The impact of Basel III on European Banks
An empirical investigation to the impact of Basel III on different types of European banks for capital- and capital disclosure requirements
14 May 2011 Job Huttenhuis
Abstract
This thesis studies the relationship between different types of banks and the impact of Basel III. The impact of Basel III is assessed for capital- and capital disclosure requirements. The sample consists of 40 European based banks. Using annual reports of 2009, which are based on Basel II, I determined the additional influence of Basel III regulation. Variables which influence is accounted for are; systemically importance, individualism, uncertainty avoidance, power distance, and legal system. The results on capital adequacy show that banks from countries with high uncertainty avoidance, high power distance, and banks from French code law countries hold significantly less capital with respect to their risk-weighted assets if measured in Basel III criteria. For prudential capital disclosures the results show that systemically important banks as well as banks from Scandinavian code law countries significantly disclose more. In addition, prudential capital disclosures are more often presented by banks from countries with a low preference for avoiding uncertainty. I provide recommendations for investors and standard setters how to deal with Basel III. Additionally, supervisors and the BCBS are given indications where they have to monitor Basel III implementation more closely.
Keywords: Basel II, Basel III, IAS 39, IFRS 7, capital requirements, capital disclosures, prudential disclosures.
The impact of Basel III on European Banks
An empirical investigation to the impact of Basel III on different types of European banks for capital- and capital disclosure requirements.
The author is responsible for the content of this thesis. Copyrights of this thesis are of the author.
Author:
Job Huttenhuis
Student number:
1534165
University:
University of Groningen
Faculty:
Faculty of Economics and Business
Specialization:
MSc. Accountancy
Supervisors University of Groningen:
Prof. dr. K.H.W. Knot
Prof. dr. R.L. ter Hoeven RA
Thesis Internship:
KPMG De Meern
Supervisor KPMG:
W. Kevelam MSc. EMA
Date:
14 May 2011
Preface
This thesis marks the end of my residence in Groningen. During this period I encountered that the combination of the bachelors accounting & controlling with business economics fitted in with my interests. Both studies in combination with being the treasurer of the Risk Board 2008-2009 enabled me to develop a broad view in the financial spectrum. I know for sure that I will always remember these five and a half years as interesting and instructive but above all as a delightful experience.
During my life and study I have been fascinated by banks. Everywhere you go banks are an essential part of your life. Saving your first euros, receiving your salary, paying for your purchases and even getting money in Cuba. My fascination increased while working for a local Rabobank during my years in high school. Suddenly, during the credit crunch, (large) banks proved to be vulnerable. Witnessing all
consternation during the crises, choosing a subject related to banks was therefore the only logical action. Only the insurance sector was able to raise a little doubt. Finally I decided to go forward and write my thesis about Basel III. Basel regulation is in place to take care that banks, even in stress scenarios, stay into business. After all, you do not want to wake up discovering that all your savings have been lost. The last months enabled me to expand my knowledge in the fields of accounting, and finance. I encountered that working on a thesis about Basel III is extremely interesting and even pleasant. I hope you will notice this while reading.
There are a lot of persons who I am very grateful for. First of all I would like to express my gratitude towards my first supervisor of the University of Groningen, dr. Klaas Knot. He continuously provided tips and feedback and he made sure I also kept focusing on details and nuances. In my opinion, this helped me raise the level of my thesis. I know he underlines “in my opinion” directly and I will never forget his following comment; “the whole thesis is your opinion”, which unarguably is true as with many, if not all, of his comments. Second, I owe thanks to dr. Ralph ter Hoeven for his willingness to function as second supervisor. Also, I thank him for his hint to approach my first supervisor. Third, I would like to express my gratitude towards KPMG for providing me the tools and knowhow to write my thesis.
Especially I would like to thank Patrick, for guiding me trough the organization and Wilfred for his support, numerous insightful comments and interesting discussions on my thesis. Furthermore, I owe thanks to all my friends and family who not only supported me during the last five months but also during more turbulent times. In particular I would like to thank my girlfriend Marloes for her loving support and my brothers, Luuk, and Gijs for still being together in great harmony. Last, but certainly not least, I would like to express great gratitude towards Bennie, Ria, Martijn, Susan, and Hans. They know why.
Utrecht, 10th April 2010
Table of Contents
Preface………...3 Chapter 1 – Introduction……….71.1
Introduction………..…7 1.2 Research Outline………..8 1.2.1 Main Question………....81.2.2 Research Goal and Scope………8
1.2.3 Organizational Context………....9
1.3 Relevance………...13
1.4 Structure……….15
Chapter 2 – Theoretical Background………...16
2.1 Introduction………16
2.2 Institutional Theory of Banks………16
2.3 Incentives for Bank Regulation……….18
2.4 Legal Base of Regulators and Supervisors………20
2.5 Impact and effect of capital requirements………...20
2.6 Impact and effect of disclosure requirements………21
Chapter 3 – Bank Requirements and Standards...23
3.1 Basel Accords……….………...23
3.2 Basel II………...23
3.2.1 Pillar 1: Minimum Capital Requirements………....23
3.2.2 Pillar 2: Supervisory Review Process……… 25
3.2.3 Pillar 3: Market Discipline………25
3.3 Basel III………...26
3.3.1 Pillar 1: Minimum Capital Requirements………..27
3.3.2 Pillar 3: Market Discipline………29
3.4 IFRS Disclosures for Banks………..…….30
3.5 Comparison on Basel and IFRS………...31
3.5.1 Accounting Concepts………..31
3.5.2 Disclosures………..35
Chapter 4 – Research Design and Methodology……….38
4.1 Introduction………....38
4.2.1 Capital Requirements………...…..38
4.2.2 Capital Disclosure Requirements………... 38
4.3 Research population and sample selection………....39
4.4 Data collection………...39
4.5 Research Methodology………..39
4.5.1 Financial Importance Grouping………..40
4.5.2 Cultural Grouping……….…..41
4.5.3 Legal Grouping………42
4.5.4 Capital Requirements……….42
4.5.5 Capital Disclosure Requirements………...44
4.6 Statistical Analysis……….46
4.7 Research Limitations……….46
Chapter 5 – Analyses and Results………....48
5.1 Introduction………....48
5.2 Descriptive and General Statistics……….48
5.3 Results on Financial Importance Dimension……….50
5.4 Results on Cultural Dimensions……….51
5.4.1 Power Distance………52
5.4.2 Uncertainty Avoidance………...53
5.4.3 Individualism………56
5.5 Results on Legal Dimension………..58
5.6 BCBS Quantitative Impact Study………..61
5.7 Summary of results………62
Chapter 6 – Conclusions and Recommendations………63
6.1 Introduction………63
6.2 Conclusions and Recommendations………..63
6.3 Thesis Limitations and Future Research………65
References………...68
List of Abbreviations……….73
Chapter 1: Introduction
1.1 IntroductionThe last years the world has encountered a severe financial crises. Started by the burst of the bubble in the United States’ housing market, the impact scattered throughout the world by securitizations and re-securitizations, for example as mortgage debt securities or collateralized debt obligations. Because of these instruments, risk-weightings and credit ratings did not adequately represent reality and as a result it was not clear what the risks were and who encountered the risks intrinsic to a product. When initial lenders defaulted the value of the instruments mentioned sharply declined. As a result, banks had to write down billions of assets.
