PRIMER: Pillar 2 of the Basel banking framework

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Pillar 2 of the Basel framework has been one of the most important innovations in international banking regulation in recent decades. Evolutionary in nature, Pillar 2 must be adapted to reflect the evolution of banking business models, the increasing complexity of the financial sector and a turbulent environment. Its importance has been particularly highlighted during the Covid-19 crisis and in many jurisdictions Pillar 2 has already started to assume an important role in expanding the importance of climate risk within banking prudential regulation. .

What is Pillar 2 and what are its origins?

Pillar 2 aimed to ensure that banks have sufficient capital to meet their business risks and use better risk management techniques to monitor and manage those risks.

The process was first introduced in an environment enthused by internal models and increasingly exposed to new risks arising from technological innovation and globalization, as part of a comprehensive reform of international prudential regulation being carried out in 2004 under the name Basel II.

See also: Finalization of Basel III: completing the puzzle

The objectives were to encourage banks to better measure and manage their risks and to make capital requirements more sensitive to risk than under the previous rules (Basel I and Basel I.5). The Basel Committee on Banking Supervision (BCBS) has recognized that banks’ business models and certain risks are too heterogeneous to be fully and adequately captured by existing rules and that it would be necessary to require banks that they develop their own methods for quantifying and managing these risks.

The key idea was to supplement the minimum capital requirements prescribed by regulators (pillar 1 under the new Basel II and the still current architecture) with appropriate supervisory measures based on an in-depth analysis of banks’ risk profiles ( pillar 2). In addition, public disclosure requirements (Pillar 3) aimed at promoting market discipline completed the picture.

Considered an international agreement, Pillar 2 represents an important step in efforts to harmonize supervisory principles and practices across jurisdictions. The global standard has been transposed in the EU by the Capital Requirements Directive (CRD) and EBA guidelines on common procedures and methodologies for the supervisory review and evaluation process. In addition, for the euro area covered by the banking union and the single supervisory mechanism, the European Central Bank (ECB) has drawn up the ICAAP Guide and ILAAP Guide.

What are the objectives of pillar 2?

The theoretical and practical basis of Pillar 2 can be understood in the context of two concepts: first, a holistic approach embedded in enterprise-wide risk management, and second, a capital management approach based on economic capital. Whereas Pillar 1 of the Basel capital regulatory framework only deals with capital requirements for credit, market and operational risks as well as regulatory liquidity ratios calculated according to more or less sophisticated regulatory approaches; Pillar 2 focuses on the economic and internal perspective of banks’ capital and liquidity adequacy.

In addition, to ensure comprehensive risk coverage, under Pillar 2, banks are required to put in place adequate procedures and systems to ensure that their capital and liquidity adequacy is sufficient with respect to all risks. significant risks to which they are or could be exposed. In addition, Pillar 2 aims to provide incentives so that banks have sufficient capital to face the risks arising from their operations, but also to develop and use better risk management techniques in the monitoring and management. of these risks.

What is the structure of pillar 2?

Pillar 2 encompasses a two-pronged process known as the Supervisory Review Process (PRS). The first part requires banks to design a formalized, documented and comprehensive approach to determining optimal capital levels, known as the Internal Capital Adequacy Assessment (ICAAP) and Adequate Liquidity Process or Internal Liquidity Adequacy Assessment (ILAAP). The second part, the Supervisory Review and Evaluation Process (SREP), asks supervisors to review and assess ICAAP and ILAAP within the broader context of assessing risk profiles. as well as internal risk management and control systems.

The SRP should ensure that banks have sufficient capital to meet all the material risks to which they are exposed. It should therefore strengthen the link between risk and capital and liquidity resources so that the bank’s risk management strategy, approaches and systems are integrated into its capital and liquidity planning. As such, the SRP extends beyond the SREP and ICAAP/ILAAP to include ongoing monitoring.

What are the four principles of pillar 2?

Pillar 2 should be tailored to the risks, needs and circumstances of a particular jurisdiction and bank. Therefore, we could consider it as the “principles-based” complement to the “rules-based” Pillar 1.

The Pillar 2 framework was built around four principles, the first addressed to banks, the others to supervisors.

