9. This section addresses how safety and soundness in the banking system can be strengthened by enhanced transparency through improvements in banks' disclosure to the public. The benefits of public disclosure are discussed, as well as issues that should be considered by supervisors and other public policy makers in designing effective public disclosure standards. It also notes that potential drawbacks of public disclosure, that in certain circumstances can limit the positive impact of transparency, need to be considered.
   (a) Market discipline and the benefits of disclosure

10. A sound and well-managed bank should, in theory, benefit when it provides comprehensive, accurate, relevant and timely information on its financial condition and performance, and ability to manage and control risks. Such a bank should be able to access capital markets more efficiently than similar institutions that do not provide adequate disclosures.
11. Market participants benefit from disclosure if they can use the information as a basis for making various types of economic decisions. High-quality public disclosure improves their capability to make informed decisions by:
    1. allowing them to more accurately assess a bank's financial strength and performance;
    2. increasing the credibility of information disclosed by a bank;
    3. demonstrating a bank's ability to monitor and manage its risk exposures, e.g., by the disclosure of quantitative and qualitative information about its risk measurement methodologies; and
    4. reducing market uncertainty.

12. There are various ways in which market participants' decisions can contribute to market discipline by providing incentives to banks to conduct their business in an efficient and prudent manner. In essence, market discipline is founded on the observation that a sound and well-managed bank is able to attain better terms and conditions in transactions with informed and rationally-behaving market counterparties. On the other hand, the market will require a higher return from funds invested in, or placed with, a bank that is perceived as having more risk. For example, current holders of traded instruments issued by a bank with increasing risk exposures may offer their holdings for sale, thus creating downward pressure on the price of those instruments, and thereby negatively influencing the price at which the bank may raise new funds in the future.

13. Market participants also provide disciplining incentives by modifying transaction terms other than price. For instance, they may reduce the volume or narrow the range of business undertaken with banks that have increased their risk profile; some may increase collateral requirements for these banks. Similarly, depositors have an incentive to withdraw uninsured and partially-insured funds with banks that are considered unsafe. Ultimately, the market can refuse to enter into a new business with an unsound bank on any terms, preventing it from replacing maturing deposits and even from speedily liquidating assets, thus increasing the risk that the bank will be unable to meet its obligations as they fall due.

14. Importantly, disclosure helps prevent the occurrence of problems in banks. Enhanced public disclosure allows market discipline to work earlier and more effectively, thereby strengthening the incentives for banks to behave in a prudent and efficient manner. To the extent a bank's management knows its activities and risk exposures will be transparent, the various actions by market participants described in the preceding paragraphs, e.g., investment decisions and other business decisions, can provide a strong incentive for bank management to improve risk management practices and internal controls. Market discipline based on adequate public disclosure can, therefore, be an effective complement to supervisory efforts to encourage banks to maintain sound risk management systems and practices.

15. Apart from being a prerequisite for effective market discipline, there are other benefits of transparency to financial stability. Market disruptions are likely to be greater if the flow of information is irregular, with long periods of good or no news and sudden releases of negative information. If disclosure is ongoing, the mechanisms of market discipline can work earlier and more effectively. Timely public disclosure can reduce the severity of market disturbances because market participants are informed on a more ongoing basis and therefore not as likely to overreact to information about current conditions.

16. Public disclosure can also help limit the systemic effects of market disruptions by increasing the ability of the market in times of stress to distinguish those banks that are vulnerable from those that are not. Banks that are prone to hide, or significantly delay, disclosure of problems are likely to be more exposed to market overreactions than banks that have a track record of prompt and balanced disclosures.

17. Furthermore, enhanced public disclosure can strengthen the control shareholders as a group can exercise over a bank's management by enabling a wider set of shareholders to participate effectively in the governance of the bank and by making the corporate governance process more transparent.

18. Moreover, public disclosure can reinforce specific supervisory measures designed to encourage banks to behave prudently, e.g., supervisory guidance on sound practice in risk management, by requiring banks to disclose whether or not they are in compliance.

19. Finally, adequate public disclosure facilitates a more efficient allocation of capital between banks since it helps the market accurately assess and compare the risk and return prospects of individual banks.
    (b) Effective public disclosure

20. A number of issues need to be considered by supervisors and other public policy makers in designing effective disclosure standards. There are two broad goals. First, the information disclosed should result in appropriate transparency. Second, the market should respond appropriately to reward banks that are well managed.
    (i) Achieving transparency

21. There are inherent difficulties in making the riskiness of any enterprise transparent, including banks. For instance, in many countries the value of core banking activities, e.g., as they relate to credit risk and impairment inherent in the credit portfolio, cannot be estimated without some degree of imprecision. Therefore, the financial strength of a bank at any point in time and its financial performance over accounting periods, which are key inputs into any assessment of its riskiness, are subject to a certain degree of uncertainty. Furthermore, the risk appetite of a bank and the quality of its internal controls are crucial to the assessment of its riskiness, but may be difficult to communicate meaningfully, and, hence, difficult to make transparent.

22. Comparability of financial information across countries is also difficult to achieve, given that accounting and disclosure standards differ considerably not only for technical reasons, but also because of the interdependence between accounting, legal, fiscal and political considerations ³. Even when standards are similar, there may be considerable scope for interpretation and judgement when applying the principles. This may, of course, also lead to problems of comparability within countries.