In order to protect the financial system from a domino effect in these stress scenarios capital requirements for banks are in effect. During the recent financial crises we have seen the fall of Lehman Brothers and Bear Sterns in 2008. In addition, nations provided billions of government support for banks and other financial institutions to prevent the world economy from more severe damage. We can conclude that banks’ capital requirements were not sufficient to cope with the financial distress encountered during the financial crises. These capital requirements are issued by the Basel Committee on Banking Supervision (BCBS). At the time of the financial crises Basel II, which prescribes capital requirements for banks, was in effect in Europe. Next to additional capital, government support provided liquidity for financial institutions. The lack of this liquidity was one of the major causes of the financial crises. This is also concluded by the Financial Stability Board (2009) and the European Union high-level group on financial supervision chaired by De Larosière (2009).
As a reaction to the financial crises and societies agitation to bank behavior, new standards on banking regulation have been developed. These new standards are described in a publication of the Bank for International Settlements (BIS), “Strengthening the Resilience of the Banking Sector” (BIS, 2009b). These standards are better known as Basel III. An accord on these requirements was reached on 12 September 2010 (BIS, 12-9-2010). Though an accord just has been reached banks already indicate that requirements are too heavy and harm economic growth (FD, 14-9-2010). On the other hand, supervisors and regulators indicate that the impact on economic growth has been taken into account (FD, 15-9-2010). Already Germany indicated that its banks had to attract a massive 105 billion to comply with Basel III, while Switzerland proposes substantially higher capital requirements for its two largest banks (FT, 4-10-2010).
To provide insight in the effects of Basel III this thesis investigates the impact of Basel III capital requirements on banks. In addition this thesis assesses the transparency of banks on capital need and
requirements using the disclosures made by banks in their 2009 annual reports. Last, this thesis assesses how Basel requirements coincide with accounting regulation for accounting concepts and capital disclosures.
1.2 Research Outline
First, this section describes which questions will be answered in this thesis. Second, the goal and scope of the thesis are highlighted. Furthermore, the conceptual framework is outlined. Fourth, the relevance of this thesis is outlined for theory and practice. Finally, an overview of the thesis structure is provided.
1.2.1 Main Question
To determine the impact of Basel III on banks my main question is as follows:
What is the impact of Basel III on capital- and disclosure requirements for European Banks? The main question entails two main themes. First, the influence of Basel III on capital requirements. Second, the impact of Basel III on disclosure requirements for banks. These requirements are not limited to Basel III but do also involve (accounting) reporting standards. In order to structure my thesis, I have subdivided the main question into the following sub questions which enable me to provide an answer to the main question.
1 What are the theoretical implications of capital- and disclosure requirements in general and on banks?
2 What are the main differences between Basel II and Basel III, especially for capital- and disclosure requirements?
3 To what extent do (different types of) banks comply with Basel III capital requirements? 4 Do (different types) banks comply with current capital disclosure requirements?
5 To what extent are prudential concepts and disclosures corresponding with accounting concepts and disclosures?
What these questions aim to answer is described in the following paragraph, 1.2.2. How these questions will be answered is outlined in Chapter 4.
1.2.2 Research Goal and Scope
The goal of this thesis is to assess the impact of the recently signed Basel III accord on European Banks. I focus on the impact on capital requirements and additional capital disclosures. Capital disclosures which entail the transparency banks have to provide on this topic. For this thesis I have selected a sample of 40 European banks with their home base in a European country. My sample consists out of the 39 largest European banks, based on asset scale using the FTSE Eurofirst 300 index, at 1 January 2010. In addition
Rabobank is added resulting in a sample of 40 banks. As a result two Dutch based banks, ING and Rabobank are included in the sample.
I empirically investigate to what extent the selected European banks do comply with the new Basel III requirements on capital. In answering this question I will provide an estimate of the amount of capital which needs to be raised. This capital raise can be realized in two ways. First, funds can be extracted from the market by means of a stock issue. Second, banks can retain (part of) their profits. In this thesis the capital raise encompasses funds extracted from the market as well as retained from profits. Theoretically it should be irrelevant for investors if this is done by a stock issue or by retaining profits (Modigliani and Miller, 1958), and therefore this thesis assesses the total amount of capital that needs to be raised. Next, I investigate what banks do disclose now based on Basel II. In addition, I aim to provide insight in Basel III impact differences due to bank characteristics. Before this can be assessed the main differences between Basel II and Basel III have to be clear Therefore I will outline the contents of and differences between these Basel accords. Last, I will compare concepts and disclosure standards from Basel III with accounting standards to indicate to what extent these regulations coincide.
As can be concluded from the sample selection, I will not assess the impact of Basel III regulations on banks with their home base outside of Europe. Furthermore, this thesis does not assess the impact of Basel III on banks liquidity requirements, which will be explained in chapter 3, paragraph 3.3.2. Moreover, this thesis will not investigate pillar 2 requirements regarding risk management and the supervisory review process, which I will explain in 3.2.3. Last, I will not provide an answer to the question if Basel III requirements enable banks to withstand a comparable, or even more severe, (financial) crises.
1.2.3 Organizational Context
This section outlines the framework and mutual relationships banks, supervisors, accountants and regulators have with respect to the development and design, implementation, and execution of capital- and capital disclosure requirements. The overview is provided on page 12 in figure 1.1, Organizational Context. The impact of capital- and capital disclosure requirements on banks is marked by 1. The development of accounting concepts and disclosure requirements is market by 2. The concepts are explained below.
The development and design of capital- and capital disclosure requirements starts at the Basel Committee on Banking Supervision (BCBS). The BCBS develops a consultative document (CD) on which
stakeholders, like (central) banks, (other) supervisors and accountants can give their views. After the consulting process the CD, and possible adjustments, is approved by members of the BCBS. These
members are represented in the “Central Banks / Supervisory Agencies” heading and include Central Banks and the European Central Bank. Of these members 56 have voting rights in the General Meeting (BIS, 2010).
Central Banks / Supervisory Agencies implement the approved banks requirements in their country. In addition to approving and implementing the requirements, they are responsible for enforcing compliance. Thus, their role is twofold. On the one hand, Central Banks and supervisory agencies represent their own country and therefore their own banks. On the other hand, they represent the BCBS, governments, and the European Commission to enforce the requirements. The legal base for enforcing compliance is provided for by Governments, this will be explained in 2.4; “Legal Base of Regulators and Supervisors”.
