Jaime Caruana: The importance of transparency and market discipline
approaches in the New Capital Accord
Keynote speech by Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel
Committee on Banking Supervision, at the Market Discipline Conference, Federal Reserve Bank of
Chicago and BIS, Chicago, 1 November 2003.
* * *
Overview
Good morning. I would like to thank President Moskow, Malcolm Knight, and the staff of the Federal
Reserve Bank of Chicago and of the Bank for International Settlements for organising and hosting this
timely conference. It is a pleasure for me to join your discussion in Chicago today. I can think of few
venues better situated to talk about markets and to explore the links between transparency, corporate
governance, and the role markets can play to encourage prudent risk taking.
Bank regulators in recent years have begun to view markets as an ally to our system of supervision.
We have consequently sought to incorporate market discipline directly into the supervisory framework.
Markets value well capitalised and well managed institutions as much as supervisors do, and can
create rewards for banks that manage their risks appropriately. Yet banks can be very complex
institutions and no market discipline is possible without widespread public access to timely, accurate,
and comprehensive information on a bank's exposures, its risk management processes, and its
outlook for the future.
I'd like to discuss this morning why the Basel Committee believes that applying transparency and
market discipline approaches in the New Capital Accord will help us achieve our objectives to reinforce
the safety and soundness of the banking system.
My first point will be that, despite its name, the New Capital Accord is about much more than just
capital. It is also about maintaining a level playing field and about strengthening incentives to foster
sound risk management through three pillars: risk sensitive minimum capital requirements,
coordinated supervisory review and - importantly, given the theme of this conference - enhanced
market discipline through greater transparency. The New Accord is therefore much more
comprehensive than its 1988 forerunner.
Second, I'll comment on the rationale behind the compound approach followed by the Basel
Committee that blends rules, discretion, and market-based incentives. It could be viewed as a portfolio
of different policy approaches that allow supervisors to achieve or at least draw close to a kind of
efficient frontier.
Third, I'll share with you key issues that the Committee faced in drafting the market discipline
component of the New Accord and, specifically, I will mention some of the concerns that arose in our
public consultations. Mainly:
• Proprietary versus public information
• Principles versus Rules
• Consistency of Accounting Standards and the New Basel Accord
Finally, I will review the present status of the Accord, the significant progress made in our last meeting
in Madrid and I will outline the next steps in its rapid finalisation, as well as our plans for keeping it fit
for the future.
Basel II: a new, comprehensive approach to achieve greater financial stability
To begin, I would like to re-emphasise the importance of market discipline to banking supervision,
especially in a rapidly changing environment. Supervisors seek improvements in the public's access to
information on a bank's condition precisely to bolster the ability of rating agencies, of business
counterparties, and even of investors or depositors to evaluate the profile of a bank's risks and the
quality of its controls. Yet as safety and soundness regulators, we wish to fortify the stability and
resilience of the financial system. In our view this goal requires not just greater transparency, but also
significant advances in the state of the art of risk management and adequate capital when unexpected
losses materialise.
For the first time, the Capital Accord will include not only explicit economic incentives expressed in the
minimum capital requirements but also implicit incentives built into the processes for supervisory
review and market disclosure.
I think it is helpful to recall why so many central banks, regulatory agencies, and commercial banks
have devoted their best resources to ensuring the success of the New Accord. The existing Accord, as
you know, was already considered a milestone in banking regulation. It offered the first internationally
accepted "yardstick" for capital adequacy and a simple measure of risk. It had received praise for
reversing a downward trend in bank capital levels and for serving as a benchmark measure of a
bank's financial health around the world.
But the 1988 Accord was a blunt instrument that quickly fell behind the times. Advances in technology,
in banking products, and in risk management changed the way that leading banks measure and
manage their risks. By the mid-1990's, bankers and supervisors agreed that the original Accord no
longer offered the largest and most sophisticated organisations a meaningful measure of risk.
Under the leadership of William McDonough, former President of the Federal Reserve Bank of New
York and my predecessor as chairman of the Basel Committee, the Committee seized the opportunity
to achieve more than a simple update of the capital requirements. Bill brought tireless energy to the
project and convinced industry leaders, bank supervisors, and central bankers that we should pursue
a far greater objective that would incorporate market discipline and also encourage advances in risk
management across the industry.
While he has moved on to new challenges as head of the Public Company Accounting Oversight
Board in Washington, the U.S. delegation to the Basel Committee remains in excellent hands. The
hard work of leaders such as Roger Ferguson, the Vice Chairman of the Federal Reserve, and Jerry
Hawke, the U.S. Comptroller of the Currency, and of other U.S. supervisors in the negotiations, has
strengthened the quality of the capital rules. They have helped ensure that the New Accord will be
flexible, forward-looking, and fit for the service of twenty-first century banking.
