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5 Pillar Two: A New Role for Supervisory Authorities

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The New Basel Accord


risk (for instance, the interest rate risk on the banking book analyzed in the first part of

this book) which, though important, are difficult to measure through a universally-valid

framework. Also, the effectiveness of the models set by pillar one largely depends on the

organizational solutions put in place by the individual banks and on the degree of involvement of the corporate top management in the risk control and measurement policies.

In order to tackle these aspects properly, it is important that supervisory authorities

perform a review of the risk measurement process carried out by the individual banks,

testing the soundness of the quantitative and organizational models adopted and requiring,

where necessary, a further capital buffer in addition to that calculated with the rules

described so far.

Pillar two of the Accord is devoted to such supervisory review, with a view to complementing the quantitative rules illustrated above. This involves an interaction between the

national supervisory authorities and the banks, so as to account for the specific risk profiles

of the individual banking institutions. Namely, the prudential control process established

by pillar two is based on four principles:

(1) Banks must set up a system of processes and techniques aimed at establishing the

overall capital adequacy as a function of their own risk profile, as well as a strategy

aimed at maintaining adequate levels of capitalization.

(2) The supervisory authorities must evaluate these processes, techniques, and strategies,

as well as the ability of banks to ensure compliance with mandatory capital requirements. Should they find that such aspects are not satisfactory, supervisors should take

prudential actions such as those prescribed below, under Principles (3) and (4).

(3) Supervisory authorities expect banks to operate with an amount of capital in excess of

the minimum requirements and may request banks to hold a higher amount of capital

than the minimum requirement. This is due to the fact that it may be expensive for

banks to collect additional capital if this has to be done quickly or under unfavorable

market conditions. The capital in excess of the minimum requirement should depend

on the experience and results reached by the bank in risk management and control,

on the kind of markets on which it operates, and on the volatility of its revenues.

(4) Supervisory authorities should promptly intervene in order to avoid that the capital

drops below the minimum requirement and should demand that remedies are promptly

put in place if the capital is not maintained/brought back to a level above the minimum

regulatory requirement.

Within the framework of pillar two, supervisors should check the following:

– compliance with the requirements (for instance, in terms of depth of historical series,

number of rating buckets, etc.) established in pillar one;

– control of risks covered by pillar one but quantified in a too simplified manner (for

instance, concentration risk);

– other risk profiles which are not included in pillar one (e.g. the already mentioned

interest rate risk on the “banking book”);

– the effect played by some bank-external factors (such as the economic cycle or technological progress) on risks.

As far as the interest rate risk on the “banking book” is concerned, supervisory authorities

should concentrate mainly on “anomalous” banks (defined as those banks where a 2 %


Risk Management and Shareholders’ Value in Banking

change in market rates would cause a value reduction of at least 20 % in the regulatory

capital), and have the power to impose a mandatory minimum capital requirement on a

national scale.

As to the effect of the economic cycle on risk, all banks adopting the internal ratings

approach should share with the supervisors the results of their stress-testing exercises

aimed at simulating the effects of a moderate recession (e.g. two consecutive months of

zero growth) on PD, LGD, and EAD, and thus on the minimum capital requirement.

More generally, pillar two recognizes that the risk a bank is exposed to depends not

only on numeric and objective parameters but also on qualitative issues such as the organizational layout of the bank, the quality of the monitoring processes, and the management



20.6.1 The Rationale Underlying Market Discipline

One of the reasons why minimum capital requirements are necessary for banks is the fact

that banks are “special” enterprises. Indeed, they

– show a high degree of “opacity” which makes it difficult to correctly evaluate the risk

of their investments;

– are financed by individuals (depositors) that are unable to properly evaluate risk and

to suitably price it by demanding higher rates to riskier banks;

– play a major role in the economic system – as channels for the transmission of monetary policy and managers of a large part of the payment system – and thus are

entitled to use instruments such as special funding from the Central Bank and deposit

insurance, which together create a safety net that discourages creditors to assess the

bank’s soundness.