Governments influence banks in several ways. For this thesis the legal framework is of importance. The legal framework in which a bank has to operate is provided for by the government. Examples from corporate law include taxes on profits and mandatory statutory audits. These audits are performed by accountants. As indicated, governments provide the legal base for supervision on banks by Central Banks and supervisory agencies.
Accountants perform audits on the financial information banks provide to their stakeholders through annual reports. For (large) banks these audits are always mandatory by law. In the Netherlands this is arranged for by the law on financial supervision1, article 15 as well as Dutch Civil Law2 . The audit standards are provided for by accounting regulators, like the International Accounting and Assurance Standards Board (IAASB). Accountants check whether banks comply with accounting standards, like IFRS, which are provided by the International Accounting Standards Board (IASB).
Accounting regulators, provide the accounting standards for the audit of banks. Accounting standards include the treatment of transactions, the measurement of concepts as well as the inherent mandatory disclosures of information. These standards are developed and adjusted to improve accounting
information for its users. The development process is influenced by stakeholders. Accountants provide input based on their experience with accounting standards and can propose improvements to these standards based on the feedback of users. The BCBS uses accounting standards to measure (proposed) capital requirements. An example is the valuation of assets and the following calculation of risk-weighted assets. More recently, the BCBS became involved in influencing accounting and disclosures standards for financial institutions. An example includes the BCBS advice on the replacement of IAS 39 (BIS, 2009).
1
In Dutch: Wet financieel toezicht. 2
Banks have to set up their annual reports in accordance with accounting standards. The disclosures required by accounting standards can differ from disclosures required by the BCBS. The differences and developments of these standards are part of this thesis. In figure 1.1, organizational context, this is marked by 2.
Banks are all subject to (accounting) regulation and requirements. The relationship indicated by 1 is the impact of Basel III requirements on capital- and capital disclosure standards. Banks are influenced by the outcomes of the process of number 2 since they have to comply with these disclosure requirements. In addition, accounting concepts provide the measurement base for banks’ assets, liabilities and
(shareholders’) equity. Not investigated in this thesis are all other relationships.
Other stakeholders, include other stakeholders than governments, central banks and other supervisors, the BCBS, accounting regulators and accountants. These include, amongst others, customers, employees, creditors and investors. As this thesis does not investigate any of these relations, this is not elaborated further. In addition, these stakeholders also have relationships with the institutions mentioned but are for clarity reasons not described.
Organizational Context Figure 1.1, Organizational context
BCBS
Capital requirements Liquidity requirements Disclosure requirementsBanks
Capital requirements Liquidity requirements Disclosure requirements Accounting StandardsAccounting Standard
Setters
Accounting standards Disclosure requirementsCentral Banks /
Supervisory
Agencies
Bank Supervision Determine capital- , liquidity and disclosure requirementsEnforcement of bank requirements
Governments
Legal Framework Legal Base Supervisors / Central BanksOther Stakeholders
Customers Investors Creditors EmployeesAuditor
(Statutory) Audit 1 2To outline the scope of this thesis further I highlight the Basel III components which are part of this thesis. Basel III consists out of three pillars. Investigated in this thesis are capital requirements, denoted in Pillar 1 and capital disclosure requirements, denoted in Pillar 3. The supervisory review process, Pillar 2, and the effectiveness of this process is not part of this thesis. Also Pillar 3 disclosure requirements which do not focus on capital disclosures are out of the thesis’ scope. However, disclosures on capital structure and capital adequacy can require disclosures which are also required by other fields. Examples include disclosures on credit-, market-, operational-, and interest rate risk. A more detailed assessment could be a suggestion for future research. Last, the impact of liquidity requirements denoted in Pillar 1 is not investigated. A schematic overview is provided in figure 1.2 below. Parts which are not investigated are grey-colored. Parts which are investigated are green colored. The figure will be the same for Basel II except for the liquidity-, system-bank capital and countercyclical capital requirements because these were not included in Basel II. However, it is important to note that the elements are the same but the content differs. An example is the additional capital conservation buffer which is included in minimum capital requirements in Basel III. The differences between Basel II and Basel III will be explained in chapter 3.
Basel III
Pillar 1 Pillar 2 Pillar 3
Capital- and Supervisory Market Discipline
Liquidity Requirements Review Process
Capital requirements Disclosures
Minimum Capital Requirements Scope of disclosures
System Bank Capital Requirement Capital Structure
Countercyclical Capital Requirement Capital Adequacy
Credit Risk
Liquidity requirements Securitization
Net Stable Funding Ratio Market Risk
Liquidity Coverage Ratio Operational Risk
Banking book positions
Interest rate risk
Figure 1.2, Basel III Elements included in thesis
1.3 Relevance
This thesis studies the impact of Basel III on capital- and capital disclosure requirements. Due to Basel III requirements banks have to cover their assets with more capital. In addition, the quality of capital also has to be higher. In practice this means that banks have to hold more common equity. Banks can choose to
deal with the requirement in two ways. They can invest a larger part of their money in higher rated assets, like AAA-(government)bonds which are seen as safer, thereby reducing risk-weighted assets. As a result less capital is required. On the other hand banks can raise capital. Second, for disclosure requirements, I study if banks do comply with disclosure requirements of Basel II. Furthermore I provide the additional disclosures that have to be made if banks already want to comply with Basel III. Last, I assess how accounting concepts and disclosure standards for banks using Basel regulations and reporting standards published by the International Accounting Standards Board (IASB) currently coincide.
For all relations described above supervisors have a legal base. However, this does not mean that banks comply. Compliance with prudential regulation is defined as the extent to which banks satisfy the minimum capital and disclosure criteria. If banks voluntarily hold higher capital buffers or provide more disclosure they do already meet the minimum criteria and therefore do comply. Regarding capital requirements, there can be banks that voluntarily hold higher buffers than required by Basel II and therefore could already comply with Basel III. The same reasoning holds for complying with capital disclosure requirements. Banks can voluntarily already disclose more information while on the other hand other banks still refuse to disclose all mandatory information.
This thesis will contribute to the existing literature by studying the impact of Basel III on European banks’ capital- and capital disclosure requirements. The impact of capital requirements has been studied by, amongst others, Sengupta (1998), Healy et. al (1999) and Botosan and Plumlee (2002). Also the impact of Basel II was studied. Amongst other examples, DNB (2006) studied the impact on Dutch banks. Griffin (2008) studied the relationship with the credit crises and Gordy and Howell (2006) examined the pro-cyclical effects. In addition, Decamps et. al. (2002) focused on the combination of the effectiveness of three pillars. This thesis focuses on the impact of Basel III on European banks in terms of additional capital to raise. Furthermore, this thesis contributes by comparing Basel capital and disclosure
requirements with IFRS capital and disclosure requirements. The impact of adopting IFRS has been studied by, for example, Armstrong et al (2006) and Söderstrom and Sun (2007). For European banks the adoption of IFRS has been studied by Gkougkousi and Mertens (2010) and Palea (2007). However, a comparison between IFRS and Basel II disclosure requirements for European banks has not been made. Because Basel III just has been announced, both the impact on capital requirements as well as differences with IFRS have not been examined before. The Bank for International Settlements did investigate the impact of Basel III (BCBS, 2010) in the long run and the impact of the transition to Basel III
(Macroeconomic Assessment Group (MAG), 2010)) on macro-economic growth. In addition, a Quantitative Impact Study (BCBS, 2010) was performed. However, all did not address the impact on individual countries and types of banks. This will be done in this thesis.
