The impact of capital and disclosure requirements on risks and risk taking incentives

This paper is primarily aimed at highlighting the role and significance of asymmetric information in contributing to financial contagion. Furthermore, in emphasising the importance of greater disclosure requirements and the need for the disclosure of information relating to “close links”, such disclosure being considered vital in assisting the regulator in identifying potential sources of material risks, it illustrates the fact that incentives (such as the reduction in the levels of capital to be retained by institutions), which have the potential to facilitate market based regulation (through non binding regulations), may not necessarily serve as suitable means in the realisation of some of Basel II’s objectives – namely the achievement of “prudentially sound, incentive-compatible and risk sensitive capital requirements”. The paper also attempts to raise the awareness that the operation of risk mitigants does not justify a reduction in the capital levels to be retained by banks – since banks operating with risk mitigants could still be considered inefficient operators of their management information systems (MIS), internal control systems, and risk management processes. The fact that banks possess risk mitigants does not necessarily imply that they are complying with Basel Core Principles for effective supervision (particularly Core Principles 7 and 17) – as the paper will seek to demonstrate. Core Principle 7 not only stipulates that “banks and banking groups satisfy supervisory requirements of a comprehensive management process, ensure that this identifies, evaluates, monitors and controls or mitigates all material risks and assesses their overall capital adequacy in relation to their risk profile, but that such processes correspond to the size and complexity of the institution.” Certain incentives which assume the form of capital reductions are considered by the Basel Committee to “impose minimum operational standards in recognition that poor management of operational risks (including legal risks) could render such risk mitigants of effectively little or no value and that although partial mitigation is rewarded, banks will be required to hold capital against residual risks”. Information disclosure should be encouraged for several reasons, amongst which include the fact that imperfect information is considered to be a cause of market failure – which “reduces the maximisation potential of regulatory competition”, and also because disclosure requirements would contribute to the reduction of risks which could be generated when granting reduced capital level rewards to banks who may have poor management systems.