Basel II: a blend of reinforcing policy approaches
The long-term objective of fostering greater financial stability led to our decision to supplement the
revised minimum capital requirements, which constitute the first pillar of the New Accord, with two
equally important pillars.
Although this may be an oversimplification, one could argue that each of the three pillars can be
viewed as representing a different policy approach for a regulatory/supervisory framework. The first
pillar emphasises the adoption of uniform rules. The second pillar relies more on the use of discretion
in setting requirements for individual banks. And the third pillar can be expressive of a market-based
approach.
Each of these choices individually considered has its merits, but also certain downsides. The point I
want to make is that the risk/reward features of each of the three options - rules, discretion and market
discipline - have their own particularities and are not totally correlated. From a portfolio theory point of
view it could be argued that the optimum result is achieved through using a combination of all three
approaches, and that this combination is far better than any of the individual options alone.
Rules constitute a very direct approach and one that offers the greatest clarity to institutions on what
supervisors expect from banks, thereby leading to a higher level of transparency from both the
perspective of the banks and the supervisors, and promoting comparability between institutions.
However, adopting a rules-based option alone, even if they are market friendly, entails certain
disadvantages. It tends to be inflexible and therefore might preclude innovation. It could also fail to
take account of bank or business line specificities.
This is why the Committee decided to complement the minimum capital requirements with the second
pillar, known as supervisory review. This allows a discretionary approach according to the situation of
specific banks or types of business - very much like the principles-based policy approach. The benefits
of such an approach are flexibility and adaptability to specific needs, both now and over time as
situations and responses change.
But this approach alone would also have its shortcomings. Market participants could find it difficult to
compare banks. The lack of a common standard across institutions might actually reduce
transparency, since markets might not know or understand why supervisors established particular
requirements for certain banks but not for others. This approach alone could also raise competitive
equality problems, making it more difficult to ensure a level playing field, one of the key objectives of
the Basel Accord.
The third option would be a market-driven solution. As I have already said, the Committee has
recognised the importance of market discipline in the third pillar of the New Accord. It draws on the
power of markets to create strong incentives for banks, incentives to help ensure that banks manage
their risks properly and do not hold unrealistically low amounts of capital for their risk.
There is a lot of merit in this approach, yet all of us know that markets sometimes behave inefficiently.
They can overreact to certain minor events yet still overlook significant indicators of risk in the short
run. Likewise, markets are not always able to capture some externalities on their own, such as the
interests of the broader public. They sometimes focus on the immediate needs of direct participants
rather than those of depositors or customers or they can be too short-sighted in their time horizon. I
think the thoughtful comments made by Malcolm D. Knight yesterday about gaps and limitations of
market discipline clarify these kinds of issues most constructively.
So it is clear that no single one of these three options provides all of the benefits that supervisors
seek. We want rules to provide clarity and strong incentives. We want the ability to use discretion to
manage diversity, to tailor requirements to the specific businesses of each bank. Finally, we want
markets to provide economic incentives for institutions to improve bank management and disclose
information that is relevant to end-users' needs.
What I am saying is that the "efficient frontier" can best be achieved through a combination of the three
pillars, given the reinforcing/diversification effects of each. Each pillar provides something that the
other cannot and is essential to achieving our overall objective of financial stability.
I realise that this presentation of the three pillars as items of a portfolio of policy options is an
oversimplification, but I think it helps us visualise why we think that the most "efficient frontier" involves
a mixture of minimum rules, tempered by supervisory discretion, and supplemented by market-based
incentives.
Current industry practices and issues that arose in consultations
Let me now move to current industry practices and how transparency is incorporated into the Basel
framework.
In deciding to revise the 1988 Accord, the Basel Committee thought carefully about what
improvements to banks' public reporting would mirror the New Accord's incentives-based approach to
foster improvements in risk management. In recent years, the Committee has noted some
improvements in the quality of bank reporting worldwide. Annual surveys conducted by the Committee
suggest that the extent of banks' public disclosures has increased markedly in some areas.
Still, important deficiencies remain. For example, in 2001 - the most recent date for which comparative
global information is available - the most prevalent disclosures covered accounting and presentation
policies, on a bank's capital structure and its measures of capital adequacy, and, for those that had
them, on the kind of market risk models the bank used. Few banks disclosed much about their credit
risk models, the types of credit risk mitigation techniques that they employed, or even the external or
internal ratings assigned to their credit exposures.
The relative paucity of data available publicly on a typical bank's credit risk profile appears inconsistent
with the fact that, for most banks, credit risk remains the single most important source of potential
losses. At present, market participants seem to know only little about the extent of most banks'
exposure to credit risk. One could conclude that it seems unrealistic today to assume that they have
enough knowledge of a bank's position to exercise properly a benign influence on its handling of credit
risk. Disclosure practices do not seem to have kept pace with the very rapid evolution in the ways that
banks take on, measure, and ultimately manage their risk positions.