This research is relevant for banks to provide insight in the impact of Basel III on their capital need and their compliance as group to Basel disclosure standards. In addition, Basel standard setters gain insight in the compliance of different types of banks with Basel standards. As a result, an indicator of which banks and countries have to be monitored more closely is provided. Third, (accounting) standards setters and policy makers3 as well as banks and accountants are given notice of the differences between Basel and IFRS requirements. Potentially this leads to more convergence between Basel and IFRS. At least an overview is provided. Furthermore, this thesis benefits banks’ (potential) shareholders by providing an estimate of the capital (different types of) banks have to retain or attract which will undoubtedly influence dividend payout and dividend policies.
1.4 Structure
This paragraph describes the set-up of the remainder of this thesis. In Chapter 2: Theoretical Background, I will outline how rules for behavior developed and why banks are regulated. In addition, I describe the legal base of the Basel accords. Through this legal base banks have to comply with Basel requirements. Last, this chapter outlines the effects of capital-, and disclosure requirements.
The standards and requirements to which banks have to comply will be discussed in Chapter 3: Bank Requirements and Standards. First, I will outline Basel II and Basel III accords. The main differences between both accords on capital-and disclosure requirements are highlighted. Second, I will provide an overview of capital disclosure regulation for banks using the IFRS framework. Last, I will compare Basel III capital-, and disclosure requirements, IAS 32 and IFRS 7. The definition and measurement of assets and liabilities is analyzed and compared with IAS 39.
In chapter 4: Research Design and Methodology, I provide a description on how the hypothesis is derived from the research questions. Additionally, I highlight my sample selection from the available population. Last, I will describe the methods used to test the research questions as well as the methods used to collect the data. The empirical results are described in Chapter 5: Research results and analysis. The results are presented based on the groups formed in chapter 4. Last, Chapter 6: Conclusions and Recommendations, provides an answer to the main question. Furthermore, limitations of this thesis and suggestions for future research are outlined in this chapter.
3 The European Central Bank (ECB), National Central Banks, The Basel Committee on Banking Standards, The International Accounting Standards Board (IASB)
Chapter 2:
Theoretical Background
2.1 IntroductionThis chapter outlines the theoretical framework and concepts underlying this thesis. In paragraph 2.2 the institute of a bank is explained. Additionally, institutional theory is outlined in the same paragraph. Second, the incentives for bank regulation are discussed in 2.3. Third, paragraph 2.4, outlines the legal base of supervisory agencies and central banks to enforce Basel regulation. Fourth, the impact and effects of capital requirements are highlighted in paragraph 2.5. Last, paragraph 2.6 describes the impact and effect of disclosure requirements.
2.2 Institutional Theory of Banks
This paragraph outlines the institute of a bank and why this institute is important for the financial system. Second, the issues with the supply of credit are discussed. This concept is instrumental to bank
operations. Furthermore, institutional theory, which is the process through which Basel norms become authoritative, is discussed in the last clause.
Banks are key to the financial system. Briefly I summarize the two most prominent explanations from theory. First, banks provide liquidity to the market through maturity transformation. They are the
intermediaries between depositors and borrowers (Diamond and Dybvig, 1983; Santos, 2001). Depositors are people or institutions who temporarily have excess liquidity but do not know when they need it. Therefore the demand flexibility to access the fund at all times. On the other hand, borrowers demand products with longer maturities for investments or mortgages as they do not know if they are able to raise new funding in the future. Banks fill this gap in demanded maturities. Second, banks perform monitoring services for depositors (Diamond, 1993; Santos, 2001). Investors have to monitor the performance of their investments, however, there exists information asymmetry between managers and investors. Investors can learn more but this comes with the costs of monitoring. When investors become depositors the bank does the monitoring for them thereby saving monitoring costs. Hereby banks can provide lending to borrowers at lower costs.
On the other hand, banks face information asymmetries with respect to borrowers (Stiglitz and Weiss, 1981). Ex ante banks cannot estimate who will be a good borrower. This process is referred to as adverse selection. “Good” can be defined as the extent to which a borrower is able to repay a loan and the associated interests costs (Scott, 2009). Thus, the lower the probability of default, the more a borrower can be defined as good. To identify these borrowers various screening devices can be used. An example is the interest rate which a borrower is willing to pay. In general, the higher the interest rate a borrower is willing to pay the higher the risk associated (Stiglitz and Weiss, 1981). This can be explained from the
fact that the higher the interest rate the more risk a borrower has to take to earn sufficient funds to cover the interest costs. Banks are not compensated for this higher risk because the return of a bank can be compared with a put option; the upside potential is maximized to the value of a loan (Stiglitz and Weiss, 1981). Therefore banks will try to attract good borrowers with not too risky projects. Since it is
impossible to select only good borrowers, banks will try to influence their behavior using terms of the contract. In addition, after granting the loan a moral hazard problem arises. Depositors still face an unbounded upside while banks face the downside if projects turn out to be unsuccessful. Therefore, banks have to monitor investors after granting a loan. Banks have the advantage that they can do this for
multiple projects. As a results the marginal costs of monitoring investors is lower at a bank compared to the costs depositors would encounter if they would do the monitoring task themselves.
In addition to moral hazard other factors can have an influence on investor behavior. If the interest rate changes the investor will adapt his or her behavior. Increasing the interest rate therefore can lead to a higher income because borrowers pay more interest for the same nominal amount. However, increasing the interest rate enlarges the chance that a borrower is unable to repay the loan or even the interest charge. As a result it is possible that an increase in the interest rate results in a lower (expected) return. It has been argued by Stiglitz and Weiss (1981) that banks use credit rationing to prevent this. This implies that the interest rate is not only the result of supply and demand but also of banks’ risk assessment. This notion would even increase their financial system importance. Next to the fact that banks are instrumental for the financial system and moral hazard problems exist, banks are complex companies. For individuals it is impossible to monitor a bank well for reasons of time, knowledge, costs or combinations of reasons. This can be divided into two risks. First, the risk of the individual who should be protected primarily for their information disadvantage (Scott, 2009). Lack of information contributes to the fact that depositors cannot monitor their money. As a result it is possible that depositors claim their money back. Because banks cannot liquidate their assets easily in the short-run it will be drawn into liquidation. This so called bank run can be positive as it disciplines bad performing banks (DeBandt and Hartmann, 2000; Santos, 2001). This assumption holds if there would not exist subsequent problems in the payment system expanding problem beyond the unsound bank. However, if a bank run is triggered by depositors’ panic based on rumours costly asset liquidation will take place when this is not necessary. In addition, these rumours can create contagion bank runs. This can result in a second risk, a system failure, which will be explained in the next paragraph. An example to protect systemic stability is the Basel accords for banks. Minimum capital requirements can reassure depositors and therefore prevent a bank run. The contents of these accords are discussed in chapter 3.
