Reliable financial reporting must be the rule, whether balance sheet and income statement are written for submission to regulatory authorities and exchanges, for compliance reasons; to inform the market at large; or only for the proprietors of a firm. The best disclosure rules are those characterized by:
● Significant accuracy, and
● Extraordinary transparency.
Both bullets are pillars of good governance. By increasing information about the risks being assumed by different entities, one also increases their incentives to act prudently and reduce the likelihood of failure. Critics say that the idea of exercising market discipline is theoretical, because extraordinary disclosure needs to be supported by measures to reduce the contagion effect. This is true, but it does not contradict the need for accuracy and transparency.
The goal of balance sheets and P&L statements, which reflect an entity’s true financial situation, is not to mitigate the contagion effect but to reveal their financial staying power, cash flow, and profitability. Contagion, and therefore systemic risk, is the central banker’s and regulator’s problem. Its solution needs the backing of a lender of last resort, as well as deep market-oriented reforms which might make banks better able to cope with trouble. At the same time, accounting and regulatory rules which are:
● Rigorous, and
● Homogeneous
help in exercising damage control. Part 1 has explained how and why IFRS pro- vides the rigorous rules which are necessary for reliable financial reporting and, by extension, for market discipline. From a regulatory viewpoint, market disci- pline is Pillar 3 of Basel II, the new capital adequacy framework by the Basel
Committee on Banking Supervision.10Pillar 3 rules require globally active banks to disclose a range of information about:
● The risks they take
● The way they assess these risks
● Their regulatory capital position, and
● Behavioural issues that reinforce regulatory supervision.
Cornerstone to all four bullet points is the fact that the new capital adequacy rules call for a significant amount of transparency in regard to the individual bank’s level of risk, and the quality of internal risk management. From a system viewpoint, for a publicly listed financial institution, market discipline is a mul- tiple feedback loop providing:
● Evidence of a company’s practices and their results
● Information on ongoing changes in seeking to survive in a highly compet- itive environment, and
● Steps taken in response to market reaction to the disclosure.
Current reporting requirements at the New York Stock Exchange (NYSE) are a proxy of how the new disclosure standards for market discipline might work. A foreign company listed on NYSE must comply with disclosure requirements of the Securities and Exchange Commission (SEC) as well as the NYSE’s own, including additional disclosure at half year to meet specific SEC or US GAAP requirements.
However, though necessary, tougher disclosure requirements imposed by just one exchange are not enough to answer the worries of a globalized economy.
Globalization has seen to it that the network is more important to it than an indi- vidual exchange on its own.
For this reason, at the Bank for International Settlements the Basel Committee now has a new peer, the Markets Committee, which groups senior officials from the G-10 central banks responsible for market operations. Its bimonthly meetings provide an opportunity for participants to exchange views on:
● Recent developments
● Structural changes in foreign exchange, and
● Events related to the different financial markets.
The Markets Committee also considers short-run implications of particular cur- rent events and their impact on the way markets are functioning. This includes a range of issues like: reasons for recent large movements in the major bilateral
exchange rates; low level of both nominal yields and implied volatility exchange rates; similar considerations in major bond markets, as well as the aftermath of the search for yield on credit spreads.
The Markets Committee also examines the effect of the presence of hedge funds;
the financial market impact of changes in pension fund regulations; influence on market functioning of the growth of electronic trading platforms; and finan- cial market impact of accumulation in foreign exchange reserves by different countries. The key objective is information-sharing among central banks.11 What the preceding paragraphs outlined is that regulators now pay more atten- tion than in the past in looking at things from the market’s perspective. With this in mind, a different way of looking at Pillar 3 is as a set of rules that concentrate on the expansion of disclosure requirements by credit institutions for better regulation of the global financial system. In the longer term, this expansion is enabling the complementary use of market mechanisms for prudential supervision.
There are reasons to believe that in the supervisors’ mind the central theme of Pillar 3 is that the markets should be able to sufficiently assess the risk profiles of all players – starting with credit institutions. Experts suggest that, precisely for that reason, the European Union will most likely give national supervisors the authority to require banks to:
● Disclose more frequently, and
● Use specific means of verification and examination.
At the same time, more emphasis is placed on an objective presentation of own funds, capital requirements for individual risk categories, and risk profile pur- suant to Pillar 1 and Pillar 2 of Basel II. Part of the same drive for greater trans- parency at market level is to provide sufficient explanation for conspicuous changes in individual items. This can help in avoiding misinterpretations.
Those in favour say that over time Pillar 3 will prove to be a valuable contribu- tion to improving communication between the banking industry and the finan- cial market at large. Discipline will be enhanced through more frequent, detailed, and accurate disclosures, because lack of it gives rise to many rumours which are usually damaging to an equity’s market standing.
In conclusion, the financial stability of a company hinges, to a large degree, on its level of indebtedness, cash flow, and profitability. To a significant extent,
financial soundness is an enterprise-specific determinant of risk premium. As we have already seen, a company’s financial staying power can be approximated through the ratio of assets over liabilities with:
● Assets taken at capitalization, and
● Liabilities assigned at book value.
