New Basel Disclosure Rules Are a Win for Market Discipline
Lack of bank transparency makes it difficult to see the extent of bank exposures to emerging markets and whether financial firms are adequately capitalized to withstand unexpected losses from this market turmoil or any other.
Investors need a clear and reliable picture of banks' risk exposures in order to exert market discipline on less creditworthy institutions. The Basel Committee's newly released revisions to banks disclosure requirements will give shareholders a much better handle on those risks, thereby helping to avert future bailouts.
The revisions to Basel III's Pillar III should go a long way toward improving the existing requirements, which are undeniably poorly implemented. Numerous banks, including continental European banks, have been abiding by Pillar III disclosures since 2006. But the disclosures were only required to be released on an annual basisand were not uniform. This made it impossible for investors to glean anything meaningful from information about banks' exposures which is the whole point of requiring transparency.
Since U.S. banks never fully exited Basel II, they have yet to abide by Pillar III disclosures.But given thatregulators in the U.S. finalized Basel III guidelines in 2012, it is very likely that they will also accept the Pillar III revisions as they are or make them even stricter, as they did with the liquidity coverage and leverage ratios.
The media and most market participants tend to focus primarily on Basel's Pillar I, since that is where the capital ratios and new buffers requirements reside. But it is Pillar III that can shed light on the opacity of banks' ratios and models. Market discipline can only be exerted when investors have solid information about banks' credit, market, operational and liquidity risks not to mention their leverage. That market discipline is critical in helping bank regulators protect taxpayers from rescuing banks that are adept at privatizing gains and socializing losses.
The guiding principles underpinning the Pillar III revisions are that banks' disclosures should be clear, comprehensive, meaningful to users, consistent over time, and comparable across banks. Large banks will likely struggle to meat these principles in their future, given their significant challenges in data collection, aggregation and reporting. Therefore bank regulators must continue to pressure banks to work on their IT architecture and solve the data collection issues. With unreliable data, we will continue to fall prey to GIGO: garbage in and garbage out.
Importantly, the Basel Committee has created templates that provide a very detailed list of the components in credit, market, and operational risks that banks have to disclose as well as rules about the frequency of the disclosures. Some parts of the template are flexible, but fortunately most are fixed. This is crucial, since disclosure uniformity is key to help the market compare the information across different banks.
The strongest revisions to Pillar III are the requirements for credit risk. This is not surprising, given that credit risk is the biggest part of risk-weighted assets. Banks will be required to disclose quantitative and qualitative information about how they calculate the credit inputs for their risk-weighted assets on a quarterly basis. The template for this part is fixed. The information in this category will become more meaningful when the Basel Committee finalizes an outstanding proposal to lessen the flexibility that large banks current enjoy in determining probabilities of default, loss given default and exposure at default. These are the critical elements to determine the credit risk portion of risk-weighted assets. Large banks will have to disclose a lot more information than ever before about their data for probability of default, including information about their back-testing results.
Additionally, banks will now be required to disclose details about what portion of the credit risks in their loan and bond portfolios are mitigated by collateral, guarantees or credit derivatives. I am very pleased that the Basel Committee is also requiring banks to disclose what effect credit derivatives have on the risk-weighted assets of their credit portfolios. Moreover, the riskiness of the portfolio has to be disclosed both with and without the credit derivatives. This is because the credit quality of the credit derivative counterparty and the credit derivative's liquidity can change over time. The financial crisistaught us that the counterparty's credit quality and credit derivative liquidity may evaporate precisely when the reference asset is suffering a downturn.
The revisions also include a section for securitization exposure disclosures. This component is timely given that in their never-ending search for yields, banks have been increasing their exposures to an alphabet soup of securitizations such as mortgage-backed securities, asset-backed securities and collateralized loan obligations.
Revisions to the market risk section are also very substantial. Banks will have to disclose how interest rates, equity prices, commodity prices and foreign exchange impact both trading book and banking book exposures subject to Basel III's market risk capital charge. The disclosures also apply to securitizations in the trading book. The level of detail that banks will have to disclose about their value-at-risk models may well reignite the debate about whether these internal models are the best way to measure market risk, given that they cannot calculate what the worst possible loss on a portfolio would be.
If banks choose to exclude some assets from their risk-weighted asset disclosures, the revisions obligate them to explain those exclusions qualitatively. This will ensure that auditors and bank examiners see documentation as to the parameters that influence which assets are included and excluded from disclosures.
Meanwhile, operational risk disclosures were not revised. This is because the operational risk measurement approaches have not been revised from Basel II.
Operational risk is by far the weakest part of the framework. Now that the Basel Committee has completed so much of the ambitious agenda that it set forth in 2010, I believe that 2015 could at long last be the year it takes on operational risk, the all-too-neglected bridesmaid. In the meantime, bank regulators should exercise every tool in their arsenal to make sure that banks abide by Pillar III. And as market participants and media, we should also push banks to comply.