Institutional theory explains the process by which rules and norms become authoritative guidelines for social behavior (Scott, 2008). For example, laws, rules as well as the Basel accords to guide bank behavior are a result. The financial turmoil and society’s reaction to this turmoil made stricter regulation for banks necessary. Regulators worldwide acknowledged the fact that banks should be given stricter regulation and more heavy capital requirements (FSB, 2009; De Larosière Commission, 2009). Amongst other examples, the Dutch parliament requires financial institutions to implement all recommendations made by the De Wit Commission (FD, 16-9-2010). As a result of this process, an accord on new capital regulation for banks was reached on 12 September 2010. This accord is referred to as Basel III, which will be explained in chapter 3 of this thesis.
2.3 Incentives for Bank Regulation
Regulation finds its origin in the public interest theory (Pigou, 1938). According to this theory market failures, also referred to as externalities, exist and should be corrected by governments. Market failures occur when the social cost of failure exceed the private costs of failure. Private costs of failure (PCF) are those costs borne by shareholders in case of bankruptcy. The social costs of failure (SCF) are the costs for society. In banking this works as follows. Shareholders have an unlimited upside potential while their downside is capped to their own investment (Hillier et. al, 2007). Therefore they encourage bank management to take more risk than the risk optimal for society. This is what we have seen during the financial crises. Governments supported banks with billions of dollars to save them from bankruptcy. Taxpayers bear these costs. The point of Malkonen (2004), that bank failures are extremely costly for taxpayers, unfortunately proved to be true. As such, shareholders have the ability to pass on part of their PCF to other parties. There exist two kinds of externalities why banks have to be regulated. These are describe below.
The first externality relates to systemic risk. This is noted by Llewelyn (1999), who puts forward that banks need to be regulated in order to sustain systemic stability. The explanation is provided by the financial fragility hypothesis (DeBandt and Hartmann, 2000). DeBandt and Hartmann identified three reasons why banks are vulnerable to systemic risk. First, as maturity transformers, the structure of their balance sheets is fragile (DeBandt and Hartmann, 2000). Banks fund themselves with liquid deposits which easily can be retained, whereas their loans are illiquid. Second, DeBandt and Hartmann (2000) point out that bank contracts are information intense. As a result, when market conditions or expectations change, information asymmetries come in and credibility problems can arise. Third, there exist close relationships between banks. They are directly exposed through the interbank money market (DeBandt and Hartmann, 2000). As a result of the aforementioned credibility problems credit supply can dry-up which effectuates itself in illiquidity of the interbank money market. This illiquidity especially harms
banks when they have to repay depositors in situations when their assets cannot be turned into cash. In addition, a crisis in the financial sector spreads more quickly throughout other sectors since banks cross-hold a lot of assets (Llewelyn, 1999).
The second externality is a moral hazard problem. Banks have depositors as well as shareholders to fund their assets. According to the Modigliani and Miller (1958) theorem it should be irrelevant how the firm is financed. However, leaving tax distortions aside, there still exists an asymmetric allocation of risk between the groups. This influences which group owns the bank. In good times, the shareholders control the bank. They have a limited downside and an unbounded upside. The downside is the amount which is paid for the stock were the upside is the value of the firm minus the amount paid to depositors,
comparable with the return on a call option. In bad times, the depositors and bondholders have the biggest incentive to monitor bank behavior. Depositors have a limited upside and their maximum downside. The maximum downside is bankruptcy of the bank. Which group, shareholders or depositors, should take on the monitoring role depends on who has the biggest incentive to monitor and influence bank management. The moral hazard problem is enlarged by deposit guarantee schemes on the one hand and the too-big-to-fail (TBTF)-problem on the other hand. Deposit guarantee schemes insure depositors and pay the amount, which was deposited, back in case of bankruptcy. In addition, when a bank is TBTF government bail-outs insure bond holders (Bikker and Lelyveld, 2002; Stern and Feldman, 2004). As a result depositors and bondholders do not monitor the bank since they are insured and therefore lack the incentive to monitor the bank. Additionally, if depositors face a loss, they can encourage management to take more risks. We have seen this incentive at shareholders but it can also occur at depositors when they are insured and the government bears the downside risk.
To prevent that the SCF exceed the PCF bank regulation is in place. For each additional amount of risk the bank should hold additional capital as described in Basel I (1998), Basel II (2004) and Basel III (2009). These requirements discourage bank risk taking and thereby they mitigate shareholder (and possible depositor) incentives to increase risk taking. Furthermore, additional capital strengthens banks’ absorbency capacity. As a result they are less vulnerable to systemic risk.
On the other hand, increasing capital requirements lowers the return on shareholders’ equity. If
shareholders demand the same return, increased capital requirements lead to the fact that banks have to take on more risky projects to fulfill shareholder demands. However, as indicated in the clause above, regulation influences bank business models and therefore bank behavior. If no regulation would exists the SCF probably would have been higher.
2.4 Legal Base of Regulators and Supervisors
The usefulness of regulation is dependable on multiple factors. First, it should be adequate. Second, regulators should have the power to enforce regulation on non-compliers. Basel standards are issued by the Basel Committee on Banking Supervision (BCBS). It is acknowledged by the International Monetary Fund (IMF) that the BCBS is a standard setting body in two fields. First, it is the only organization that provides prudential standards for banking. In addition, it set standards on accounting for banks. These accounting standards are concerned with prudential disclosures. Though the BCBS is a supranational body it has no regulating power. In Europe Basel standards are implemented and enforced using the Capital Requirements Directive (CRD) issued by the European Commission. The Committee of European Banking Supervisors (CEBS) implements the CRD through standards and guidelines in Europe (CEBS, 2005). The Netherlands are represented at the CEBS by the Dutch Central Bank (DNB). Its legal base descends from the article 3 of the Dutch Bank Law from 1998. In addition it tasks are determined in article 1.24 of the law on financial supervision (Wft). Capital or solvency supervision is denoted in article 3.57 Wft. Through these regulations the DNB has the authority and power to enforce Basel II and III compliance. This leads to the conclusion that banks, active in the Netherlands, have to follow up Basel III agreements. For other European countries regulation is similar. This legal base is critical for this thesis since banks have no other option then to comply. If banks do had the option to be non-compliant the outcomes of this thesis could not be generalized to other banks since, in that case, banks do not have to comply and can make their own choices on capital requirements and disclosures.
