Why Basel II’s pillar 3 brought market discipline to banks

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Sep. 10 2014, Updated 9:00 a.m. ET

Pillar three

Basel II’s third pillar concerns market discipline, and the requirements are related to disclosures of a bank’s market-related investments. According to pillar three, banks were expected to build comprehensive reports on their internal risk management systems. The reports were required to be publicly disclosed to the market at least twice a year.

All types of banks like JPMorgan (JPM), Wells Fargo (WFC), Morgan Stanley (MS), Goldman Sachs (GS), and other banks in an ETF like the Financial Select Sector SPDR Fund (XLF) were to publish these reports.

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This raised some confidentiality issues in the sector since the list of elements to be published was thought to be exhaustive and confidential to a bank. Parameter options chosen for Basel II might have been considered confidential by some. Such parameters included the description of risk management objectives and policies, internal loss experience by risk grade, collateral management policies, and exposures by maturity, industry, and geographical location.

The goal was to let the market place additional pressure on banks to improve their risk management practices. It goes without saying that bank credit and equity analysts, bond investors, and other market participants found the disclosed information very useful in evaluating a bank’s soundness.

Innovations from Basel II Accord

In summary, the six most noteworthy innovations that Basel II Accord brought to banking regulations were

  1. Increasing sensitivity to capital requirements for different risk levels
  2. Introducing regulatory capital needs for operational risk
  3. Providing important flexibility in Basel II through several options that were left at the national regulators’ discretion to suit local needs
  4. Increasing national regulators’ power, as they were expected under pillar two to evaluate a bank’s capital adequacy by considering its specific risk profile
  5. Improving the recognition of risk-reduction techniques
  6. Implementing detailed mandatory disclosures of risk exposures and risk policies

Those measures should help the global industry progress in its general understanding of credit risk management issues. The measures also constitute the intermediary step before full internal model recognition.

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