1)
Bank’s assessment of capital (and liquidity) adequacy: Banks must demonstrate that internal capital/liquidity objectives are consistent with the overall risk profile. The ICAAP/ILAAP processes measure and monitor all material risks to which the bank is exposed.

2)
Prudential control process: Supervisors should regularly assess the extent to which the bank has a robust internal process for assessing capital adequacy and risk position.

3)
Capital above the regulatory minimum: Supervisors expect banks to operate above minimum Pillar 1 capital requirements.

4)
Supervisory intervention: Supervisors should intervene at an early stage to prevent capital from falling below minimum requirements. Therefore, they should be able, for example, to restrict dividends or require the raising of additional capital.

What is comprehensive risk coverage?

Regarding the scope of risks, under Pillar 2, banks must address all material risks, including those for which quantitative models are not possible or not yet satisfactory. In addition to the risks already explicitly included in Pillar 1 (credit, market, operational), banks should in particular include interest rate risk in the banking book (IRRBB).

IRRBB can be defined as the risk that changes in market interest rates will reduce the profitability and economic value of a portfolio of assets and liabilities. In the case of trading book assets and liabilities, interest rate risk is considered part of market risk and dealt with under Pillar 1. However, for interest rate risk in the banking book, the global standard has opted for the Pillar 2 approach, although recent revisions provide for some standardization with a measure based on the sensitivities of economic value of equity (EVE) and net interest income ( NII).

See also: OVERVIEW: Market Risk – A Banking Regulation Perspective

The other risks generally included in the risk profile of banks within Pillar 2 are strategic, commercial and reputational risks. However, given the flexible and adjustable nature of Pillar 2, it is clear that after the information provided under Pillar 3, climate risk also finds its place in this part of the overall prudential framework.

What is SREP?

The common SREP framework, for example, as developed by the EBA, is built around the following main elements:

1)
Categorization of establishments: The application of the proportionality principle in the SREP is motivated by the categorization of institutions into four categories according to their size, risk profile, scope of application, nature and complexity of their activities.

2)
Monitoring of key indicators: Regular monitoring of key risk indicators supports the SREP by signaling changes in the bank’s risk profile.

3)
Business Model Analysis (BMA): Business model analysis involves the assessment of a bank’s business model, including the viability of the business model (i.e. the ability to generate acceptable returns from a prudential point of view over the next 12 months, and the sustainability of the business model (i.e. a more forward-looking concept that refers to a bank’s ability to generate acceptable returns of a point from a prudential point of view throughout a cycle).

4)
Governance and Controls Assessment: As part of the overall governance assessment, supervisors should consider whether an institution’s internal governance framework is adequate given its risk profile, size, nature and complexity.

During the SREP, supervisors assess:

a)
‘Risks to capital’, which covers credit risk, market risk, interest rate risk in the banking book and operational risk; and

b)
“Liquidity risk”, which reflects a bank’s ability to cover ad hoc cash needs in times of economic uncertainty when depositors can withdraw significantly more money than usual.

What are Pillar 2 cushions?

After reviewing the outcome of the “risks to capital” assessment, supervisors quantify the additional capital needed to cover material risks. Specifically, the EU regulatory framework provides for two Pillar 2 top-ups in addition to Pillar 1 and its buffers.

1)
Pillar 2 (P2R) requirement which is binding and must be complied with at all times, and

2)
Pillar 2 Guidance (P2G) which is a non-binding capital expectation at a level above the overall capital requirements.

In the context of recent developments, it is possible that the recent climate stress test initiated by the ECB could have an impact on banks’ capital requirements.

The UK approach, for example, also relies on two buffers under SREP: one, pillar 2A: binding requirement, and two, pillar 2B: non-binding requirement.

However, the American approach to bank risk assessment is based on two distinct frameworks: the CCAR (Comprehensive Capital Analysis and Review) and a capital rule. The CCAR targets the largest banks, but unlike the EU and UK approaches, it is a top-down, supervisory-led exercise based on a dynamic balance sheet, in which banks’ capital plans are included in the assessment. If the results of the CCAR are not deemed adequate, regulators may also require, for example, changes to dividend distributions or a capital increase.

See also: Regulatory developments in the United States

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