Incorporating Market Discipline into the New Basel Accord
To improve the ability of markets to contribute to greater stability in the banking sector, the New
Accord will contain a series of disclosure requirements. The Committee views Pillar 3 as a further
refinement of accounting standards requirements as they should apply to banks in the light of the
specific risks they face. Some of the requirements may furthermore be tied to a bank's eligibility for
adopting an advanced approach to credit or operational risk or for recognising the benefits of particular
instruments and transactions in mitigating risks.
We based our decisions on the information that should be disclosed on the following principles: that
market participants require an understanding of how the capital requirements apply to the
consolidated banking organisation; that they should know what risks banks face, to what degree, and
how they assess those risks; and that they should have details on what capital they hold.
More generally, by emphasising principles in the disclosure rules - that banks should have a formal
disclosure policy approved by the board, that internal measurement tools must be credible, that they
must adequately capture risk, and that they must be used by banks in the daily management of their
operations and not just for regulatory capital purposes - transparency may actually result in more
consistency in the application of advanced approaches than detailed quantitative criteria.
Issues That Arose in Consultation:
The process for transcribing these principles into rules for the New Accord has involved extensive
discussion among supervisors, representatives of the accounting profession, and financial institutions.
This past summer alone, for example, the Committee received over 200 public comments on the
proposals set out in our third consultative paper, or "CP3" as we call it. The third pillar attracted a
degree of controversy among many banks mainly in earlier drafts of the rules, but thanks to the very
positive discussions that the Committee had with the industry and with accounting standards-setting
bodies, all the pillars of CP3 now enjoy broad support. This brings me to the next part of my address,
in which I'll cover the key concerns that arose during consultations.
Proprietary versus public information
Certainly, an early concern about the market discipline component of the New Accord was that the
required disclosures appeared to go far beyond what banks traditionally reported publicly. In some
institutions' opinion, the Committee was seeking to require the disclosure of information previously
considered confidential. While the Committee is mindful of the concern that some information should
remain private, we believe that concepts of public versus proprietary information require some
reflection. In order to determine whether information should be disclosed, consideration should also be
given to end-users' needs. For example, in order for shareholders, creditors, and counterparties to
appreciate the risks of their own exposures to a bank, they must understand that bank's appetite for
risk and its approach to, and methodologies for, managing risk. What should drive this debate is what
a bank itself would want to know before making an investment or credit decision, rather than the
concerns that some have about what had formerly been considered secret.
The Committee believes it has struck an appropriate balance between meaningful disclosure and
protection of proprietary and confidential information.
Principles versus Rules
A second concern that arose in consultations was the Committee's decision to adopt specific rules for
disclosure, rather than articulate broad principles for transparency. But on this point, many institutions
seem caught up in a contradiction. On the one hand, banks suggest that we avoid overly detailed
guidance on public reporting that might create burdensome and inflexible rules. On the other, nearly
all banks have urged the Committee to provide clarity to ensure the consistent application of the New
Accord across jurisdictions. Understandably, some banks are concerned that, in the absence of
specific rules, competitors in other countries might be subject to less scrutiny than they are.
We recognise that a principles-based approach offers benefits, especially in terms of simplicity and
flexibility. But our main intention is to offer markets a clearer picture of a bank's risk profile, regardless
of what jurisdiction that bank may call home. To promote both greater insight into a bank's true risks
and a more level playing field for all banks, we advocate disclosure rules based on principles rather
than looser principles that might be subject to local interpretation. Likewise, the Committee rejected
proposals for supplemental disclosures that would be optional under the New Accord.
This has admittedly resulted in disclosure requirements that are more detailed and perhaps less
elegant than a simple expression of principles might be. But perhaps supervisors can take some
comfort from the physicist who recommended that "if you are out to describe the truth, leave elegance
to the tailor."
Consistency of Accounting Standards and the New Basel Accord
One cannot discuss transparency and market discipline without considering the mechanics through
which financial data are recorded and reported. And this brings me to a final key observation raised in
comment letters, namely the industry's position that if we are to leverage market discipline through
better reporting, the Committee should clarify the differences between accounting standards and
supervisory objectives.
Numerous institutions have called on the Committee to continue to align the regulatory framework
more closely with the converging standards in accounting worldwide. Many industry representatives
have noted quite correctly that a greater degree of accordance is warranted especially now that the
New Basel Accord includes explicit disclosure requirements intended to promote greater insight into a
bank's risk profile. Likewise, the Basel Committee's treatment of provisions and the valuation of
financial instruments must keep pace with changes in the relevant accounting standards.
We have made a considerable effort to see that the narrower focus of Pillar 3 does not conflict with the
broader accounting requirements, and we have liaised closely with our colleagues in the International
Accounting Standards Board in pursuit of this objective. In fact, the Committee views Pillar 3 as a
further refinement of the accounting standards requirements as they should apply to banks in the light
of the specific risks that they face. The Committee is convinced that such specificity is both
appropriate and necessary for prudential reasons.
