#04-12
"How Can the Invisible Hand Strengthen Prudential Supervision?"
Introduction: The Basel Committee has placed market discipline in a symmetrical position, alongside minimum capital standards and the supervisory review process, as one of three complementary pillars in the proposed new capital adequacy framework (Basel II). The reality of the proposal, however, falls short of this rhetorical symmetry. The space allocated to market discipline in the most recent restatement of the proposal (Basel Committee 2003) is less than a tenth of the overall proposal. (Pillar 2, the supervisory review process, fares only marginally better.) Moreover, the attention to market discipline is, at best, incomplete. The proposal focuses exclusively on disclosure, which is arguably a necessary, but surely not a sufficient condition for effective market discipline. Nonetheless, a properly formulated market discipline policy, strengthened by an appropriate supervisory review process, holds the promise of greatly enhancing the safety and soundness of the financial system without imposing the heavy compliance costs inherent in the complex capital charges laid out under Pillar 1.
In this paper I will examine the case for market discipline in principle and consider concerns raised about the operation of market discipline in practice and how they could be addressed. Next I will consider the Pillar 3 proposal to improve disclosure. Finally, I will conclude with a consideration of how enhanced market discipline could achieve the Basel Committee's (BIS 2001, p.1) stated objective of "strong incentives on banks to conduct their business in a safe, sound and efficient manner including an incentive to maintain a strong capital base as a cushion against potential future losses arising from risk exposures."
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