07 July 2019

BIS: Proportionality under Pillar 2 of the Basel framework

A key aim of the study is to determine whether and, if so, how supervisory authorities apply proportionality in tailoring risk management expectations and supervisory practices according to the size, complexity and risk profile of regulated entities.

Authors also review the construct and evolution of bank rating systems since the advent of Basel II, given its fundamental role in shaping supervisory assessments and outcomes under Pillar 2.

While all surveyed jurisdictions have a process that incorporates the four principles of Pillar 2, their application varies.

Another insight is that authorities apply proportionality in supervision through one (or a combination) of two methods. The first approach, which authors label “principles-based proportionality that hinges on supervisory judgment”, entails the development of high-level principles that are subject to tailoring through the judgments of supervisory teams. The second method, which they classify as “guided discretion”, imposes a more prescriptive guidance that is supplemented with supervisory judgment. The proportionality approaches used in supervision involve trade-offs. The principles-based proportionality methods allow supervisory teams flexibility in tailoring supervisory assessments to

Most surveyed jurisdictions impose supervisory requirements on banks to facilitate the implementation of principle 1 of Pillar 2.

When ICAAP, stress testing and recovery plans are required, most authorities tailor applicable rules using either principles-based or guided discretion methods.

In regard to supervisory responsibilities under Pillar 2, a mix of principles-based and guided discretion approaches is used to tailor supervisory intensity and supervisory risk assessments to a firm’s size, risk profile and complexity.

The design of bank rating systems, which influences supervisory risk assessments and the supervisory intensity applied to firms, has evolved post-GFC. Many jurisdictions now place more weight on “liquidity risk”, “firm-wide governance” and “business model analysis” in their rating system architecture.

The appropriate balance between “rules versus discretion” in supervision is context-driven. Nevertheless, there are advantages in adopting guided discretion approaches with respect to tailoring ICAAP, stress-testing and recovery plan requirements imposed on banks; in determining the supervisory intensity of a firm; and in assessing capital adequacy.

With the post-crisis regulatory reforms now complete, there is value for the supervisory community to pay even more attention to Pillar 2. The expansion of Pillar 1 requirements under Basel III, including new global liquidity rules and the introduction of various capital buffers, has expanded the supervisory review process and its interactions with Pillar 1. In addition, new sources of risk such as cyber and climate-related risk, together with a greater focus on a firm’s conduct and culture, pose fresh challenges for banks and supervisors. In this context, continued collaboration between jurisdictions, through the ongoing exchange of experience on the various methods used to implement Pillar 2, can facilitate a robust implementation of the post-crisis reforms while taking into account the evolution of bank risk management and supervisory practices.

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