Therefore, banks’ creditors would hardly be efficient at performing this disciplinary

function that banks themselves perform with enterprises (monitoring the degree of risk,

imposing interest rate conditions consistent with such degree of risk, and even denying

loans when risks are too high). An industrial or commercial company increasing its risk

profile (for instance, by adopting a higher financial leverage) would most likely suffer an

increase in the loan cost. A similar “market discipline” effect (meaning that the financial

markets “penalize” risky companies by financing them less and at higher rates) is much

weaker if the borrower is a bank.

Pillar three is aimed at removing those factors that make it hard to apply market

discipline onto banks. Specifically, it requires that banks comply with strict disclosure

criteria, requiring that they provide investors with a prompt and detailed information

report on risks and capital. This way, banks’ creditors should be in a position to more

correctly and timely evaluate their actual levels of risk.

20.6.2 The Reporting Obligations

Back in September 1998,38 the Basel Committee already recommended that banks provide

the market with information on six key areas: (i) their economic and financial results, (ii)


Basel Committee (1998), “Enhancing Bank Transparency”, September.

The New Basel Accord


their financial structure (capitalization and liquidity), (iii) their strategies and procedures

for risk management, (iv) their exposures to the different risk categories, (v) accounting

policies, (vi) management and corporate governance.

The June 2004 Accord follows the same approach. In order to avoid overloading banks

with complex and unnecessary tasks, and to avoid “flooding” the market with non-essential

data, the Accord specifies that financial institutions shall only report information defined

as “relevant” (i.e. data that, if omitted or misrepresented, might alter or affect the judgment

of an investor). A list of key data to be made available to the public is also provided:

√ size and composition of capital and risky assets;

distribution of credit exposures among the different PD groups and the default rate

√ recorded on each rating bucket;

√ risk measurement and control systems in place;

√ accounting practices in use;

capital allocation criteria within the bank.

As a rule, such information should be disseminated every six months (or once a year

for qualitative data concerning the bank’s credit policies, its management systems and

reporting, or every three months for capital coefficients and related aggregates). However,

these transparency requirements shall not apply to information that, if known by the bank’s

competitors, might reduce the bank’s value, thus reducing its competitive advantages.

20.6.3 Other Necessary Conditions for Market Discipline

Pillar three tackles only one of the issues that hinder market discipline versus banks, i.e.

poor transparency on risk conditions. Indeed, there are other necessary conditions to be

met in order for market discipline to operate correctly. In addition to transparency, it is

necessary that:

(1) there exist creditors who are “not protected” by a public guarantee (be it mandatory

deposit insurance, or the fact that the bank is owned by the State);

(2) there are no conjectural guarantees, such as those connected to a supervisory policy

of “too big to fail ” (TBTF);

(3) the management pursues the interests of its shareholders and thus promptly responds

to the signals coming from the capital markets.

The first point led several observers to back up the reform proposals aimed at obliging

banks to issue subordinated debts.39 Indeed, subordinated creditors are paid back after the

bank’s other bond holders and on a residual basis. At the same time, unlike shareholders,

they do not benefit from any extreme “bets” made by the bank (as their remuneration is

fixed and is not affected by extraordinary corporate profits). Thus, they have a very similar

payoff as supervisory authorities and depositors’ insurance funds. This should motivate

them strongly to perform a careful risk monitoring activity.

However, subordinated creditors might also be poorly sensitive to risk (and thus hardly

incentivized to carry out an efficient monitoring and disciplinary action) if the bank is


See Flannery (1998).


Risk Management and Shareholders’ Value in Banking

protected by explicit or implicit guarantees.40 Therefore, creditors who are not secured by

banks – not only subordinated creditors but also bond holders and other banks – should

not expect any help from the authorities in case the issuer falls into a financial crisis.

From this viewpoint, the experience of several European Countries, where the costs of

banking crises are often borne by the national government, seems to point to the need for

a reform.

