Copyright is owned by the Author of the thesis.  Permission is given for 
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An empirical analysis of the usefulness of the 
Basel II Pillar 3 disclosures on bank risk 
management to monitor bank performance and 
forecast bank profitability during periods of 
economic instability. 
 
A thesis presented in partial fulfilment of the 
requirements for the degree of 
Master of Management 
in 
Banking 
 
at Massey University, Manawatu, 
New Zealand. 
 
Rachel Ainsworth 
2012 
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Abstract: 
The third pillar of the Basel II capital adequacy framework requires banks to 
disclose risk information to the market to supplement regulators? monitoring.  It is 
expected that this ?allows market discipline to work earlier and more effectively? 
(BCBS, 1998, pp. 6).  The expectation that the pillar 3 disclosures will lead to 
market discipline is supported in the theoretical literature but not demonstrated in 
the empirical literature.  The purpose of this thesis is to determine if the 
information contained in banks? disclosures is useful to monitor bank performance 
and to explain bank profitability as this is a precondition for effective market 
disclosure.  The usefulness of information in the pillar 3 disclosures was 
examined for twenty of the largest global banks from 2008 and 2009.   It was 
found that pillar 3 disclosures are useful to analyse and monitor the performance 
of banks as the disclosures can be used to identify banks for which key risk 
metrics are inconsistent with other metrics.  The pillar 3 variables did not however 
significantly improve the explanatory ability of earnings models over models 
containing only financial information, although this may be due to the small 
sample size.  These results show that there is valuable information contained 
within pillar 3 disclosures which could be used by the market to provide market 
discipline as expected in the Basel II framework. 
 
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Table of Contents 
1. Introduction ..................................................................................................... 1 
2.  Literature Review ....................................................................................... 7 
2.1 The Purpose of Disclosures .................................................................... 8 
2.2 The Process of Market Discipline in Banks ........................................... 10 
2.3 Earnings as a Measure of Market Discipline ......................................... 15 
2.4 Bank Earnings ...................................................................................... 18 
2.5 Summary of the Literature Review ........................................................ 22 
3.  Research Methodology............................................................................. 24 
3.1 Qualitative Analysis ? Comparisons of the Performance of Banks ....... 24 
3.2 Quantitative Analysis ? A Model for Future Earnings ............................ 27 
3.2.1 Model Specification ........................................................................... 27 
3.2.2 Statistical Methodology ..................................................................... 30 
3.3 Variables to be included in the data ...................................................... 35 
3.4 Data Collection and Sample Selection .................................................. 39 
3.5 Key Statistics in the Raw Data .............................................................. 45 
4. Results.......................................................................................................... 48 
4.1 Qualitative Analysis ? Comparisons of the Performance of Banks ....... 48 
4.2 Quantitative Analysis ? A Model for Earnings ....................................... 55 
5. Discussion .................................................................................................... 58 
Appendix: The residuals from the earnings models ............................................ 67 
References .......................................................................................................... 70 
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List of Diagrams 
Diagram 1:  The process by which market discipline occurs. ................................ 4 
 
List of Tables 
Table 1:  Banks included and excluded from the data ........................................... 3 
Table 2:  Banks included and excluded from the data ......................................... 43 
Table 3: Summary Statistics ............................................................................... 45 
Table 4: Pearson Correlation Coefficients ........................................................... 47 
Table 5:  Regression model results for earnings ................................................. 56 
 
List of Graphs 
Graph 1:  Risk weighted assets versus earnings ................................................ 48 
Graph 2:  Net interest income against credit risk weighted assets ...................... 49 
Graph 3:  Collective provisions against net interest margin ................................ 50 
Graph 4:  Collective provisions versus credit risk weighted assets ..................... 51 
Graph 5:  Collective provisions versus next year?s individual provisions ............. 52 
Graph 5:  Individual provisions against impaired assets ..................................... 53 
Graph 7:  The Texas ratio version 1 versus the Texas Ratio version 2 ............... 54 
Graph 8: Residuals from Model 1a...................................................................... 67 
Graph 9:  Residuals from Model 2a ..................................................................... 68 
Graph 10:  Residuals from Model 3d ................................................................... 69