BASEL II - Overview of The New Basel Capital Accord
Pillar 2: Supervisory Review

The second pillar of the New Accord is based on a series of guiding principles, all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks, and for supervisors to review and take appropriate actions in response to those assessments. These elements are increasingly seen as necessary for effective management of banking organisations and for effective banking supervision, respectively.

Feedback received from the industry and the Committee's own work has emphasised the importance of the supervisory review process. Judgements of risk and capital adequacy must be based on more than an assessment of whether a bank complies with minimum capital requirements. The inclusion of a supervisory review element in the New Accord, therefore, provides benefits through its emphasis on the need for strong risk assessment capabilities by banks and supervisors alike. Further, it is inevitable that a capital adequacy framework, even the more forward looking New Accord, will lag to some extent behind the changing risk profiles of complex banking organisations, particularly as they take advantage of newly available business opportunities. Accordingly, this heightens the importance of, and attention supervisors must pay to pillar two.

The Committee has been working to update the pillar two guidance as it finalises other aspects of the new capital adequacy framework. One update is in relation to stress testing. The Committee believes it is important for banks adopting the IRB approach to credit risk to hold adequate capital to protect against adverse or uncertain economic conditions. Such banks will be required to perform a meaningfully conservative stress test of their own design with the aim of estimating the extent to which their IRB capital requirements could increase during a stress scenario. Banks and supervisors are to use the results of such tests as a means of ensuring that banks hold a sufficient capital buffer. To the extent there is a capital shortfall, supervisors may, for example, require a bank to reduce its risks so that existing capital resources are available to cover its minimum capital requirements plus the results of a recalculated stress test.

Other refinements focus on banks' review of concentration risks, and on the treatment of residual risks that arise from the use of collateral, guarantees and credit derivatives. Further to the pillar one treatment of securitisation, a supervisory review component has been developed, which is intended to provide banks with some insight into supervisory expectations for specific securitisation exposures. Some of the concepts addressed include significant risk transfer and considerations related to the use of call provisions and early amortisation features. Further, possible supervisory responses are outlined to address instances when it is determined that a bank has provided implicit (non-contractual) support to a securitisation structure.