The third point underlines the need for the bank’s management to pursue the goal of

maximization of their shareholders’ value and thus to act so as to avoid an increase in

the cost of liabilities due to any increase in the assets risk level. If, on the other hand, the

management pursues its own “private” interests (for example, aggressive growth policies

through acquisitions), it might decide to bear the higher cost of funding, regardless of

the damage that this would cause to the shareholders. In order for the market discipline

to work, it is thus necessary that the banks’ governance forces managers to care for the

interests of the shareholders.


The 2004 reform features a few major pros. First of all, it increases the flexibility and

risk sensitiveness of the capital ratios for credit risk. This is clearly demonstrated by

Figure 20.4, which compares the capital requirements introduced by the 1988 Accord

and those introduced by the reform for loans granted to companies (with a turnover of

more than Euro 50 million) belonging to different rating buckets (which, for the sake of

simplicity, are showed with the scale designed by Standard & Poor’s). Compared to the

old “flat” requirement of 8 %, now the increase in flexibility is highest when the internal

ratings approach is applied. Figure 20.4 only shows the foundation approach, assuming

that maturity, EAD, and LGD are fixed and equal to 2.5 years, one Euro, and 45 %,

respectively. With the advanced approach, where the bank is free to internally estimate

also these three risk parameters, flexibility would be even higher.

Secondly, the reform recognizes the advantages, in terms of risk diversification, of

retail portfolios with exposures to individual, families, and small enterprises. Figure 20.5

compares the old 1988 requirement with the new minimum capital requirements. The

new standard approach clearly causes the regulatory capital to decrease by one fourth

(from 8 % to 6 %). On the other hand, the internal ratings approach allows to calibrate the

capital requirement according to the customer’s risk level, reaching the point where much

riskier counterparts than the average (PD close to 6 %) are subject to a higher capital

requirement than the “old” 8 %.

Another, more general, advantage is that the Accord not only reforms the capital requirements (pillar one), but it also extends the role and tasks of the supervisory authorities

and of the market. More specifically, the 2004 Accord not only disciplines the banks’

behaviour, but it also redefines the tasks, responsibilities, and professional resources

required from the supervisory authorities themselves. It is therefore important to consider the three pillars as equally important and as strictly related to one another, i.e. as

parts of an overall regulatory framework that cannot be assessed separately.


For example, Sironi (2003) shows that the German Landesbanks, enjoying an explicit guarantee by their

Lander (State), may get funding through subordinated bonds at rates that on average are 50 basis points (0.5 %)

lower than the ones that subordinated investors would require for the same risk level if no such guarantee were


The New Basel Accord


Large corporates

30 %

Foundation IRB Approach, EL

Foundation IRB approach, UL

25 %

New standardised approach

1988 Accord

20 %

15 %

10 %




0.03 %

Figure 20.4



0.07 %




0.10 %

0.17 %


Rating class and corresponding PD





Capital requirements for exposures to large corporates under various regulatory

A further positive aspect is the evolutionary approach followed in the area of credit

risk (and operational risk, see Chapter 21). Indeed, it starts with an exogenous capitalization requirement that is fully independent of the internal risk management system put in

place by the banks, and goes as far as partly recognizing the risk parameters estimated

with such systems (PD in the foundation approach, and LGD, EAD, and maturity in the

advanced approach). Banks are invited and enticed to move from simpler to more sophisticated approaches as their internal resources and skills allow them to adopt more complex

methodologies. Over a few years, this very rationale may lead to recognizing internal

models for measuring credit risk on a portfolio basis, thus overcoming the simplifications

that are inherent in the model presented in section 20.4.

The emphasis placed on organizational and operational issues also appears to be particularly appropriate. For instance, as mentioned above, in order for internal ratings systems to

be recognized and validated by the supervisory authorities, the reform explicitly requires

an actual use of the system for management purposes. Thus, a rating system shall not be

acceptable for calculating capital requirements unless it plays “an essential role in granting

credit lines, risk management, internal capital allocation, and in the corporate governance

functions.” Furthermore, in several points the reform provides for a direct responsibility of


Risk Management and Shareholders’ Value in Banking

Small Enterprises and individuals (retail)

30 %

Foundation IRB Approach, EL

Foundation IRB approach, UL

25 %

1988 Accord

New standardised approach

20 %

15 %

10 %




0.03 %


0.07 %




0.10 %



Rating class and corresponding PD





Figure 20.5 Capital requirements for retail exposures under various regulatory regimes (exposures

other than mortgages and qualifying revolving exposures)

corporate functions other than risk management (such as internal audit, and the very Top

Management), which are called upon understanding the basic mechanisms of the system,

supervise over its integrity, and use the estimates as part of the corporate strategies and

management practices.

