The greater disclosure required of banks by the Banking (Disclosure) Rules will benefit them and make the financial system more stable and efficient.
The Banking (Disclosure) Rules were published last week for statutory consultation. As their name suggests the Rules concern information disclosures by authorized institutions (AIs) and represent the latest - and one of the last - pieces of the Basel II implementation jigsaw. The three pillars of Basel II are intended to be mutually reinforcing: the minimum capital requirements in Pillar 1 and the supervisory review process in Pillar 2 are complemented by Pillar 3, which relates to enhanced market discipline through disclosures by banks.
The transparency that results from greater disclosure by banks reinforces the efforts of supervisors by encouraging market discipline, rewarding banks that manage risk effectively and penalising those whose risk management is imprudent. It also provides tangible benefits to the banks by giving them more efficient access to the capital markets and a broader range of counterparties. Finally, greater transparency also benefits the financial system as a whole, by reducing the uncertainties that might give rise to bank runs and helping limit systemic problems by allowing market participants to determine which banks are vulnerable. It provides an essential underpinning to a more stable and efficient financial system.
Given the clear benefits of transparency, the HKMA has in the past developed policies to encourage banks to make greater disclosures. The Banking Ordinance provides for the disclosure of banks' annual accounts and requires AIs to make adequate disclosure in order to be authorized. The HKMA has elaborated these statutory disclosures through a number of Supervisory Policy Manual modules related to AIs' balance sheet, income statement and capital adequacy ratio.
However, with the introduction of Basel II, the HKMA recognises that this regime needs to be expanded to reflect the disclosure requirements recommended under Pillar 3. Similar to Pillar 1, the third pillar adopts a risk - and principles-based approach to regulation focusing on AIs' own assessment and management of business risks. The primary purpose of the disclosure requirements is to encourage banks to demonstrate the robustness of their risk management systems and that all relevant risks have been identified and controlled.
In line with the Pillar 3 recommendations, the Banking (Disclosure) Rules will introduce a larger risk-based element into AIs' financial disclosures. There will be different levels of disclosure requirement depending on which capital adequacy regimes - Basic, Standardised or Internal-Ratings Based (IRB) - the AIs use. AIs which have small and simple operations and adopt the Basic Approach will find that the required level of disclosure is similar to the current requirements under the Financial Disclosure Guidelines, but AIs that use the IRB Approach will have to increase their disclosures substantially to allow market participants to assess the robustness and effectiveness of their internal risk-rating systems. In other words, part of the "price" of being an IRB AI is that the institution must be able to demonstrate to market participants the fundamental soundness of its internal risk-management systems.
The HKMA has also taken the opportunity to update its disclosure regime, for example by reflecting the changes to accounting standards in Hong Kong resulting from the adoption of International Accounting and Financial Reporting Standards (IAS/IFRS). HKFRS 7 requires significantly greater disclosures than previous accounting standards, while other new standards also require changes to the balance sheet and income statement. As a result, the existing disclosure regime would have to be modified even without Basel II, although the new accounting standards do echo Pillar 3's risk-based emphasis by taking a "through the eyes of management" approach. In addition, consultation with the users of financial disclosures identified a clear demand for more information about AIs' exposures in Mainland China, and the Banking (Disclosure) Rules have therefore included provisions to this effect.
Another important difference between the Banking (Disclosure) Rules and the current disclosure guidelines is that the Rules will have the status of secondary legislation and must therefore be presented to the Legislative Council for negative vetting. Failure to comply with the Rules will be a criminal offence, and AIs should assess the need for system enhancements at an early stage to ensure compliance, although it should not be treated merely as a compliance-driven exercise. The real challenge for AIs is to meet the demands of analysts, investors and rating agencies for more information about their risk and capital management in the most efficient, consistent and insightful way.
Banks may take a little time to fully realise the benefits of improving their disclosures. But over the long run the benefits will more than outweigh the compliance costs. In addition to the general benefits mentioned earlier - such as contributing to supervisory monitoring and making the banking system more stable - AIs improving their disclosures will enjoy some direct benefits. AIs with robust risk management systems will find their cost of funds reduced and their borrowing conditions improved (with longer maturities and less need to provide collateral). Improved disclosures should also give AIs better access to sources of liquidity in times of market stress. Since the market requires Hong Kong banks to hold a capital buffer against unforeseen risks, greater transparency should also help them to demonstrate that they have identified and controlled these risks, therefore allowing a more efficient allocation of capital.
Simon Topping
Executive Director (Banking Policy)
7 September 2006
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