Basel II Pillar 3 disclosure

Deloitte research shows there is still room for improvement
27 May 2010

Highlights

The banks are able to cover most requirements but there are significant differences between the reports

The information that market participants are looking for must become clearer

Regulators should impose more guidance in terms of detail

Brussels, 27 May 2010 – Even though the eye of the financial storm seems to have passed, the question remains as to how quickly the banking sector will recover financially, and how fast it will be able to regain the trust of its various stakeholders. The developments in the financial industry have expedited the review of Basel II regulation, for which the Basel II Committee issued an avalanche of consultative papers in 2009. However, with these topics dominating the headlines, the Basel II implementation efforts up to now might be overlooked. To ensure better insight into the banks’ exposure to risk, Basel II’s Pillar 3 is imposing onerous disclosure requirements.

Deloitte presents the findings of its survey (Basel II Pillar 3 Benchmarking Survey) of 47 Pillar 3 reports, covering banks in ten European countries, corresponding to 2008 year-end financial statements. This Deloitte study, a joint effort between several of its European practices, shows that banks are able to cover most requirements. However, there are significant differences between the reports. The current gaps in meeting the Pillar 3 requirements make it clear that there is ample room for improvement in Pillar 3 disclosure.

After the end of FY 2008, public disclosure according to Pillar 3 of the Basel II framework became mandatory for all European banks: for many banks, the 2008 report has been their first Pillar 3 disclosure. Only some regulators have given specific guidance regarding the level of detail of the information to be disclosed; as a result, there has been some confusion among the banks.

In order to identify the current best practice, Deloitte compared 47 publicly available Pillar 3 reports from banks of ten different countries within the context of the Basel II regulation [1]. These Pillar 3 reports provide information on capital requirements, risk exposures, risk management practices and capital adequacy. These disclosures are aimed at enabling market participants to assess an institution’s risk profile and capital adequacy, in order to arrive at a sound, independent judgement.

Basel II Accord

In recent years, Basel II has increased the worldwide standard for risk management within banks. Basel II aims to improve the consistency of capital requirements internationally, to make regulatory capital requirements more risk-sensitive, and to promote enhanced risk management practices within banking organizations. An important element of the Basel II accord is the possibility of using the banks’ own risk models and internal rating systems in order to assess the capital requirements when opting for the more advanced approaches of Basel II.

With credit risk models based on the formulae of the Basel II Accord, an institution can assess the potential losses relating to its credit portfolios. Internal rating systems provide these models with indicators of the likelihood of borrower default and an estimate of the likely loss following such a default.

Given Basel II’s increased reliance on the institution’s discretion in assessing capital requirements, Pillar 3 disclosure requirements are of particular relevance if one wants to compare and benchmark various institutions. As such, Pillar 3 reporting is expected to become an important tool in assessing the quality of a bank and its management.

Deloitte Survey: Pillar 3 implementation of Basel II

The Deloitte Basel II Pillar 3 Benchmarking Survey assesses the maturity of the Pillar 3 implementation of Basel II. The Accord’s Pillar 3 or ‘Market Discipline’ section complements the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). Pillar 3 aims to promote greater marketing discipline by enhancing transparency in information disclosure to peers and other stakeholders. In order to achieve this objective, Pillar 3 consists of quantitative as well as qualitative disclosure requirements regarding capital requirement figures, risk exposures, risk management practices and capital adequacy. These disclosures should enable market participants to assess an institution’s risk profile and capital adequacy.

Following the implementation of Basel II, many banks started their first Pillar 3 disclosure with the figures of 2008 (year-end). Frank De Jonghe, Partner at Deloitte Belgium: “This study shows that banks are able to cover most requirements. However, there is are significant differences between the reports. The current gaps in meeting the Pillar 3 requirements make clear that there is ample room for improvement in Pillar 3 disclosure”.

According to the Deloitte study, a considerable amount of information is already being disclosed and much has been achieved in Basel II Pillar 3 reporting. Notwithstanding some clear examples of missing information (and as a consequence, question marks about formal compliance with Pillar 3 regulation) most of the reports are comprehensive. In general, the reviewed Pillar 3 reports do meet many of the detailed requirements. This does not imply that the reports add real value to the insights of stakeholders.

Frank De Jonghe, Partner at Deloitte Belgium: “We noticed in several Pillar 3 reports that important linking pins were not specified. While being compliant with disclosure requirements, a ‘look through’ to the real risks and mitigating factors of the bank was sometimes missing. The pieces of the reporting puzzle were there, but simply did not always fit together. For instance, one might question the relevance of disclosing information about rating distribution of a credit portfolio, while any link to the corresponding PD figures is missing”. Some information to be disclosed is potentially of great interest for competitors; this is an incentive for banks to comply formally with the letter of the regulation, without giving too much away.

The degree of compliance varies, which Deloitte surmises to be related to the relative novelty of the disclosure requirements. The outbreak of the financial crisis and its aftermath have made it clear that notwithstanding the already extensive disclosure requirements, even the current schedule seems incomplete in helping to predict difficulties with any degree of accuracy. Pillar 2 might be of help in this respect, but the specific regulatory requirements under Pillar 2 comprise sensitive information that one might not want to disclose to competitors.

Also, it must be noted that full regulatory compliance in this area can be a challenge for the banks. Some information that ought to be disclosed is often not readily available within a bank's IT systems, and as internal definitions vary from the regulators’ definitions, the information may not be part of the regular internal reporting procedure or the underlying data may not have been captured in the system at all – which according to our experience is still surprisingly often the case with regard to collateral. Moreover, the recent consultative papers by the BIS underline that Basel II regulation is still subject to amendments, which will also need to be included in Pillar 3 reporting.

For this reason full compliance can be expensive. Frank De Jonghe: “Therefore, the information at which the market participants are actually looking; must become clearer so that all banks can decide whether any investment in additional disclosure is worthwhile. Likewise, all regulators should make clear which level of detail they expect and – probably depending on the size of the bank – determine under which circumstances it is acceptable for information to be missing”.

[1] Austria (3), Belgium (4), Denmark (3), France (5), Germany (10), Italy (3), Poland (1), Switzerland (4), The Netherlands (9), United Kingdom (5). The analysis of the Pillar 3 reports was performed in the 4th quarter of 2009 and was based on FY 2008 reports.