Finally, several sections of the revised Accord are to be appreciated as they help banks

to develop their own ratings systems in line with the international best practice, thus

protecting them against possible mistakes and naivety. Such provisions represent a sort

of “operational guide” for banks committed to building an internal ratings system and,

although they may appear oversimplistic, they could certainly not be taken for granted

before the introduction of “Basel II”. Such provisions include the requirement that the

ratings system be two-dimensional, i.e. to separately evaluate the borrower’s probability

of default and the loss in case of loan default; the introduction of an adjustment for

residual maturity in order to account for the risk of downgrading; an attempt at reducing

the possibility to resort to regulatory arbitrage by an extremely accurate treatment of

securitization transactions, credit mitigation techniques and credit derivatives.

Next to these pros, there are also cons and open issues. One of the first drawbacks

of the Basel Committee proposals has to do with the risk weights established for the

The New Basel Accord


different rating buckets in the standard approach. As a matter of fact, they are relatively

undifferentiated compared to what emerges from data on historical default rates and

spreads of corporate bonds, as demonstrated by some recent empirical studies.41 For

instance, the historical data provided by Moody’s on default rates at one year for class

B3 are approximately 100 times higher (15.03 % versus 0.13 %) than the rates for class

Baa1. However, class B3 is subject to a risk weight of 150 %, while class Baa1 is subject

to a risk weight of 100 %. From a 1:100 ratio between default rates, a 2:3 ratio is reached

for risk weights.

However, this limited risk sensitivity of the new risk weights must be understood and

accepted, since it was dictated by political reasons: the Basel Committee, in fact, feared

that a migration from a “flat” regime (where all loans to a given category of borrowers

were subject to the same capital requirement) to a more risk-sensitive one could bring

about unwanted effects (e.g. a severe credit rationing for riskier firms, leading to an

economic recession) and therefore took care to prevent any disruptive change.

A second limitation relates to the totally rigid and unrealistic way in which the internal

ratings system measures the concentration and correlations among borrowers. As to the

former, in 2001 the Committee had provided for the calculation of a “granularity” measure of the loan portfolio based on the Herfindahl index. However, such proposal was

abandoned during the negotiations for the drafting of the final Accord, and the application

of any correction was left to the national authorities within the framework of pillar two.

As far as correlation is concerned, the approach based on the subportfolios set forth in

section 20.5, while on the one hand exempting banks from measuring the actual degree of

diversification of their portfolios, on the other hand operates so that the capital “consumption” linked to a new loan becomes independent of the composition of the pre-existing

portfolio. This clashes with the notion of marginal capital (or marginal VaR) set forth in

Chapter 14.

A third limitation – as illustrated earlier – is connected with pillar three and specifically

with the possibility to make market discipline on banks truly effective. The reform does

tackle the issue of disclosure, but it does not face the problems linked to incentives for

bank creditors to perform an efficient risk monitoring activity.

Another – often quoted – limitation of the revised Basel Accord is its complexity.

Indeed, in its full version (Basel Committee on Banking Supervision, 2006) the Accord is

a 333 page volume illustrating in detail issues and mechanisms that are not simple, often

offering several alternative solutions. Actually, we believe that what appears to be complex is the subject of the Accord (risk management) and not the Accord in itself. Length

and complexity are therefore unavoidable, when tackling this subject in an exhaustive and

in-depth manner.

A further problem raised by the Accord – procyclicality – shall be dealt with in the

final part of this chapter.


