Extending the Scope of Prudential Supervision: Regulatory Developments during and beyond the “Effective” Periods of the Post BCCI and the Capital Requirements Directives.
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The main argument of this paper is, namely, the need for greater emphasis on disclosure
requirements and measures – particularly within the securities markets. This argument is justified
on the basis of lessons which have been drawn from the recent Financial Crises, one of which is the
inability of bank capital requirements on their own to address funding and liquidity problems. The
engagement of market participants in the corporate reporting process, a process which would
consequently enhance market discipline, constitutes a fundamental means whereby greater
measures aimed at facilitating prudential supervision could be extended to the securities markets.
Auditors, in playing a vital role in financial reporting, as tools of corporate governance, contribute
to the disclosure process and towards engaging market participants in the process. This paper will
however consider other means whereby transparency and disclosure of financial information within
the securities markets could be enhanced, and also the need to accord greater priority to prudential
supervision within the securities markets.
Furthermore, the paper draws attention to the need to focus on Pillar 3 of Basel II, namely, market
discipline. It illustrates how through Pillar 3, market participants like credit agencies can determine
the levels of capital retained by banks – hence their potential to rectify or exacerbate pro cyclical
effects resulting from Pillars 1 and 2. The challenges encountered by Pillars 1 and 2 in addressing
credit risk is reflected by problems identified with pro cyclicality, which are attributed to banks’
extremely sensitive internal credit risk models, and the level of capital buffers which should be
retained under Pillar Two. Such issues justify the need to give greater prominence to Pillar 3.
As a result of the influence and potential of market participants in determining capital levels, such
market participants are able to assist regulators in managing more effectively, the impact of
systemic risks which occur when lending criteria is tightened owing to Basel II's procyclical effects.
Regulators are able to respond and to manage with greater efficiency, systemic risks to the financial
system during periods when firms which are highly leveraged become reluctant to lend. This being
particularly the case when such firms decide to cut back on lending activities, and the decisions of
such firms cannot be justified in situations where such firms’ credit risk models are extremely
sensitive – hence the level of capital being retained is actually much higher than minimum
regulatory Basel capital requirements.
In elaborating on Basel II's pro cyclical effects, the gaps which exist with internal credit risk model
measurements will be considered. Gaps which exist with Basel II's risk measurements, along with
the increased prominence and importance of liquidity risks - as revealed by the recent financial
crisis, and proposals which have been put forward to mitigate Basel II's procyclical effects will also
be addressed.
Keywords
HG Finance