Oct 17

Basel II: Second and Third Pillars

by David Harper, CFA, FRM, CIPM

FRM |

2nd3rdPillarsIntro2

Learning Outcomes (LO 68.16 & 68.17)

  • Describe the four principles of the Basel II Accord’s Second Pillar and describe specific issues that should be addressed as part of the supervisory review process.
  • Discuss the purpose of the Third Pillar, and describe the procedures for addressing the concept of market discipline.

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Mutually reinforcing pillars

The Second Pillar is the rule-book for the referees, so to speak. Under Basel II, supervisors have expanded roles: the second pillar extends beyond mere compliance. The Accord recognizes that the (mechanical) rules of the First Pillar may not sufficiently achieve the Accord's goals (i.e., risk-sensitive capital). The four principles are (Source: Basel II--Revised international capital framework. Highlight emphasis mine)

  • Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. 
  • Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
  • Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
  • Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

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Clearly the Second Pillar promotes a bias for action. Additionally, BIS wants supervisors to be alert to "specific issues." Some of these specifics are instructive (thematic) to the FRM candidate:

  • Stress tests under internal ratings-based (IRB) approach to credit risk and under the internal models approach (IMA) to market risk: supervisors are expected to require capital above the First Pillar requirements where stress tests show the need. This is thematic beyond Basel: stress testing complements primary models.
  • Credit concentration risk: the IRB frameworks assumes a well-diversified portfolio. Its conservatism partly mitigates this idealism. But still, as BIS Working Paper 15 demonstrates, name concentration adds two to eight percent to the credit value at risk (CVaR) while sector concentration adds 20 to 40%!
  • Counterparty risk: as banks shift from buy-and-hold toward originate-to-distribute, counterparty risk comes to the fore

 

Third Pillar

Basel II is evolutionary: banks are encouraged to transition from basic (standardized) approaches to their internal models. The expected benefit is lower capital charges. The price is tougher qualifying criteria (quantitative and qualitative standards) and greater disclosure to market participants. So, in regard to the learning outcome, the purpose of the third pillar is: to encourage more sophisticated risk management systems (where systems is more than just metrics) and to match the wisdom of vigilant market participants with the necessary discretion implied by the internal models.

Tactically, the third pillar itemizes qualitative and quantitative disclosures for the bank's capital structure and adequacy (i.e., Tier 1,2, and 3 capital used to support credit, market and operational risk) and the several types of risk exposures.

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