20.8.1 The Impact on First Implementation

The new capital requirements were subject to several quantitative impact studies (or QIS)

aimed at testing the potential consequences of the new legislation which were coordinated


See Altman and Saunders (2001) and Resti and Sironi (2007).


Risk Management and Shareholders’ Value in Banking

by the Basel Committee itself. Such studies were based on simulations performed by a

broad sample of banks based in different countries, which were asked to calculate the

capital requirement based on the new regulations and to compare it with the capital

requirement based on the 1988 rules.

A particularly challenging study called QIS5 was carried out in 2005–2006 on a sample

of 382 banks in 32 countries. Such banks were divided into two groups:

– “Group 1”: large, highly diversified banks characterized by a tier 1 capital of over

three billion Euros and by strong international operations;

– “Group 2”: regional or specialized banks, with a tier 1 capital of less than three billion

Euros, whose business is mainly concentrated in one country or in specific business


Table 20.5 reports the key results of this study. They are to be taken very cautiously

because the exercise required to estimate parameters, such as PD, LGD, or EAD, before

many of the banks involved had sufficiently tested their credit risk measurement systems.

Table 20.5 QIS 5 results – % change in capital requirement

Standardized FIRB

AIRB Most likely

approach approach approach approach

G10∗ Group 1





G10 Group 2























Group 1

CEBS Group 2

Other∗∗ non-G10 Group 1

Other non-G10 Group 2

Includes the 13 member countries of the Basel Committee (see Appendix 18A to Chapter

18). ∗∗ Countries participating in the works of the Committee of European Banking Supervisors; in addition to the European G10 countries, the group includes Bulgaria, Cyprus,

Czech Republic, Finland, Greece, Hungary, Ireland, Malta, Norway, Poland, and Portugal


Australia, Bahrain, Brazil, Chile, India, Indonesia, Peru, and Singapore.

Source: Basel Committee (2006b).

Four key results emerge:

– In general, a decrease in the capital requirement is found, which is particularly remarkable with the IRB approach (especially in the advanced version). However, it is worth

pointing out that the QIS5 results do not take into account the floors mentioned in

section 20.2 and therefore might overestimate the possible reduction in the minimum

regulatory capital. A small increase is recorded for G10 banks if the standard approach

is implemented. Much higher increases are recorded by banks in non-G10 countries

and non-CEBS countries (Australia, Bahrain, Brazil, Chile, India, Indonesia, Peru, and

Singapore). More specifically, among Group 2 banks an increase of approximately

20 % is observed, also based on the data of the last column, where the capital of each

The New Basel Accord


bank in the sample was calculated with the approach (standardized, IRB foundation,

or IRB advanced) which it is likely to be adopted as from 2007/2008;

– The impact of Basel II varies largely for each individual banks, as demonstrated by

the large discrepancy among the individual data reported in Figure 20.6. The higher

risk sensitivity of the new requirements causes different banks to be subject to more

diversified capital requirements;

– On average, smaller banks (Group 2) appear to be more favored;

– European banks appear to be slightly more favored over the average G10 banks.

Standardised approach

Foundation IRB approach

60 %

60 %

40 %

40 %

20 %

20 %



−20 %

−20 %

−40 %

−40 %

−60 %

−60 %

−80 %

−80 %





Advanced IRB approach



Most likely approach

60 %

60 %

40 %

40 %

20 %

20 %



−20 %

−20 %

−40 %

−40 %

−60 %

−60 %

−80 %

−80 %







Figure 20.6 Changes in regulatory capital for individual banks in the G10

Source: Basel Committee on Banking Supervision, 2006b

Table 20.6 shows the contribution of the individual segments to the overall change in the

regulatory capital. With the standardized approach, the total change is exactly the one

showed in Table 20.5; for the internal ratings approach, the two columns in Table 20.5

(foundation and advanced) were merged into one, selecting for each bank the approach


Risk Management and Shareholders’ Value in Banking

Table 20.6 QIS 5 results – Contribution of regulatory capital to the % change

Standardized Approach




Most likely IRB Approach






Group 1 Group 2 Group 1 Group 2 Group 1 Group 2 Group 1 Group 2

Wholesale; of










– Corporate









– Bank








– Sovereign









SME corporate









Retail; of which:









– Mortgage









– Revolving









– Other









SME retail









Market risk







Operational risk






























Source: Basel Committee (2006b).

that it is most likely to adopt as from 2007/2008. An analysis of these more detailed data

allows to better understand the results emerging from the previous table:

– The increase in the overall regulatory capital associated with the standard approach is

mainly caused by the new requirement on operational risk (Chapter 21). Indeed, without

it the impact of Basel II on minimum capital requirements would remain negative.

