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Indira Gandhi Institute of Development Research, Mumbai, India BASEL II PILLAR III MARKET DISCIPLINE Dilip Nachane Senior Professor Indira Gandhi Institute.

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Presentation on theme: "Indira Gandhi Institute of Development Research, Mumbai, India BASEL II PILLAR III MARKET DISCIPLINE Dilip Nachane Senior Professor Indira Gandhi Institute."— Presentation transcript:

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

2 Indira Gandhi Institute of Development Research, Mumbai, India The Three Pillars Pillar IPillar IIPillar III Minimum Capital RequirementsSupervisory ProcessMarket Discipline Market risk Slight change from Basel I Credit risk Significant change from Basel I Three different approaches to the calculation of minimum capital requirements Capital incentives for banks to move to more sophisticated credit risk management approaches based on internal ratings Sophisticated approaches have system/controls and data collection requirements as well as qualitative requirements for risk management Operational Risk Not explicitly covered in Basel I Three different approaches to the calculation of minimum capital requirements Adoption of each approach subject to compliance with defined ‘qualifying criteria’ Banks should have a process for assessing their overall capital adequacy and strategy for maintaining capital levels Supervisors should review and evaluate banks’ internal capital adequacy assessment and strategies Supervisors should expect banks to operate above the minimum capital ratios and should have the ability to require banks to hold capital in excess of the minimum (i.e. trigger/targets in the United Kingdom; prompt corrective action in the United States Supervisors should seek to intervene at an early stage to prevent capital from falling below minimum levels. Market discipline reinforces efforts to promote safety and soundness in banks. Core disclosures (basic information) and supplementary disclosures to make market discipline more effective

3 Indira Gandhi Institute of Development Research, Mumbai, India Outline of the New Basel Capital Accord FoundationsAdvanced Standard approach Internal rating-based approach Basic Indicator approach Standardized approach Advanced measurement approach Standard approach Internal rating-based approach Asset securitization Event riskBusiness risk Credit risk Market risk (amendments 1996) Operational risk Weighted risk Definition of Capital Interest rate risk Liquidity risk PILLAR II Supervisory review process PILLAR III Market discipline PILLAR I Minimum capital requirements

4 Indira Gandhi Institute of Development Research, Mumbai, India Market discipline is sought to be achieved via 1.Disclosure Requirements 2.Remedial action in case of non-disclosure 3.Complementarity between Pillars I, II and III 4.Disclosure of information in regulatory reports, which may or may not be made public at the discretion of the supervisor/regulator.

5 Indira Gandhi Institute of Development Research, Mumbai, India AreaSelected Requirements GeneralBanks should adopt a disclosure policy. The policy should state the frequency of disclosure and how compliance with the disclosure policy will be monitored. The information should be disclosed at least once a year. As far as possible, the information should be disclosed in one publication and through one channel. The information should be broken down by asset class. The goals and policies for the bank’s risk management should be described. CapitalInformation about shareholders’ equity, its composition and deductions to it (e.g., goodwill). Description of the Internal Capital Adequacy Assessment Process (ICAAP) Statement of Risk Weighted Assets (RWA), solvency and minimum capital requirement Description of the models used for estimating credit risk, market risk and operational risk Credit riskDefinition of default Description of methods used for value adjustments and provisioning Credit exposure broken down by geography, industry, time to maturity and couterparty Market riskInformation about the characteristics of the internal model used Description of the approach used for stress testing and back testing of the internal model Reporting of aggregate Value-at-Risk (Var), high, mean and low VaR, over the reporting period Operational risk Approaches for the assessment of shareholders’ equity The standardised Approach is used for calculating the required capital The Group’s Risk Management department is responsible for the process of gathering internal loss data, and reporting to business management and relevant Risk Committees Overview of some of the disclosure requirements under Pillar III

6 Indira Gandhi Institute of Development Research, Mumbai, India 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 Indira Gandhi Institute of Development Research, Mumbai, India 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 Indira Gandhi Institute of Development Research, Mumbai, India Proprietary and Confidential Information 1.There is need to strike a balance between the disclosure requirements and information of a proprietary or confidential nature. 2.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. 3.Confidential information usually relates to customers, relationship with whom may be bound by a legal agreement or counterparty relationship.