23. Furthermore, it is clear that a bank, due to the need to preserve a degree of confidentiality, e.g., in relation to customers, cannot publicly disclose all data that may be relevant to an assessment of its activities and risk exposures. Privacy laws may restrict a bank's ability to disclose information on individual customers. Moreover, disclosure of detailed information on its individual customers and its risk management techniques and strategies, could significantly reduce the value to the bank of investing in these activities. Public disclosure standards should seek to balance the need for market participants to assess the quality of a bank's management with protecting the value to the bank of proprietary data.

24. Moreover, the usefulness of information depends on how current it is. Since banks' risk profiles can change rapidly, transparency requires the timely release of relevant information.
    (ii) Achieving market discipline

25. The effectiveness of public disclosure as a means of promoting safety and soundness in banks also depends upon market participants taking measures that promote financial stability based on information disclosed. Sometimes such behaviour cannot be presumed.

26. For example, if shareholders, creditors and the market in general believe that governments will allow non-disclosure, partial disclosure, or even misleading disclosure should a bank run into difficulties, they are unlikely to consider publicly disclosed information credible. In these cases, market participants may seek to compensate for the lack of credible public disclosure by relying more on secondary sources of information, e.g., rating agency ratings, media and rumours.

27. In addition, the effectiveness of public disclosure on market discipline may be limited if market participants believe they are protected by an official "safety net". Also, public disclosure may have limited effectiveness in relation to banks with heavy reliance on retail deposits, since retail depositors may lack the training to monitor a bank's condition via its public disclosures. In some cases deposit insurance programmes may further limit certain depositors' incentives to withdraw funds from badly managed banks.

28. There may also be differences in risk tolerance among market participants, such as between creditors and shareholders. For example, if a bank is already on the brink of bankruptcy with its share capital eroded, shareholders may have an economic interest to tolerate or promote risky strategies, since they have little to lose should risky strategies fail, but a lot to gain if they succeed. Thus, shareholders would no longer react to information by providing disciplining incentives.

29. Furthermore, even if the market does apply appropriate discipline, its effect on the bank's behaviour depends upon the incentive structure within the firm. It is assumed that market discipline will result in shareholder pressure on the board to behave prudently, that the board will in turn provide incentives to executive management to behave prudently, and so on down the organisation. But there are potential weak links in this chain. For example, the ultimate sanction against management and employees - dismissal - may not match the severity of the ultimate sanction on shareholders - losses. This can provide management with an incentive to take inappropriate risk because of the potential benefit to their remuneration. Market conditions may be such that a bank must offer remuneration packages to management and staff that provide incentives which are not fully aligned with the bank's longer term financial health. Further, generous severance payments to senior executives may also reduce the incentives to behave prudently.

30. Several of the factors influencing the market's response to public disclosure have their origin in policy trade-offs in the design of the institutional framework underlying capital markets and banking business. Since market discipline requires that some depositors, lenders or investors have an economic incentive to favour safe and sound banks, arrangements that limit stakeholders' exposure to risk will reduce the effectiveness of market discipline.
    (c) Potential drawbacks of public disclosure

31. In promoting transparency, supervisors and other public policy makers need to take into account the potential drawbacks that public disclosure can have in certain circumstances. Private and public interests may not always coincide. In particular, when the market becomes aware that a bank is in a weakened position it may react more harshly than is desirable from the point of view of the authorities who have responsibilities for depositors' protection and for managing systemic risk. In the absence of irrevocable liquidity facilities or arrangements, the bank may fail as a result of a liquidity crisis, even if it is solvent in terms of net assets. The market's lack of confidence in a bank may spread to other banks, leading to a systemic disturbance. However, in an environment of adequate ongoing disclosure, the likelihood of this kind of contagion is less likely. Moreover, in many countries banks are already required to disclose substantial information about their financial condition, performance, risk profile and risk management in their annual reports, and most stock exchange rules require listed banks to disclose market-sensitive information promptly.

32. The fact that disclosure may cause problems when a bank is in a weak condition does not refute the proposition that disclosure provides incentives for healthy banks to continue conducting their operations in a sound and efficient manner. Moreover, as noted earlier, disclosure will likely cause correction of problems at an earlier stage. Finally, some argue that a bank's disclosure of negative information can even have a positive impact on the market's evaluation of a bank if it increases the credibility of its management, as evidenced by its forthright disclosures, thereby improving the market's confidence in the bank.

33. Another potential drawback of public disclosure is the cost involved. It is often difficult to assess whether the benefits of additional disclosure outweigh the costs. One reason is that the direct costs of producing and providing information, i.e., the incremental cost of developing, implementing and maintaining a system to generate the required disclosures and their publication, are not borne by the potential users that may derive benefits from improved disclosure. While policy-makers often take for granted the net benefits of additional disclosure, some studies indicate that disclosure requirements can, in some cases, impose substantial costs. Nevertheless, within well-managed banks, information that is relevant should already be available internally and used by management to operate the business.

Footnote(s):

3. The Basle Committee recognises that many international efforts are underway to improve the comparability of financial information across countries.