on capital. The preceding will impact upon the firm’s performance, shareholder, and stakeholder values, thereby causing reflection on the part of management before undertaking moves to generated potentially higher returns from higher risk investments. Basel II defines operational risk as “… the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems of from external events…” (Banco de Espana, 2005). The Accord seeks to avoid banking, and financial sector firm failures through concentrating on capital reserves via the identification of risk variables. It sets forth capital allocation set asides that are intended to protect the insitution from operational risk that can be calculated via the firm undertaking any of the three mechanisms available (Banco de Espana, 2005): 1. Basic Indicator Approach (BIA) This is a relatively straight forward methodology that calculates the allocation of capital to be set aside for operational risk as represented by a formula that is a fixed percentage of the gross business income in total. 2. Standardised Approach (SA) This is based upon the gross income that is applied across business lines which is then multiplied by a factor that varies from business type to business type to thus compensate for varied risk facets. In order to utilise this method, which results in a firm having a lower risk set aside than under the Basic Indicator Approach, the institution must convince regulators that their methodology follows the rules 3. Advanced Measurement Approach (AMA) This represents the most complex of the three methods in that the capital set aside is based upon the analysis of loss data that is gathered from a three to five year prior period base. The system resulting, along with the controls that are necessary to use this method necessitate large-scale changes and modifications internally. However, the up side to this methodology is that the benefits from lowered capital reserve set aside, which is substantial. Chapter 4 - Conclusion The Sarbanes-Oxley Act of 2002 in the United States was enacted as a legislative response to the crisis in public company reporting, and conduct that impacted on the securities market. It was put into place to correct the wide ranging effects of corporate reporting malfeasance. The Sarbanes-Oxley Act sets forth distinct, and comprehensive requirements for ‘ALL’ U.S. corporations in the public arena, along with their executives as well as auditing firms that must be followed with regard to reporting procedures, and conflicts of interest. Risk management, which is the underpinning of the Basel II Accord, is not contained within Sarbanes-Oxley as it was enacted to deal strictly with securities, along with issues in reporting, governance, and transparency in the reporting as well as financial operations of listed companies. Basel II is a broad ranging accord that is directed at the financial sector on a global basis, that was initiated in the European Union to implement a uniform standard to address the varied forms of risk in the financial services sector, and the attending capital reserve set asides. Although Basel II is global in nature in setting uniform financial services standards, its roots were in the European Union which had to devise a means of standardising the varied banking systems as represented by its diverse member nations as well as the impact of the common currency, the euro. Risk management forms the core of Basel II in that it sets forth methodologies for financial institutions to put into place three types of strategies that are uniformly understood thus alleviating reporting differences, and permitting regulators to equate differing types of financial service firms in differing countries under one system. The Accord significantly strengthens the financial sector as well as provides a means to eliminate, or drastically reduce financial services firm failures thus enhancing the effectiveness of the industry. It establishes a capital reserve standard whereby risks are equated, and adequate resources are applied against differing types of risk. The Accord affords the European Union as well as all global countries with the means to identify troubled financial institutions before, as opposed to being either too late in the process, or after the fact, and thus minimizes the disruptive effects of firm failure. The financial creditability of financial services firms is also enhanced as a result of the increased transparency that is provided by a uniform set of rules, capital reserve requirements, and known procedures for dealing with risk management under the three pillars of the Accord. . The sound risk management underpinning provides a platform for the attraction of international currency transactions, and the platform to ease consolidation in the banking sector. The Sarbanes-Oxley Act, and Basel II address different sectors of the business community. The Act, Sarbanes-Oxley address specifically reporting requirements, and methods for U.S. based public companies, while Basel II is a financial services accord that is utilised internationally. Respectively, both have their similarities in that they have been enacted to ensure public confidence in the business sector through heightened reporting, transparency, and regulation procedures designed to minimise failures, malfeasance and failures. 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