9 Indira Gandhi Institute of Development Research, Mumbai, India 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. 1.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. 2.Large internationally active banks should disclose their Tier I and total capital adequacy ratios along with their components on a quarterly basis.

10 Indira Gandhi Institute of Development Research, Mumbai, India 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. Qualitative Disclosures An outline of differences in the basis of consolidation for accounting and regulatory purposes, plus an explanation of them. Any restrictions, or other major impediments, on transfer of funds or regulatory capital within the group. Quantitative Disclosures The name of the top corporate entity in the group to which regulatory capital requirements apply The entities within the group (a) that are fully consolidated (b) that are pro-rata consolidated, (c) that are given a deduction treatment and (d) from which surplus capital is recognised. The aggregate amount of surplus capital of insurance subsidiaries (whether deducted or subjected to an alternative method) included in the capital of the consolidated group and the quantitative impact on regulatory capital of using this method versus using the consolidation or the deduction approach The name, country of incorporation or residence, proportion of ownership interest and if different, proportion of voting power for any entity (significant minority position or subsidiary) which is neither included within the consolidated approach nor deducted from capital (e.g., where the entity is not consolidated and the investment then risk-weighted), together with the firm’s total investment (e.g., current book value) in that subsidiary. In addition indicate the valuation basis for the investment (e.g., historical cost, equity method, or fair value) plus an explanation for the treatment and impact on regulatory capital (e.g., revaluation reserve). The name of any subsidiary not included in the consolidation, i.e., that are deducted, that does not meet its regulatory capital requirements and the aggregate amount of capital deficiencies in all such subsidiaries.

11 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Capital Qualitative Disclosures Summary information on the terms and conditions of the main features of all capital instruments especially in the case of innovative, complex or hybrid capital instruments Quantitative Disclosures The amount of the tier 1 capital, with separate disclosure of : Paid up share capital / common stock Reserves Minority interests in the equity of subsidiaries Innovative instruments Other capital instruments Surplus capital Goodwill and other amounts deducted from tier 1 The total amount of tier 2 and 3 capital Deduction from tier 1 and tier 2 capital Total eligible capital

12 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Capital Adequacy Qualitative Disclosures A description of the bank’s capital strategy and its approach to assessing the adequacy of its capital to support current and future business including Information about contingency planning and Other factors impacting on capital adequacy. Quantitative Disclosures Basel Capital Accord requirements for credit risk. Standardised approach Foundation IRB approach (must be summarised by aggregated portfolio) Advanced IRB approach (must be summarised by aggregared portfolio) Standardised approach for equity Risk sensitive approach for equity Total risk-weighted assets for credit risk Basel Capital Accord requirements for market risk Standardised approach Internal models approach The equivalent of risk weighted assets for market risk Basel Capital Accord requirements for operational risk Basic indicator approach Standardised approach Advanced measurement approach The equivalent of risk-weighted assets for operational risk Total and Tier 1 capital ratio For the top consolidated group For significant bank subsidiaries (stand alone or sub-consolidated depending on how the Capital Accord is applied)

13 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Credit Risk Qualitative Disclosures The qualitative disclosure requirement with respect to credit risk, including Definitions of past due, impaired and default Definitions of specific and general allowances – statistical methods Quantitative Disclosures Total credit risk exposures, plus average grass exposure over the period broken down by different types of credit exposure. Geographic distribution of exposures, broken down by different types of credit exposure. Industry/counterparty type distribution of exposures, broken down by different types of credit exposure. Maturity break down of the whole portfolio, broken down by different types of credit exposure Amount of past due/impaired loans broken down by geographic distribution and counterparty type / industry sector, including analysis by days overdue. Amount of allowances for credit losses, including information on: allowances (opening and closing balances and movements during the period, with specific distinguished from general); and recoveries and charge-offs (differentiating among amounts credited or charged to profit and loss account and those treated as adjustments to allowances) Amount of credit risk transferred through credit derivatives or into securitisation vehicles (regardless of whether this is recognised for regulatory capital purposes)