2.5 Impact and effect of capital requirements
Capital requirements influence banks in the short-, and the long run. In the short run a bank only has the option to reduce lending to meet capital requirements (Santos, 2001; VanHoose, 2007). In the long run banks capital can be increased and banks can adapt their behavior to meet capital requirements. In addition to the fact that banks can adapt their lending, regulatory capital requirements can affect banks’ investment decisions as well as their funding sources (Pasiouras et al, 2009). Investment decisions deal with the debit-side of the balanced sheet and include the quality of lending, for instance only mortgages with deposit guarantee schemes attached. These choices determine portfolio composition. Funding sources are on the credit-side of the balance sheet and concern the choice for deposits or equity.
Kopecky and VanHoose (2006) show that regulatory capital requirements reduce bank lending for previously unregulated markets. Additional regulation on capital requirements like Basel III has the same effect, though the market already was regulated by Basel I and Basel II, in the short run. However, the effect is partially mitigated by the Basel III phase-in period until 2019. Regarding banks’ investment decisions the quality of lending is not influenced (Kopecky and VanHoose, 2006). However, literature
does suggest that regulatory capital requirements increase risk-taking (Blum, 1999). This can be
supported by the argument that banks increase risk taking to comply with capital requirement to prevent a share issue. According to Rochet (1992) this especially is true for undercapitalized banks. Calem and Rob (1999) do support the increase in risk taking for undercapitalized banks but show that there exists a U-shaped relationship between capitalization and risk taking. This implies higher risk taking if banks capital ratios are more distant from the capital requirement level. Risk based capital regulations, like Basel II and Basel III, do discourage an increase in risk taking. According to Santos (2001) the risk appetite incentive is further reduced by requiring a minimum capital level.
For the financial system as a whole Barth et. al (2001, 2004) find a negative association between bank restrictions, like capital requirements, and banking sector stability. Specifically, additional capital requirements are linked to a higher percentage of non-performing loans (Barth et. al, 2004). This can be explained by the fact that banks charge higher interest rates and thereby attract more non-performing loans (Stiglitz and Weiss, 1981) as noted in paragraph 2.2. In addition, Pasiouras et. al (2006) show a negative relationship between capital requirements and Fitch bank credit ratings. This can be explained by the fact that ratings are based on ex-post information. This means that the credit ratings are adjusted when new information is added. A change in bank prudential capital requirements indicates a higher associated risk which than also is included in the rating. In contrast, higher capital requirements do provide more loss absorbent capacity thereby increasing individual bank stability. Furthermore, individual banks encounter less profit efficiency (Pasiouras et al., 2009) but do have lower costs of capital.
Summarizing this paragraph, literature is not univocal on the effects of bank capital requirements. At least in the short run lending is reduced and in the long run bank capital, both absolutely and relative to bank lending, is increased (Santos, 2001; VanHoose, 2007).
2.6 Impact and effect of disclosure requirements
Disclosures of information increase as a result of market demands and standard setting. Standard setting is defined as regulating firms’ external information production decisions by a central authority (Scott, 2009) and is also referred to as the official supervision approach. Market demands are information that is demanded by investors to monitor the firm. Market demands are referred to as the private monitoring approach. Both have the ability to improve bank efficiency (Beck et al., 2006). This view is supported by Pasiouras (2008) but only partially by Barth et al (2004) and Levine (2005) who argue that only private monitoring has an effect on banks’ performance.
Scott (2009) divides the information disclosed in two groups, proprietary-, and non-proprietary information. Proprietary information directly influences future cash flows of the firm whereas
non-proprietary information does not have this effect. While capital requirements can influence firms’ cash flows, disclosure requirements only influence the amount of information that has to be made publically available. This includes, amongst other information, financial statement-, audit as well as prudential information.
In general, increased disclosure has the ability to lower capital costs (Lambert et al., 2007; Botosan and Plumlee, 2002; Barth et al, 1999) as well as the cost of debt (Sengupta, 1998). Moreover, Healy et al. (1999) show that increased disclosure benefits share performance. However, increased disclosure comes with the direct costs of providing information. Examples include the costs of an investor relation
department and preparation of disclosure documents (Duarte et al., 2008). In addition, indirect costs can be even larger. Indirect costs include the disclosure of sensitive information to competitors (Duarte et al, 2008; Scott, 2009). When all firms in an industry have to disclose the same information these indirect costs, relative to competitors, will be minimized.
Summarizing the arguments, disclosure promotes firm efficiency and it lowers the costs of funding. However, the indirect costs of disclosure should be taken into account, but when all firms face the same regulatory disclosure requirements, this effect is mitigated.
Chapter 3: Bank Requirements and Standards
3.1 BaselThe Basel accords are issued by the Basel Committee of Banking Supervision (BCBS) of the Bank for International Settlements (BIS). The BCBS aims to improve understanding of key supervisory issues as well as to improve the quality of banking supervision worldwide. At present 27 countries support the initiatives provided by the BCBS. Common understandings, in line with institutional theory (Scott, 2008), are used to develop guidelines and supervisory standards where these are considered desirable.
The first Basel accord was signed in 1988. Its main focus provided a framework for credit risk4. Assets were classified in five categories with different risk weights. These should be covered by at least 8% in capital by the end of 1992, if a bank was internationally active. Here the first link with accounting is established. What (instruments) should or can be qualified as capital? This also is reflected in the title of the initial (Basel I) and revised (Basel II) framework; “International Convergence of Capital
Measurement and Capital Standards” (BIS, 1988, 2004). Accounting needs to provide the tools to measure the requirements for capital standards. These tools are described in 3.5.1. The transparency that is enforced through IFRS is compared to Basel requirements in paragraph 3.5.2.
This chapter outlines first the Basel II framework in 3.2. In addition, Basel III is explained and compared to Basel II in 3.3. Furthermore, relevant IFRS disclosures are highlighted in 3.4. Last, as already
indicated, a comparison between Basel and IFRS requirements is provided in 3.5.
3.2 Basel II
The consultative document regarding the revised capital framework, known as Basel II, was published in 1999. Ultimately, this framework was issued in June 2004. According to the BCBS it provided a more risk-sensitive approach. The framework is applied to internationally active banks on a consolidated basis. This preserves the integrity of banks’ capital and avoids double gearing. In contrast to Basel I, this framework is based on three pillars; minimum capital requirements, supervisory review process and market discipline (BIS, 2004). The contents of these pillars will be discussed in the coming paragraphs.
3.2.1 Pillar 1: Minimum Capital Requirements
The total of minimum capital requirements is in Basel II used to cover credit, market and operational risk, and should be at least 8% of risk weighted assets. This requirement consists out of two components, first the calculation of risk-weighted assets and second the composition of capital.
4
Risk-weighted assets (RWA) are used to classify the risk associated with an asset. The BCBS allows two methodologies. The first method, also referred to as the standardized manner, uses external credit
assessments5. The alternative approach is based on the internal rating system of a bank. The alternative method has to be approved by the banks’ supervisor.
