PILLAR 3: MARKET DISCIPLINE

The third major element of the Committee's approach to capital adequacy is market discipline. The accord emphasizes the potential for market discipline to reinforce capital regulations and other supervisory efforts in promoting safety and soundness in banks and financial systems.

Given the influence of internal methodologies on the capital requirements established, it considers that comprehensive disclosure is important for market participants to understand the relationship between the risk profile and capital of an institution. Accordingly, the usage of internal approaches is contingent upon a number of criteria, including appropriate disclosure.

For these reasons, the accord is setting out a number of disclosure proposals as requirements, some of them being prerequisites to supervisory approval. Core disclosures convey vital information for all institutions and are important for market discipline. Disclosures are subject to "materiality." Information is "material" if its omission or misstatement could change or influence the assessment or decision of any user relying on that information. Supplementary disclosures may convey information of significance for market discipline actions with respect to a particular institution.

ADDITIONAL PROPOSALS

In the June 2008 "Principles for Sound Liquidity Risk Management and Supervision" (Draft version), the Basel Committee emphasized the critical role of liquidity, which does not imply yet any capital charge. The paper refers to liquidity funding risk and mismatch risk and explicitly mentions that "banks failed to take account of a number of principles of liquidity management when liquidity was plentiful" (§3). The document mentions 17 principles. Amongst the main ideas, the report emphasizes:

• the requirement of a high liquid assets capable of withstanding a range of stress events

• the definition of a liquidity risk tolerance by the banks

• the incorporation of liquidity costs, benefits and risk in product pricing, performance approval and new product approval

• a sound process for projecting cash flows (which refers to asset and liability management practices)

• diversification of sources of funding

• settlement risk

• the design of a formal contingency plan

• disclosure of liquidity positions.

This is no more than a restatement of otherwise sound principles that were in force when banks were less aggressive in terms of mismatch risk.

Special mentions refer to off balance sheet commitments, which include:

• liquidity lines to SPE and liquidity lines to such vehicles, which are liquidity commitments

• asset "wrapped" by monolines of which liquidity depends on the credit standing of the monolines

• drawdown on letters of credit.

However, there is no capital charge on liquidity funding risk and measures are not well defined, presumably relying on usual bank "sound" practices for measuring liquidity risk as developed in the ALM section of this book.

A number of proposals are being defined to address the sources of the financial crisis. Some blame the procyclicality of current regulations, as in [34], and the Financial Stability Forum report [29] starts from a conceptual framework that emphasizes procyclicality. Procyclicality relates as well to fair value accounting standards addressed in the next chapter. A summary of the proposals is provided at the end of this book (Chapter 60).

 
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