14 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Market Risk (Standardised Approach) Qualitative Disclosures The overall qualitative disclosure requirement for market risk, including the portfolios covered by the standardised approach Quantitative Disclosures The capital requirements for: Interest rate risk Equity position risk Foreign exchange risk Commodity risk The capital charge for options positions.

15 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Market Risk (Internal risk based approach) Qualitative Disclosures The overall qualitative disclosure requirement for market risk, including the portfolios covered by the IMA For each portfolio covered by the IMA: The characteristics of the models used. A description of stress testing applied to the portfolio. The scope of acceptance by the supervisor. Quantitative Disclosures The aggregate value-at-risk (VaR) for the IMA portfolios The high, median and low VaR values over the reporting period and period-end. A comparison of VaR estimates with actual outcomes, with analysis of important “outliers” in back-test results.

16 Indira Gandhi Institute of Development Research, Mumbai, India Disclosures for Operational Risk Qualitative Disclosures In addition to the general qualitative requirement the approach(es) for operational risk capital assessment that bank qualifies for Description of the advanced measurement approach, if used by the bank. Quantitative Disclosures Operational risk capital charge per business line (if available)

17 Indira Gandhi Institute of Development Research, Mumbai, India 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. 1.No significant difference in the risk profile between publicly traded and non-traded bank. 2.Very often publicly traded banks tend to have worse supervisory ratings than non-publicly traded banks.

18 Indira Gandhi Institute of Development Research, Mumbai, India 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 Indira Gandhi Institute of Development Research, Mumbai, India Basel II : Second & Third Pillars 1.Second Pillar (Supervisory Review Process 2.Third Pillar (Market Discipline) (i)Structure and components of bank capital (ii)Accounting policies used for valuation of assets and liabilities (iii)Risk exposures and risk management strategies (iv)Capital ratio and main features of its capital instruments. (i)Supervisors should be able to prescribe higher capital adequacy ratios for specific banks. (ii)Banks should develop internal procedures for assessing overall capital adequacy in relation to their risk profiles. (iii)Strategies and procedures adopted in (ii) should be open to supervisory review. (iv)Prompt corrective action by supervisors. Stress disclosures by banks to enable counterparties (to bank transactions) make well-founded risk. Salient components of disclosure information

20 Indira Gandhi Institute of Development Research, Mumbai, India Macroeconomic Implications of Basel II 1.Capital adequacy and the aggregate economy 2.Cross-sectional Implications (i)Restriction of credit supply to high-rated borrowers (ii)Special problems for SMEs (Basel directive of July 2002) (iii)Basel II may curtail credit supply to borrowers based in LDCs (Ferri et al (1999) (iv)Impact on Capital Flows to EMEs. (i)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. (ii)Monetary transmission affected via the emergence of a financial accelerator (van den Heuvel (2002)). (iii)Differential effects of monetary policy on poorly capitalized and adequately capitalized banks (Tanaka (2002)). (iv)Pro-cyclicality (Ghosh & Nachane (2003)).

21 Indira Gandhi Institute of Development Research, Mumbai, India Basel II and India Likely Implications (i)Basel II may lead to increased capital requirements in all banks across the board. (ii)Likely pressures on interest rate spreads. (iii)Unsolicited ratings and low penetration of ratings. (iv)High-risk assets may flow to weaker banks who are more likely to be adopting a standardized approach. (v)Anomaly between prescribed risk weights for unrated entities and entities with lowest rating. (vi)Success of Basel II contingent upon good corporate governance.


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