FSI Examines Application of Proportionality in Supervisory Approaches

The paper specifies that diverging Pillar 2 approaches can also be attributed to the role of supervisory judgment in applying proportionality and in assessing an institution's risk profile. The study finds that some authorities provide explicit guidance to support the judgments of supervisors, while others allow greater discretion to supervisory teams to fulfill their Pillar 2 responsibilities. This paper reveals that, while all surveyed jurisdictions have a process that incorporates the four principles of Pillar 2, their application varies. For example, some jurisdictions require all banks to submit a self-assessment of their own risk profile and internal capital adequacy assessments, while other jurisdictions impose such requirements on only a subset of banks. In addition, there is limited consensus on what Pillar 2 capital add-ons, if imposed, should cover, including how these capital add-ons interact with the new Basel III buffer requirements. The process used to determine Pillar 2 capital add-ons, if warranted, also differs.

Another insight is that authorities apply proportionality in supervision through one (or a combination) of two methods. The proportionality approaches used in supervision involve trade-offs. The principles-based proportionality methods allow supervisory teams flexibility in tailoring supervisory assessments to institution-specific circumstances. The guided discretion approaches eliminate some of the judgment required from supervisory teams by hard-wiring certain proportionality elements into applicable guidance. Almost all jurisdictions apply proportionality when adopting rules for internal capital adequacy assessment process (ICAAP), stress testing, and recovery plans. Nearly all tailor rules and supervisory expectations according to size, risk and complexity. In addition, some countries exempt smaller and less complex banks from applicable requirements, especially from developing recovery plans.

The paper concludes that supervisors may benefit if Pillar 2 implementation becomes the central area of focus, following the finalization of Basel III. 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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Keywords: International, Banking, Proportionality, Basel III, Pillar 2, Supervisory Approach, FSI, BIS