The Basel II framework: the role and implementation of Pillar 2

Discussions on the reform of the “Basel I” capital ratio, or “Cooke” ratio, which dates from 1988, were initiated in the late 1990s under the aegis of the Basel Committee. They culminated in June 2004 with the publication of a new Accord on international convergence of capital measurement and capital standards, commonly referred to as “Basel II”. The new Accord was updated in November 2005 to incorporate several technical additions. The Basel II framework is designed to permit a more risk-sensitive and more comprehensive coverage of banking risks. It consists of three complementary and mutually reinforcing “pillars”. Pillar 1 consists of the basic minimum capital requirements. Pillar 2 introduces the principle of a structured dialogue between banking institutions and supervisors. Pillar 3 is focused on transparency and market discipline. Each of these three pillars represents a major innovation, marking the transition from a prudential framework based on simple quantitative rules to a more complete set of standards which, in addition to using a more risk-sensitive quantitative approach, incorporates qualitative principles that institutions are expected to comply with. However, Pillar 2 has a unique characteristic that distinguishes it from the other two Pillars. It reaffirms and provides a rationale for the existing practice of many supervisors: conducting a quantitative and qualitative review of all risks using their own tools but also the processes for risk monitoring developed by banks themselves. These reviews may lead to various supervisory measures, including the imposition of additional capital requirements under Pillar 2. The extensive consultations conducted in the past few years between supervisors and the banking industry have gradually led to the implications of Basel II being taken on board by all of the parties concerned. First of all, institutions focused on adapting their information systems to the requirements laid down in Pillar 1. For a long time, Pillar 2 was the least commented on part of the Basel reform. However, the entry into force of the new ratio will take place from the beginning of 2007 –in France as in the other countries of the European Economic Area– since the transposition of the Accord into Community law has taken the form of a new Capital requirements directive (CRD). In the run-up to this deadline, Pillar 2 has become a major topic of discussion between banks and their supervisors, and it therefore seems opportune to further clarify how the Commission bancaire will implement Pillar 2. In particular, the cross-border implementation of the new framework raises many questions, to which European supervisors have responded by developing rules that are as harmonised as possible. Beyond these considerations, thought needs to be given to the fundamental purpose of Pillar 2 and to its practical implementation. The increased risk-sensitivity of capital requirements under Pillar 1 undeniably represents a major advance, but it results in increased correlation of capital requirements with the business cycle, the degree of which will be specifi c to each institution. From the perspective of micro and macro-prudential stability, the fl uctuations in the regulatory ratio that might result from this correlation must be understood and, if possible, kept in check. This article seeks to show how this objective could be achieved through a possible approach to Pillar 2 involving the putting in place of a capital cushion in addition to the regulatory minimum.