Pillar III and Market Discipline
Pillar III (market discipline) of the New Basel Capital Accord is intended to complement the minimum capital requirements laid out in Pillar I and the supervisory review (of capital) process laid out in Pillar II of the New Basel Capital Accord.28 This development is an important one because it recognizes the role of market discipline in supplementing the efforts of supervisors in monitoring the safety and soundness of banks. It also places the responsibility for promoting transparency, hitherto largely in the ambit of accounting and corporate governance standards, into the formal framework of banking supervision.
Disclosure under Pillar III, however, is limited in scope to those items that have a direct bearing on the computation of capital adequacy of the institution. Thus, under Pillar III, a bank would have to disclose information material using the approach that it has adopted under Pillar I. However, this limitation in scope does not limit the amount of information that is required to be disclosed, and the suggested disclosures are still substantial and comprehensive, as discussed below.
To facilitate disclosure, Pillar III provides 13 templates. They cover the following: (a) scope of application, (b) capital structure, (c) capital adequacy, (d) credit risk (general), (e) credit risk (standardized approach), (f) credit risk (IRB approach), (g) equity (banking book) positions, (h) credit risk mitigation, (i) securitization, (j) market risk (standardized approach), (k) market risk (internal models approach), (l) operational risk, and (m) interest rate risk in the banking book. Each template, in turn, breaks up the disclosure requirements into (a) quantitative and (b) qualitative disclosure. For example, under credit risk (standardized approach), banks are required to disclose not only the percentage of a bank’s outstandings in each risk bucket that is covered by each agency’s ratings but also the names of the rating agency and the agency’s role.
Pillar III disclosure is to apply only to the top consolidated level of the banking group to which Pillar I applies. Hence, individual banks within the banking group need not separately meet those requirements. However, the Total and Tier I capital ratios of individual banks within the group are to be disclosed separately by the Pillar III entity in the template on capital adequacy.
The disclosure has to be detailed at the portfolio level, where applicable. Thus, for example, if the bank implements a foundation internal ratings-based approach, then in the template for credit risk, it should disclose for each of the five portfolios a broad overview of the model approach with a description of the definitions of the variables and with methods for estimating and validating the variables as part of the quantitative disclosure. For the quantitative disclosure, it should disclose for each of the portfolios exposures across different probability of default (PD) grades and should supplement this information with (a) historical data on actual loss experience in the preceding period for each
portfolio, (b) analysis of how these data differ from past experience, and (c) a discussion of the factors that affected the loss experience.
The purpose of such detailed disclosure is to enable concerned market participants to make their own assessments of the risk exposures and risk assessment processes and, hence, to develop a truer picture of the capital adequacy of the institution. The structured presentation will allow for a consistent framework across institutions, which will enhance comparability. This development is particularly important because, under some approaches in Basel II, banks would be using internal methodologies and data sources for computing capital instead of supervisor-defined risk weights, as in the past.
The frequency of the Pillar III disclosures is intended to be generally semiannual, though an underlying expectation is that all material information should be published as soon as practicable. Further, there is also an expectation that all large internationally active banks and the significant banks would disclose information on their Tier I and total capital adequacy ratios and their components on a quarterly basis. Similarly, all information on risk exposure that is prone to rapid change should also be disclosed quarterly. However, qualitative disclosures of a general nature, which are not subject to this frequency of change (e. g., those that deal with risk management objectives and policies), need to be reported only on an annual basis.
The incentive, location, and manner of disclosure are left to the jurisdictions. An important consideration in the design of the disclosure has been that the framework does not conflict with the requirements under the accounting standards, which are much broader in scope. Hence, the medium and location of the disclosure could vary and would also depend on the method used by supervisors to effect the disclosure. Thus, the disclosure could be affected by making it mandatory under the accounting regime or the listing requirements. In other cases, it could be built into a supervisory regulation or reporting requirements. In some cases, it may be influenced by pure moral suasion or may be voluntarily adopted to maintain competitive equality. Further, in some cases (e. g., credit risk mitigation techniques and credit derivatives, asset securitization, and internal ratings), the incentive for disclosure is provided by virtue of its being a qualifying criterion for the recognition or use of those techniques under the New Basel Capital Accord.
There is a presumption of validation built into the disclosure, especially where the disclosure forms part of the accounting requirements, which are generally audited because they should be consistent with the audited statements. In case the disclosures are part of the supervisory reporting requirements that are subsequently made public, there is a presumption that the information is reliable. When it is published by the bank on a standalone basis or on the bank’s Web site, then banks should ensure that this information has undergone some verification before being posted.
However, Pillar III stops short of requiring that the disclosure be audited by an external or independent party, unless, of course, this step automatically forms part of the regime under which the disclosure is made. The additional reporting burden is a clear disincentive for banks to voluntarily adopt Pillar III. Supervisors will have to find effective means
of ensuring reliability of disclosure, especially in circumstances where this disclosure takes place outside their purview. Nevertheless, it can be expected that the markets would be quick to penalize any incorrect disclosure ex post. While one is interpreting the disclosure, care will have to be exercised to take into account the different items of national discretion that have been applied in the particular jurisdiction because this information could affect comparability across countries.