New Basel Capital Accord

Pillar 3 Calls for Public Disclosure Under Banking SupervisionThe new third pillar of the supervisoryreview process relies on market forcesas a regulatory mechanism. Thismechanism assumes that well-informedmarket participants will reward riskawaremanagement of companies andeffective risk management by banks withtheir investment and credit decisions,thereby sanctioning a bank taking onmore risk.As market discipline can only beeffective as a regulatory factor withcorresponding transparency, specificdisclosure requirements have been laiddown. These requirements relate tofactors such as consolidation of information,capital structure, includingexplanations of the background of innovativecapital elements, the calculationof risk positions, details on interest raterisk and a comparison of estimated riskand realized risk (backtesting).Flexibility has been built into the systemto achieve a balance between theinterests of banks and those of marketparticipants. In practice, therefore, theextent and frequency of disclosures byindividual banks will be governed by theprinciples of materiality and the protectionof confidential information.While semi-annual disclosure of informationis recommended in principle andexpected of large internationally activebanks, annual reporting can be viewedas sufficient for regional banks or banksspecializing in a specific business, withstable risk profiles.The suggestions on disclosure take theform of recommendations as the bankingsupervisors in most countries arenot responsible for issuing financialreporting standards. At the same time,however, linking these suggestions toPillar 1 encourages their implementation.Thus, applying certain proceduresto determine the regulatory capitalcharge, such as using internal ratings orcredit enhancements from collateral will1234be linked to specific disclosures. Thefact that models which lead to a reductionin the capital charge requirementwill only be recognized if appropriatedisclosures are made is an inducementwhich ultimately gives the recommendationson transparency the status offixed rules.The requirements on transparencycover four areas:Application of Capital RequirementsWhen capital requirements are applied on a consolidated basis, the companiesbelonging to the group must be listed and an explanation given of how these investmentshave been accounted for in calculating risk positions and liable capital (e.g.through consolidation or deduction from capital).Capital StructureDetails on the nature and scope of individual capital elements and total liablecapital are required. These should include information on agreements relating tospecific elements, such as terms, repayment methods or step-up provisions.Risk ExposuresDisclosure of risk exposures should enable market participants to assess a bank’s riskpositions and risk management. The information provided should therefore includecredit risk, market risk, operational risk and interest rate risk in the banking book.A comparison of the current and ex post risk profiles should be made as a backtest.Capital Adequacy for the Individual Risk AreasBanks should disclose not only their total capital ratio, but also the capital ratios inindividual risk areas.20 ERNST & YOUNG – NEW BASEL CAPITAL ACCORD