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Extending the scope of prudential supervision: Regulatory developments during and beyond the “effective” periods of the Post BCCI and the Capital Requirements directives.

Ojo, Marianne (2010): Extending the scope of prudential supervision: Regulatory developments during and beyond the “effective” periods of the Post BCCI and the Capital Requirements directives. Published in: Journal of Advanced Research in Law and Economics , Vol. 1, No. 1 (July 2010)

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Abstract

The main argument of this paper is, namely, the need for greater emphasis on disclosure requirements and measures – particularly within the securities markets. This argument is justified on the basis of lessons which have been drawn from the recent Financial Crises, one of which is the inability of bank capital requirements on their own to address funding and liquidity problems. The engagement of market participants in the corporate reporting process, a process which would consequently enhance market discipline, constitutes a fundamental means whereby greater measures aimed at facilitating prudential supervision could be extended to the securities markets. Auditors, in playing a vital role in financial reporting, as tools of corporate governance, contribute to the disclosure process and towards engaging market participants in the process. This paper will however consider other means whereby transparency and disclosure of financial information within the securities markets could be enhanced, and also the need to accord greater priority to prudential supervision within the securities markets.

Furthermore, the paper draws attention to the need to focus on Pillar 3 of Basel II, namely, market discipline. It illustrates how through Pillar 3, market participants like credit agencies can determine the levels of capital retained by banks – hence their potential to rectify or exacerbate pro cyclical effects resulting from Pillars 1 and 2. The challenges encountered by Pillars 1 and 2 in addressing credit risk is reflected by problems identified with pro cyclicality, which are attributed to banks’ extremely sensitive internal credit risk models, and the level of capital buffers which should be retained under Pillar Two. Such issues justify the need to give greater prominence to Pillar 3.

As a result of the influence and potential of market participants in determining capital levels, such market participants are able to assist regulators in managing more effectively, the impact of systemic risks which occur when lending criteria is tightened owing to Basel II's procyclical effects. Regulators are able to respond and to manage with greater efficiency, systemic risks to the financial system during periods when firms which are highly leveraged become reluctant to lend. This being particularly the case when such firms decide to cut back on lending activities, and the decisions of such firms cannot be justified in situations where such firms’ credit risk models are extremely sensitive – hence the level of capital being retained is actually much higher than minimum regulatory Basel capital requirements.

In elaborating on Basel II's pro cyclical effects, the gaps which exist with internal credit risk model measurements will be considered. Gaps which exist with Basel II's risk measurements, along with the increased prominence and importance of liquidity risks - as revealed by the recent financial crisis, and proposals which have been put forward to mitigate Basel II's procyclical effects will also be addressed.

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