Supervisors Need More Guidance on Using Pillar 2 Tools

BIS paper says many prudential risks that arise from rising interest rates are “beyond the scope of Pillar 1” and better addressed through a robust Pillar 2 supervisory review process.

The Financial Stability Institute (FSI) of the Bank for International Settlements (BIS) has published a new paper calling for further guidance to support supervisors in addressing risks caused by rising interest rates.

The paper comes after recent banking collapses in the US that resulted in part from rapid interest rate hikes that affected the banks’ solvency and liquidity positions. It explores how the effects of rising interest rates on bank balance sheets are addressed in existing accounting and prudential frameworks and outlines their supervisory implications.

The paper says the recent episodes underscore the importance of banks adopting the Basel Framework’s definition of CET1 capital to ensure that market value fluctuations of all exposures subject to fair value accounting, are, at a minimum, reflected in the numerator of both CET1 risk-based capital and leverage ratios.

Pillars 1 and 2 of the Basel Framework aim to address the implications of rate shocks on a firm’s capital and liquidity risk profile. However, the paper says, many of the prudential risks that arise from rising interest rates and declining asset values are “beyond the scope of Pillar 1” and are “more effectively addressed through a robust supervisory review process under Pillar 2”.

“Pillar 1 prescribes minimum capital and liquidity requirements that, by design, are either narrow in scope or are not tailored for each bank’s risk profile,” the paper says. “Therefore, it cannot capture bank-specific risks posed by rising interest rates and falling asset values across a bank’s balance sheet.”

For example, Pillar 1 requires capital coverage for adverse fluctuations in fair value for trading book exposures, which excludes all banking book items. In regards to liquidity, the requirements are based on assumptions with respect to banks’ ability to sell liquid assets and the relative stability of their funds’ providers that may not always reflect a bank’s liquidity risk profile.

The Pillar 2 supervisory review process, on the other hand, equips supervisors with a “broad range of tools to identify, assess and, if warranted, require remedial actions to address the collective impact of heightened interest rate, liquidity and business model risks on a firm’s overall risk profile”.

“By deploying quantitative (e.g. capital and liquidity add-ons) and, especially, qualitative measures (e.g. banks enhancing risk management and internal controls), supervisors can act on such
weaknesses before they crystallise, hence mitigating the risk of a crisis of confidence,” the paper says.

However, it notes, making the right calls at the right time on the most consequential issues that drive a firm’s overall risk profile is “easier said than done”. Specifically, the principles-based nature of Pillar 2 – which is premised on supervisors’ ability and will to exercise sound judgment – can result in “divergent supervisory practices within and across jurisdictions”.

While this latitude may be necessary to accommodate jurisdiction-specific circumstances, the paper says any excessive discrepancies in implementation could lead to “unwarranted fragmentation and could have an impact on financial stability”.

The paper says authorities may consider whether further guidance on the implementation of Pillar 2 is warranted to provide more structure and consistency in supervisory decision-making and, more broadly, to “enhance the quality of supervision at the global level”.

The paper is published here by Rodrigo Coelho, Fernando Restoy and Raihan Zamil.


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