Total RWA is calculated in both methods as follows;
Total RWA = sum (Asset total per category *Risk Weight).
The ratio is based on the credit assessment of the asset. For instance, claims on central banks receive a 0% risk weight. Claims on low quality corporate investments, meaning a credit rating of BB- or lower, receive a 150% risk weight. An overview, based on Basel II, is provided in table 3.1 below. Basel III has an additional surcharge on exposures to other financial institutions of 25%. This included under the “banks” heading by multiplying the initial weight by 1.25.
Governments Banks Corporations
AAA up to AA- 0% 25% 20% A+ up to A- 20% 62.5% 50% BBB+ up to BBB- 50% 62.5% 100% BB+ up to BB- 100% 125% 100% B+ up to B- 100% 125% 150% Below B- 150% 125% 150% Not classified 100% 62.5% 100%
Table 3.1: Risk Weights by category and credit rating
As described, minimum capital requirements are set at 8% of RWA. Different instruments qualify to be included for the capital requirements. The highest quality is known as common equity, consisting out of equity and retained earnings, which should be at least 2%. Common equity is part of Tier 1 Capital. Other Tier 1 instruments include for example subordinated debt like perpetuals or minority interest in
subsidiaries. Innovative instruments6 are limited to 15% of Tier 1 capital. Tier 2 capital consists out of other instruments with features of equity. At most Tier 2 capital can be 100% of Tier 1 capital. This leads to the conclusion that Tier 1 Capital has to be at least 4%.
To arrive at the capital requirement per category, for example on common equity, Tier 1 capital, and Total Capital, total RWA is multiplied with the capital requirement percentage:
Minimum Capital requirement = Total RWA * % capital requirement
5
Standard & Poors, Moody’s, Fitch 6
In addition, the same figures can be used to calculate the capital ratio per category, for example on common equity, Tier 1 Capital or Total Capital. This ratio is calculated as follows:
Capital ratio = Eligible Capital / Total RWA
I stress that the stated requirements are minimum requirements. National supervisors have the authority to demand higher standards. In addition, it is also possible that instruments eligible for Tier 1 capital, using principle 49III.1a7 differ between countries (BIS, 2004). Both can lead to significant differences in the application and therefore the impact of Basel II.
3.2.2 Pillar 2: Supervisory Review Process
The supervisory review pillar aims to ensure that banks have adequate capital to support the risks they face in their day-to-day practice. In addition, it encourages banks to develop adequate risk management techniques to monitor and manage the aforementioned risks. The BCBS stresses that capital requirements cannot be substituted for inadequate control or risk management processes. This view is logical since not adequate risk management procedures can result in too much exposure to different types of risks and can draw a bank into bankruptcy. An example can be found at Société Générale where inadequate risk management procedures almost caused the collapse of the bank. Inadequate authorization procedures enabled a trader to invest 50 billion in uncovered and thus risky positions. Ultimately, closing these positions resulted in a loss of 4,9 billion euro (Guardian, 5-10-2010).
The supervisory review process is divided into four principles, the first explicitly gives requirements for banks. The other standards advice supervisors on how to act. As this theses focuses on banks only the first principle is shortly discussed. This principle covers five different fields to ensure that banks assess their capital strategy, their risk profile, and their strategy for maintaining capital levels as well as the
relationships among these requirements. Because there are no specific requirements to disclosures or minimum capital to banks this will not be further discussed. Disclosures mentioned in this section give guidance to supervisors on what to disclose8.
3.2.3 Pillar 3: Market discipline
The purpose of pillar 3 is to ensure that pillar 1, and 2 are properly implemented and used. By setting standards for disclosure requirements on capital standards as well as on the supervisory review process market parties can assess the adequacy of implemented measures. From theory it follows that the market
7 Principle 49III.1a states “Each of these elements may be included or not included by national authorities at their discretion in the light of their national accounting and supervisory regulations” (BIS, 2004)
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punishes banks which do not meet up to the standards or refuse to disclose. Non-disclosure leads
investors to expect the worst (Scott, 2009). As a result of uncertainty caused by non-disclosure, investors demand higher returns on their investments.
Pillar 3 disclosures can be in line with accounting disclosures. But, Basel II has additional disclosures to enforce transparency on prudential assessments. These additional disclosures are not required to be audited by an external auditor. However, this can be required by regulators or accounting standards setters. While Basel requirements try not to conflict with accounting requirements the BCBS can indicate the direction by which, in their view, accounting standard setters should develop new standards.
The information that is not required to be audited can be published separately from the audited reports. However, the BCBS encourages banks to provide all information in one location. If not, at least the bank should indicate where the additional information can be found. Banks should disclose pillar 3
requirements on a semi-annual basis. However, qualitative disclosures like objectives, policies and definitions can be published once a year. Banks have an option not to disclose everything. For proprietary information9 banks can disclose general information instead of specific information, since disclosing this information could influence its competitive position. However, they have to indicate why the specific information is not disclosed.
The disclosure requirements apply to the top consolidated level of the banking group. Within the group, in general, not all requirements have to be met. However, for significant bank subsidiaries the total capital ratio and Tier 1 capital ratio should be disclosed. This enables investors, supervisors and other
stakeholders to assess individual capital adequacy of the subsidiary.
Regarding capital requirements the capital section of pillar 3 are especially relevant. This section consists of requirements for capital structure and capital adequacy. Capital structure deals with the composition of capital and the terms and conditions related to the instruments included. Capital adequacy includes the banks’ assessment of capital adequacy to support current and future activities. This is subdivided into requirements for credit, market and operational risk, requirements on equity exposures, total- and Tier 1 capital adequacy.
3.3 Basel III
Basel III has an identical three pillar approach as Basel II. The main goal of Basel III is to improve financial stability, by improving the ability of banks to absorb shocks arising from financial and economic distress (BIS, 2010). Second, Basel III aims to improve risk management and governance. Last, Basel III
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targets to strengthen banks’ transparency and disclosures (BIS, 2010). This section will highlight the differences between the two standards. I focus especially on pillars 1, and 3 for capital- and disclosure requirements since pillar 2 is not part of the scope of this thesis.
3.3.1. Pillar 1: Minimum Capital Requirements
The methodology of RWA is the same with respect to Basel II. Capital requirements are based on the total of RWA. The first main difference is the definition of capital (the numerator) which is stricter. Second, the capital ratio is increased.
As indicated, the definition of hard capital is less lenient, so fewer instruments are eligible for equity capital. An example is the exclusion of hybrids in Tier 1 capital. Ceccetti (2010) indicates that due to the more lenient definition of capital in Basel II banks only had equity buffers of about 1% while 2% was the existing norm.