Because the market is a tough critic, equity price movements tend to reflect this ratio. The probability of default owing to overindebtedness increases with the volatility of the firm’s equity. These relationships are factored into an estimating algorithm by taking account of implied volatility of the share price, computed by using options.
My professors at UCLA taught their students that the most successful entrepre- neurs don’t just take risks; they also appreciate the need to control the exposure which they take. Xenophon (430–354 BC) once wrote ‘Whoever wants to keep alive must aim at victory’ – and in business victories can be won both by exploit- ing opportunities and by exercising timely damage control.
Notes
1 John J. Tarrant, Drucker, Warner Books, New York, 1976.
2 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, London, 2005.
3 D.N. Chorafas, Integrating ERP, CRM, Supply Chain Management and Smart Materials, Auerbach, New York, 2001.
4 Adam Smith, The Wealth of Nations, Modern Library, New York, 1937.
5 Robert N. Anthony, Management Accounting, Irwin, Homewood, IL, 1956.
6 Benjamin Graham and David L. Dodd, Security Analysis, McGraw-Hill, New York, 1951.
7 D.N. Chorafas, Management Risk. The Bottleneck Is at the Top of the Bottle, Macmillan/Palgrave, London, 2004.
8 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth-Heinemann, London and Boston, 2004.
9 Basel Committee, Trading Book Survey: A Summary of Responses, BIS, Basel, April 2005.
10 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth-Heinemann, London and Boston, 2004.
11 BIS, 75th Annual Report.
Economic Capital Is on Both Sides of the Balance Sheet
14
1. Introduction
One of the basic prerequisites of good corporate governance is the existence of reserves able to cover worst-case events with liquidity. The bank should hold such liquidity in order to enhance its financial staying power. This is the role economic capital, also known as respectability capital, must fulfil.
The nature of worst-case events changes over time. During the first three and a half decades of the post-World War II years, major risks commercial banks faced were associated to their role as financial intermediaries. In consequence, regula- tory capital requirements were sized-up in a way that permitted them to confront losses from loans.
But by the early 1980s the type of risks had significantly changed because trading in derivatives grew fast, and along with it came a new, more pervasive type of expo- sure. In the 1980s and up to the mid-1990s, derivatives trades were written off- balance sheet(OBS) with the result that they were only lightly regulated. Moreover, by being written off-balance sheet they did not alter to any great degree the assets and liabilities side of the B/S discussed in Chapter 13. Then came two major changes:
● The 1996 Market Risk Amendment by the Basel Committee obliged banks to report to regulators their trading exposure through value at risk (VAR),1and
● Starting with the American, British, and Swiss regulators, supervisory authorities required that derivatives gains and losses are recognized in the balance sheet, even if they are not yet realized.
Both Basel II and IFRS have strengthened and formalized this requirement. This is a change which evidently has a major impact on the balance sheet. Moreover, Basel II redefined the need for capital by distinguishing between expected losses (EL) and unexpected losses (UL).2 Regulatory capital is practically what is required for expected losses, while unexpected losses must be covered through liquidity provided by economic capital.
Economic capital is signalling to the market that the bank has endowed itself with enough resources to enhance its financial staying power. For every practi- cal purpose, economic capital is risk capitalwhich must be calculated for unex- pected losses and extreme events. Briefly stated,
● Ifregulatory capital is the minimum amount necessary to have a licence
● Then, respectability capital is the minimum amount needed by a unit, and the bank as a whole, to be accepted as business partner.
The Basel Committee says that with the advanced internal ratings-based (A-IRB) approach to regulatory capital, banks will be also provisioning for unexpected losses. This, however, does not necessarily mean for extreme events – though some institutions may do so for respectability reasons.
Extreme events find themselves at the tail of the risk distribution – and can be statistically targeted in terms of likelihood of appearance. As Figure 14.1 shows, economic capital covering risks at the 99.97% level of confidence is key to obtaining an AA credit rating from the independent rating agencies. This 99.97%
signals to the market that the bank is a creditworthy business partner.
From a qualitative point of view, capital is referred to as economic because it treats positions solely on an economic basis. This means in a way irrespective of differ- ences in accounting issues, or of regulatory nature. Economic capital is risk capi- tal because it is the amount of money needed to remain solventunder extreme:
● Market
● Business, and
● Operational conditions.
It is also the basis used to calculate the economic return on a given set of activi- ties, on the basis of capital assessed for and allocated to them. The growing focus on economic capital has raised the crucial question as to which side of the bal- ance sheet it comes from. Many bankers believe that economic capital originates on the ‘assets’ side alone. That’s wrong.
REGULATORY CAPITAL ECONOMIC CAPITAL UNEXPECTED LOSSES EXPECTED LOSSES
OBTAINING AA RATING GETTING A LICENCE
CREDIT RISK:
99% LEVEL OF CONFIDENCE 99.97% LEVEL OF CONFIDENCE MARKET RISK:
Figure 14.1 Getting a licence and obtaining AA rating are two different objectives