However, for Group 1 banks a tightening of capital requirements is recorded also in

the wholesale area due to the higher capital consumption associated with interbank

loans and loans to sovereign States;

– The IRB approach leads to capital savings in almost all of the segments of the loan

portfolio. Loans to sovereign States are penalized in terms of capital absorption, while

lendings to customers – especially to private (retail) individuals and small enterprises

(SMEs) – benefit from a major reduction. The benefit is particularly high for smaller

banks (Group 2), where these customer segments account for a high share of their

credit portfolios. This explains one of the results emerging from the previous table.

The New Basel Accord


20.8.2 The Dynamic Impact: Procyclicality

The previous section illustrated the likely impact of the Revised Accord in static terms,

i.e. during its first implementation. However, the criticisms raised by several observers

mainly focused on its dynamic impact, i.e. on how the new capital requirements may

evolve over time.

More specifically, the capital requirements designed by Basel II – being based on ratings – may strengthen the fluctuations of the economic cycle (i.e. evolve in a procyclical

manner) and have negative effects on the stability of the banking system.

Indeed, if the capital ratios depend on the (external or internal) ratings of the counterparts, a recession, leading to higher default rates and more frequent downgradings,

would lead to an increase in the minimum required capital. As it would be difficult to

collect new capital during a recession, in order to maintain the ratio between capital and

risk weighted assets, banks would end up granting less credit to the economy, and this

would expose companies to further financial distress, thus strengthening the recession.

Similarly, at a time of strong economic growth associated with a general upgrading of the

creditworthiness of counterparts, the capital ratios would decrease, thus allowing banks

to provide more credit to the economy.

In general, any capital adequacy system, be it based on ratings or not, tends to be

procyclical. Indeed, during recessions default rates increase, which in turn requires larger

provisions and writeoffs, thus reducing the banks’ capital endowment and possibly leading

to a credit crunch. The novelty introduced by Basel II is that procycicality stems not only

from the evolution of defaults, but also from changes in the borrowers’ ratings. The

consequence is a stronger procyclical effect, due to the evolution of both default rates

and migration rates (upgradings and downgradings).

However, procycicality does not depend merely on the way in which capital requirements are technically designed. Two more factors are also important: the provisioning

policies implemented by banks and the operation of their internal ratings systems. These

three aspects are analyzed below.

Procyclicality and design of capital requirements – A system of capital ratios based

on ratings tends to be more procyclical than a system based on fixed weights such as the

one dictated in 1988. However, this higher procyclicality depends on two factors.

The first is the strength of the correlation between ratings and risk weights. Under the

standard approach, as shown in section 20.3, this is based on the risk weights showed in

Table 20.1. This weighting system is very “cautious” in increasing capital requirements as

the rating worsens (indeed, a 1:100 ratio between default rates corresponds to a 2:3 ratio

between the related risk weights). This choice, although somehow unsatisfactory (because

it represents the relationship between rating and risk in a very unrealistic way), appears

to be advisable if the goal is to reduce procyclicality: indeed, the weights in Table 20.1

imply that the increase in the capital requirement, due to a downgrading, turns out to be

generally small.

Under the internal ratings approach, the capital requirement is given by equations

(20.12) and (20.16), i.e. by the regulatory functions connecting PD with the minimum

capital requirement. A key parameter in defining the form of such functions is asset correlation ρ: The higher the value of ρ, the smaller the benefit deriving from a diversification

and therefore, for a given PD, the higher the capital requirement. As seen in section 20.5,

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