Market discipline, and hence financial stability, is strengthened when accounting and disclosure
requirements reflect sound risk management principles and represent the control practices that banks
adopt. Consequently, we recognise our responsibility to participate actively in the development of
national and international accounting standards. When designing standards for the disclosure of
components of capital, for loan reporting, and for other topics of mutual concern, we have sought out
the views of accounting standards-setting bodies. This dialogue will continue.
Where regulatory and accounting principles may not yet be fully consistent, we have sought to align
our requirements as best as possible with international accounting standards and to resolve other
matters reasonably and based on our understanding of the potential direction that accounting
standards might take in the future. Because we recognise that there is still much to be done in this
area we will continue to monitor pillar 3 in the light of accounting and market developments. I should
add that we are seeking new opportunities for discussion with accounting standards-setting bodies
and private sector accounting professionals.
The Status of the New Accord
The Committee is currently reviewing carefully these responses and other issues that the industry
raised. In relation to pillar 3, we are evaluating closely what should be reported publicly, versus what
can remain confidential. We are refining the rules so that they will help secure a more level playing
field without being overly burdensome. We are aligning our reporting requirements with those
emerging from accounting standards.
In terms of the way forward, as you may know, in mid-October the Committee reached an important
agreement on a work plan for taking these and other issues into account, and significant progress was
made on major issues. What is most important to the Committee is the quality and consistency of the
new Accord. At the same time, we recognised the need to provide banks with as much certainty as
possible while they plan and prepare for the adoption of the new rules. In our last meeting in Madrid,
the members of the Committee agreed on the importance of finalising the New Accord expeditiously
and in a manner that is technically and prudentially sound.
We noted in a statement to the press that we expect to address the remaining issues and complete
the text of the New Accord in the coming months and no later than mid-year 2004. This period of time
will also allow us to take careful note of valuable information coming from domestic consultations
under way in some jurisdictions, including the process for the Advance Notice of Proposed
Rulemaking in the United States.
The Committee also discussed the importance of ensuring that the calibration of the New Accord
achieves its objectives. Accordingly, prior to implementation, a further review of the calibration will be
conducted on the basis of additional information, such as further impact assessments in some
jurisdictions and the monitoring of banks' parallel calculations.
In terms of specific issues, a number of areas were identified where major improvements were
possible: the expected versus unexpected losses calibration issue, securitisation, credit cards
commitments and risk mitigation techniques. At present, we have offered for public review a proposal
to resolve a fundamental concern raised by the industry on the treatment of expected versus
unexpected losses. I would encourage those interested to read the statement outlining our proposed
revision on our website and to share any thoughts you may have by the end of this year. We have also
simplified the proposals for securitisation exposures, as we decided to replace the "Supervisory
Formula" approach to unrated tranches with a simpler rule.
Also, as we draw closer to finalisation, the Committee has intensified its efforts to facilitate a consistent
implementation of the New Accord. A set of principles has been outlined for the cross-border
application of the New Accord to promote closer practical co-operation and information exchange
among supervisors. These implementation issues are very important to promote consistency and to
reduce the burden on internationally active banks.
There are, however, other areas that we can already identify as part of our future work plan to
advance risk management, to promote greater transparency, and to strengthen the stability of the
financial sector. Given that I have mentioned in this presentation the benefits of utilising the
diversification effects of different approaches in the search for an efficient frontier, I'd like to conclude
with just one of the potential items on our agenda for future work once the New Accord is
implemented.
This item would be to consider the benefits of full credit risk models in the calculation of minimum
capital requirements. In theory, a bank's capital requirements would then reflect to the greatest degree
the economic benefits of diversification in its balance sheet. In fact, the Committee did at one point
evaluate whether advanced banks should be permitted to estimate the degree to which their assets
might behave similarly or default together in the New Basel Accord.
As you know, we decided that we are not quite there yet. We know that some banks are making
commendable progress in thinking about ways to estimate the value of diversification. Nonetheless,
we remain concerned about the degree of confidence one might have in those estimates, given the
relative lack of data available. Likewise, we have not yet seen evidence that there is a critical mass of
banks that would today consistently meet the "use" test spelled out in the New Accord. In the coming
years, and we can start very soon, we look forward to continuing this dialogue with banks, banking
associations, and researchers to find ways to move Basel in the direction of full credit risk models.
Although banks and supervisors have much to do in the years ahead, we are confident that the
development of an incentives-based capital framework, accompanied by more consistent and focused
supervisory review and a concurrent enhancement of market discipline, will improve the management
of risk across the industry, promote broader financial stability and resilience, and ensure that the
banking system is better able to promote sustainable growth in the economy.