By Cem Karacadag, Michael W Taylor
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Additional info for The new Capital Adequacy Framework: Institutional Constraints and incentive Structures
Example text
In fact, the prevalence of banking crises and continued financial sector fragility in many countries points to the contrary. The ultimate test of market discipline is the extent to which institutions Ð bank and nonbank Ð respond to market signals by modifying their behavior. This, in turn, requires effective governance structures and legal frameworks. For example, shareholdersÕ ability to influence management hinges on competent board members in an executive board that plays an active role monitoring company management.
A number of thorny issues arise. First, in countries where the approval process is more lenient, and quality of ratings on borrowers is lower, the ability of capital standards to achieve banking system soundness and a level playing field would be compromised. Second, policies will have to be developed on how to handle rating differences among approved agencies on the same borrower. Third, consistency among international and local rating agencies on rating definitions and scales is a key prerequisite for the successful use of ratings.
Ultimately, even if the market sends proper signals, market discipline works only if the recipients of those signals actually respond by altering their behavior. Each one of these essential conditions Ð disclosure, incentives to exercise discipline, and recipient response, in turn, hinge on a set of underlying preconditions all related to governance structures. 48 The Third Pillar: Market Discipline First, adequate accounting and audit standards are essential foundations of the information required to scrutinize firms, including financial intermediaries.