With respect to capital requirements the minimum common equity requirement is increased to 4,5% of RWA. Tier 1 capital should amount to 6% of total capital. Total capital is targeted at 8% therefore Tier 2 capital can fill at most 2% of RWA. Of course, additional Tier 2 capital is allowed but this does not exempt banks from common equity and Tier 1 requirements. In addition a capital conservation buffer of 2,5% of RWA is introduced. The capital conservation buffer should fully consist out of equity. Banks should retain (part of) their earnings and are restricted to pay out dividend and bonuses if the 2,5% target is not yet met. Summarizing, minimum common equity requirements is 7%. Total capital should amount to 10,5% of RWA. Furthermore supervisory agencies, like central banks, are given the opportunity to use a counter-cyclical capital buffer. Supervisory agencies can issue this buffer if, in their opinion, credit growth is excessive and system wide risks build up. This countercyclical buffer has a range of 0 – 2,5% of RWA and is composed out of common equity. Concluding, if supervisors impose a maximum
countercyclical capital buffer on banks, common equity requirement will be 9,5% and total capital amounts to 13%.
Systemically Important Banks
For systemically important banks possibly an extra capital surcharge will be added. This relates to the importance of a system bank for the economic system. Second, this relates to the risk of moral hazard which is faced by countries when banks become too-big-to-fail (Bikker & Lelyveld, 2002; Stern & Feldman, 2004). Since this new “system bank requirement” is not crystallized yet, I cannot assess its impact in this thesis. Switzerland already announced higher capital requirements for UBS and Credit Suisse, its two largest banks (FT, 4-10-2010). As a result banks and national supervisors can be forced to
comply with these requirements. An example can be Rabobank10, though not listed on a stock exchange, it presents itself as one of the safest banks in the world. If it wants to keep high credit ratings it will have to comply with the strictest regulations which in this case turn out to be Swiss regulations.
To summarize, a schematic outline on Basel III capital requirements is provided below, figure 3.1.
Basel II and III Capital Requirements
Basel II Basel III
Equity requirement
Common Equity (CE) 2,0% 4,5%
Tier 1 Capital (incl. CE) 4,0% 6,0%
Tier 2 Capital 4,0% 2,0%
Total Capital 8,0% 8,0%
Conservation Buffer (CB) n.a. 2,5%
Countercyclical Buffer (CcB) n.a. 0,0% 2,5%
Total Basel II 8,0%
Total Basel III 10,5%
Total Basel III incl. max. CcB 13,0%
System Bank requirement
System Bank Buffer X
Total Basel III SB 10,5% + X
Total Basel III SB incl. max CcB 13,0% + X
Figure 3.1, Basel II and III Capital Requirements
Liquidity Requirements
Liquidity requirements are also part of the new Basel accord. The BCBS proposes a short- and long term measure. The liquidity coverage ratio (LCR) assesses the short-term liquidity of banks. It tests whether banks are able to cover net cash outflows in a scenario of stress. Approved liquid assets by the BCBS are cash, Central Bank reserves and marketable government securities. This indicates that the BCBS assumes that marketable government securities always will be liquid. If this is always true, for instance in stress scenarios with Greece government securities, can be determined in the long run. The net stable funding
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ratio (NSFR) aims to reduce the mismatch between maturity of assets and liabilities through the requirement that banks should finance their assets with long-term funding. König (2010) provides evidence that minimum liquidity requirements only are effective if they are accompanied by minimum capital requirements. This combination is made in Basel III. However, liquidity requirements are not part of this thesis for three reasons. First, the exact requirements are not yet clear and regulation possible is altered (FD, 20-10-2010). Second, assumptions and data needed are not publically available. Last, is would broaden the scope of this thesis too much.
3.3.2 Pillar 3: Market Discipline
The BSBS tries to realize market discipline by enforcing disclosures. The following additional disclosure requirements are explicitly mentioned in the consultative document on Basel III (BIS, 2009). First, banks have to disclose a full reconciliation of all regulatory capital elements back to the balance sheet in the audited financial statements. Second, all regulatory adjustments need to be disclosed. Together,
disclosures on regulatory elements and regulatory adjustments should provide an overview of the impact of the prudential filter. In my opinion, if disclosed properly, investors have a good overview of the impact of the prudential filter on the banks’ capital. In addition, it provides investors an opportunity to take a look at the supervisory assessment of banks’ capital. An example of the disclosure of regulatory elements and regulatory adjustments is provided in figure 3.2.
Figure 3.2: Disclosure of regulatory elements and adjustments in an annual report (UBS, 2009)
Third, a description of all limits and minima which shows positive and negative elements of capital for which the limits are disclosed. In practice, banks should mention here the minimum criteria to which they have to comply following Basel regulation. Fourth, the description of main features of capital instruments needs to be disclosed. This description should entail nominal value, duration of the contract, interest rate, or other conditions. Last, if banks disclose ratios about the components of regulatory capital this must be
accompanied by an explanation of how those ratios are calculated. In practice, banks always disclose (some) ratios on capital adequacy, thus in all annual reports from now onwards you should expect an explanation of these ratios. In addition, the terms and conditions of regulatory capital need to be disclosed on the banks’ website. These requirements complement existing pillar 3 disclosure guidelines.
This thesis focuses on the reporting discipline banks show in their annual reports. As the BCBS indicates it is useful for users of the annual reports to find all information in one place. Since already a lot of information needs to be published through annual reports the most suitable place to publish all information is an annual report.
3.4 IFRS Disclosures for banks
International Financial Reporting Standards (IFRS) are accounting standards developed by the
International Accounting Standards Board (IASB). These standards are in effect for companies quoted on the stock exchange, which includes banks, in the European Union (EU) since 2005. Though the IASB had no regulatory power the European Commission has embedded IFRS and therefore it is mandatory by law in the EU. Companies not listed on the stock exchange do also have the possibility to report under IFRS. An example is Rabobank (NL), though not listed it sets up its financial statements in accordance with IFRS. The IFRS framework consists out of multiple standards. The International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) provide the accounting guidelines.
Interpretations of these standards are provided by the IFRS Interpretations Committee (IFRIC). All IFRS guidelines are based on four qualitative characteristics which financial reporting needs to fulfill. The characteristics are; understandability, relevance, reliability and comparability. Interpreting these
guidelines, financial reporting should be understandable by users. Furthermore, it should be relevant for decision-making and enable users to evaluate past, present, and future events. Third, reliable financial reporting is complete, neutral, and free from material errors, and bias. This includes presentation and disclosure of financial circumstances that (potentially) influence financial statements. Last, users should be able to compare financial statements through time, and between firms. Therefore, measurement needs to be consistent between companies and over time. Additional reporting and disclosures based on Basel criteria should comply with all four principles. The main challenge is to enable users to compare additional Basel reporting with IFRS guidelines and disclosures to understand why the information is different.
In this thesis IAS 32, 39 and IFRS 7 are discussed. All provide standards on how to deal with or present financial instruments. Financial instruments account for (most of) the accounts on a bank balance sheet. IAS 39, deals with the recognition and measurement of financial instruments. IAS 32 and IFRS 7 provide standards on the presentation and accompanying discloses of financial instruments.