The Basel Committee on Banking Supervision has produced two further consultative papers on individual aspects of the new capital adequacy framework. They build on the proposals contained in the original proposals for updating the Capital Accord ('the original paper')1. The first of the papers is designed to support and strengthen the original proposals for the nature and extent of disclosures that banks should make in order to promote the role of market discipline in promoting bank capital adequacy. The second paper, which will be discussed in Part II next week, surveys the current applications of, and methodologies behind, internal ratings systems used by banks.
MARKET DISCIPLINE
The original proposal paper identified three pillars on which the future promotion and regulation of capital adequacy should be based. The first is minimum capital requirements; the second a supervisory review of capital adequacy, while the third is concerned with the role that should be played by market discipline. The latter of these derives from an earlier initiative by the Committee to identify common standards for transparency and disclosure by banks. The rationale behind it is that enhanced disclosures on the nature, components and features of a bank's capital will enable counterparties (as well as regulators) to form their own view of it's ability to absorb losses. In particular, importance is attached to detailed disclosure of complex and hybrid capital instruments. Similarly, improved standards of disclosure for on- and off-balance sheet exposures have also been recommended 3.
Disclosure should be at least annual and more frequent where appropriate and should be based on the six principles set out in the paper, which cover capital structure, risk exposures and capital adequacy measures. In the first category, capital structures, the paper recommends disclosure of:
* Capital structure and components of capital--disclosures
should be based on the definitions laid down in the
Accord, with each individual components of each Tier set
out separately (for Tier 1, share capital/common stock,
innovative or complex instruments; for Upper and Lower
Tier 2, including deductions and so on).
* Terms and conditions/main features of capital
instruments--in order to provide a clearer picture of the
loss-absorbing capacity of the various capital instruments
on a bank's balance sheet, disclosures should include
information on maturity, step-up provisions, use of trigger
events and terms of derivative instruments embedded in
hybrid capital instruments4.
* Accounting policies for asset and liability valuation,
provisioning and income recognition--this builds on an
earlier initiative on statement of accounting practices by
the Committee5.
In the second category, risk exposures, the paper recommends disclosure of qualitative and quantitative information about risk exposures, including risk management strategy. Again, this builds on earlier initiatives undertaken by the Committee in the areas of credit and market risk. A group has been established that is investigating operational risk, which will be reporting later in the year. Pending this report, the paper recommends that disclosures relevant to legal and strategic risk be made. An additional recommendation is that quantitative and qualitative information should be made available on interest-rate risk in the banking book.
So far as the final category, capital adequacy measures, is concerned, banks can be expected to make annual disclosures of:
* Capital ratios and other consolidated capital adequacy
information, which may, for example include future capital
targets, though non-disclosure of other supervisory
requirements is explicitly envisaged;
* Measures of risk exposures calculated in accordance with
current Basel methodologies, which on the credit risk side,
would extend to book value and risk weightings for
on- and off-balance sheet assets; and on the market risk
side, information should be provided on the parameters,
stress- and back- testing methodologies of computer
models used.
Finally, every bank is urged to include:
* Analysis of factors impacting on its capital adequacy
position--quite detailed suggestions are made in this
category, including changes in capital structure
and their impact on key ratios; contingency plans for
accessing the capital markets in times of stress; and capital
management strategy, including future capital plans and
the impact of non-deduction of participations in banks and
other financial institutions.
* Analysis of the structure and process of allocating capital to the
economic risk generated by business activities--the rationale
behind this is to facilitate early supervisory intervention if a
bank's capital strategy does not provide a sufficient buffer
against risk.
There is a particularly delicate balance to be struck here--banks will be understandably reluctant to make detailed statements about the criteria by which different forms of risk are classified and the criteria by which capital is allocated to a particular risk type. Notwithstanding the emergence of industry-wide standards, for example in risk modelling, these processes will obviously differ significantly depending on the nature of an individual bank's management, its history, areas of traditional strength and a multitude of other considerations. In the U.K., banks have historically had close relationships with their regulators, enabling the latter to develop sophisticated perceptions of the operations and management of individual institutions. There is a potential danger that requiring the same degree of disclosure to be made in public could have adverse consequences for these relationships.
1 A New Global Capital Adequacy Framework, Basel Committee on Banking Supervision, June 1999.
2 Enhancing Bank Transparency, Basel Committee on Banking Supervision, September 1998.
3 See 'Trading and Derivatives Disclosures by Banks and Securities Houses,' Annual Survey, Basel Committee on
Banking Supervision, December 1999 (latest report). On other forms of risk disclosure see 'Risk Concentrations
Principles' and 'Intra-group Transactions and Exposures,'
Basel Committee on Banking Supervision,' both December 1999.
4 See also 'Best Practices for Credit Risk Disclosure,' July 1999.
5 See 'Sound Practices for Loan Accounting and Disclosure,' July 1999.
This week's Learning Curve was written by Simon Gleeson, attorney at Allen & Overy'sfinancial services group in London.
For the next two weeks, DW's Learning Curve feature will examine the two consultative papers issued by The Basel Committee on Banking Supervision. This week the discussion will focus on market discipline. Next week, DW will explore the issues surrounding internal ratings systems.
