Academic journal article Journal of Applied Finance

Market Discipline and Supervisory Discretion in Banking: Reinforcing or Conflicting Pillars of Basel II?

Academic journal article Journal of Applied Finance

Market Discipline and Supervisory Discretion in Banking: Reinforcing or Conflicting Pillars of Basel II?

Article excerpt

The market-discipline and supervisory-process pillars of the Basel II framework are less discussed than the framework's capital requirements pillar. Both theoretical predictions and empirical findings in the academic literature indicate that while the market-discipline pillar is for many nations a potentially useful first step toward improving bank information disclosure, it falls short of promoting effective market monitoring by private investors or encouraging the utilization of market signals by both investors and bank regulators. The Basel II supervisory-process pillar is completely misguided in its reliance on regulatory discretion; implementation could have counterproductive effects on bank safety and soundness. That is, the market discipline pillar does not go far enough in the direction suggested by academic research, and the supervisory process pillar actually goes in the wrong direction. [G28, E51]

During past decades, there has been an historical oscillation of financial stability policies across objectives of management, resolution, and prevention (Bordo, 2003). Following three decades in which national governments and regulators placed primary weight on the management and resolution of financial crises, the primary objective most recently has been prevention. The culmination of official efforts aimed at crisis prevention is the international bank regulation and supervision framework that has come to be known as Basel II.

Basel II presently is scheduled for a phased implementation beginning in 2009. Its framers suggest an analogy in which the framework is an elevated foundation resting on three "pillars." Pillar 1 is a redesigned system of risk-based capital requirements, Pillar 2 is a guideline for supervisory review, and Pillar 3 is a set of rules intended to promote market discipline. More than 80% of the description of the new framework (Bank for International Settlements, 2006) is devoted to Pillar 1. Hence, researchers so far have shone the brightest spotlight on capital adequacy regulation.

There is a growing understanding, however, that the three-pillar foundation is important. Basel II is unlikely to provide banking systems with either a level playing field or a stable foundation unless each pillar is sufficiently well designed and structured to hold. The presumption in most discussions of the Basel II pillars is that in practice each will prove to reinforce the others.

This paper evaluates this official presumption. The following section provides a basic overview of the Basel II guidelines regarding market discipline and the supervisory review process. In light of recent research on market discipline and bank regulatory policy, sections III and IV review and discuss conceptual issues associated with the market-discipline pillar and supervisory-review pillar, respectively. section V concludes by evaluating whether the present Basel II guidelines regarding the two pillars are likely to reinforce or conflict-thereby resulting in productive or counterproductive outcomes for bank safety and soundness.

I. An Overview of Basel II's Other Two Pillars

The basic structure of Basel II is laid out in the Bank for International Settlements ' "International Convergence of Capital Measurement and Capital Standards" (2006). Roughly 150 pages lay out details of the Pillar 1 system of capital requirements, a significant extension of the Basel I framework. Detailed discussion of the Pillar 1 capital framework is beyond the scope of this paper, but Santos (2001) and VanHoose (2007) review implications for bank behavior; Stolz (2007) and VanHoose (2008) consider broader stability impacts; and Gup (2004) and Benink, Danielsson, and Goodhart (2005) discuss a number of related issues.

The BIS document devotes fewer than 40 pages to discussion of Pillars 2 and 3, which are the focus of this paper. The following is a summary of the essential aspects.

A. The Market Discipline Pillar of Basel Il

According to the Bank for International Settlements (2006, pp. …

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