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PA R T I I I
Financial Institutions
the guidelines to examiners on trading and derivatives activities. Now bank exam-
iners focus on four elements of sound risk management: (1) the quality of oversight
provided by the board of directors and senior management, (2) the adequacy of
policies and limits for all activities that present significant risks, (3) the quality of the
risk measurement and monitoring systems, and (4) the adequacy of internal controls
to prevent fraud or unauthorized activities on the part of employees.
This shift toward focusing on management processes is also reflected in recent
guidelines adopted by the Canadian bank regulatory authorities to deal with interest-
rate risk. These guidelines require the bank s board of directors to establish interest-
rate risk limits, appoint officials of the bank to manage this risk, and monitor the
bank s risk exposure. The guidelines also require that senior management of a bank
develop formal risk-management policies and procedures to ensure that the board of
directors risk limits are not violated and to implement internal controls to monitor
interest-rate risk and compliance with the board s directives. Particularly important is
the implementation of
stress testing
, which calculates losses under dire scenarios, or
value-at-risk (VaR) calculations, which measure the size of the loss on a trading port-
folio that might happen 1% of the time
say over a two-week period. In addition to
these guidelines, bank examiners will continue to consider interest-rate risk in decid-
ing a bank s capital requirements.
The free-rider problem described in Chapter 8 indicates that individual depositors and
creditors will not have enough incentive to produce private information about the
quality of a financial institution s assets. To ensure that there is better information in
the marketplace, regulators can require that financial institutions adhere to certain
standard accounting principles and disclose a wide range of information that helps
the market assess the quality of an institution s portfolio and the amount of its expo-
sure to risk. More public information about the risks incurred by financial institutions
and the quality of their portfolios can better enable stockholders, creditors, and
depositors to evaluate and monitor financial institutions and so act as a deterrent to
excessive risk taking.
Disclosure requirements are a key element of financial regulation. Basel 2 puts
a particular emphasis on disclosure requirements with one of its three pillars focus-
ing on increasing market discipline by mandating increased disclosure of credit
exposure, amount of reserves, and capital. Provincial securities commissions, the
most significant being the Ontario Securities Commission (OSC), also impose dis-
closure requirements on all corporations, including financial institutions, that issue
publicly traded securities. In addition, it has required financial institutions to pro-
vide additional disclosure regarding their off-balance-sheet positions and more
information about how they value their portfolios.
Regulation to increase disclosure is needed to limit incentives to take on exces-
sive risk, and it also improves the quality of information in the marketplace so that
investors can make informed decisions, thereby improving the ability of financial
markets to allocate capital to its most productive uses. The efficiency of markets
is assisted by the OSC s disclosure requirements mentioned above, as well as its
regulation of brokerage firms, mutual funds, exchanges, and credit-rating agencies
to ensure that they produce reliable information and protect investors. Bill 198,
introduced by the Ontario government in October 2002 in response to the
Sarbanes-Oxley Act in the United States, took disclosure of information even fur-
ther by increasing the incentives to produce accurate audits of corporate income
statements and balance sheets, and put in place regulations to limit conflicts of
interest in the financial services industry.
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