The second pillar in the Basel standards deals with the roles of the supervising authorities. It is their role to secure that the approved methods entail an appropriate level of capital requirements in relation to the assumed risks and that the models are suitable to estimate and manage the risks. In addition the supervising authority can determine individual capital requirements for the individual financial institution.
5.3.1 Tighten regulations
The regulation is also supposed to urge the financial institutions to develop internal controls and risk management in preparation for obtaining a more sophisticated risk culture and thereby enhancing its risk estimation process. Furthermore the regulations and obligations for supervising authorities have been tightened in order to minimize risks of failures among managements in the financial sector.
Both the supervising authorities as well as the financial institutions do face a challenging assignment, which is why Basel II was considered as a good framework to enhance corporate
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Hans Henrik Duus Gebauer Christensen
34 governance and implement sufficient risk management. The current crisis has, however exposed several lacks in the standards, which will be discussed in this thesis, section eight.
In pillar II it is possible to incorporate circumstances that are not included in the estimation of solvency demand under pillar I. This happens if the supervising authorities assess that there are circumstances in the financial institutions which are not included under pillar I. E.g. it is the individual financial institution’s management’s obligation to estimate the solvency required, taken several circumstances like business profile, risk concentration, larger clients, volume growth etc.
into account. For securities dealers, it is important to have a solvency ratio that is sufficient enough to absorb the market price exposures from their trading book. Because of the obvious difference from institution to institution the solvency required differs.
The rather advanced and different methods to estimate risks in the different institutions presuppose a higher level of competence among the employees at the supervising authorities. They are not only obligated to secure the minimum capital requirement at 8%, but they are also obligated to take all the institutions risks into account and secure that the capital base is adequate. Thus the supervising authorities must have resources to analyze and scrutinise the models that the institutions want to use.
The supervising authorities must demand that the institutions have effective systems to identify, measure, monitor and control credit risk as a part of the overall approach to risk management. The authority must in every case conduct an individual examination of the institutions’ strategies, policies, processes and procedures regarding their risk management and continue to control their lending portfolio.The fulfillment of this job will be discussed in section eight, in this thesis.
The supervising authorities are empowered to demand further capital reserves as well as they can demand qualitative improvements like better processes and procedures. The Basel committee has set up four principles to carry out effective supervising:
1. The credit institutions must have internal procedures for determination of the needed capital in relation to their risk profile and also a strategy to sustain the capital base.
2. The supervising authorities must evaluate the financial institutions internal procedures under pillar I and react on the results of these evaluations. Furthermore the supervising authorities
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Hans Henrik Duus Gebauer Christensen
35 must evaluate whether the internal models that are used under pillar I, fulfill the supervising standards, plus assess whether the institutions comply with the demands of disclosing more details like described in pillar III. (pillar III will be described later in this thesis).
3. The financial institutions are expected to operate with an adequate buffer in addition to the minimum required capital base. The supervising authorities can impose additional capital demands, exceeding the 8% if it is considered necessary.
4. The supervising authorities must have the possibility to intervene on an early stage in order to secure whether an institutions capital base is sufficient27.
5.3.2 Estimating required solvency
The committee does not elaborate on what can trigger extra capital demand, hence the interpretation of the regulations are the local supervising authorities’ job. The committee, however, identify significant risks that, under some circumstances, can cause a rise in the capital demand – an example is the interest rate risk on fixed loans and securities. If the supervising authorities regard the capital base as unsustainable to absorb this risk, further capital demands can be imposed. Or the financial institution can be forced to bring down the certain exposure to meet the original capital demand.
The committee suggests that stress tests are used to evaluate whether an institution operates too close to the minimum capital demand. Stress tests are also mandatory, for the institutions using internal methods under pillar I, to assess the credit risk. The supervising authorities can choose to apply the institutions own stress tests if they need to examine if it is necessary for an institution to reduce risk or increase demand of capital. For the sake of transparency and credibility of the whole supervising procedure, supervising authorities ought to publish the criteria used for the institutions’
calculations.
The guidelines in pillar II are very broad formulated leaving room for the local supervising authorities to determine the practice for imposing individual capital demands. The loose
27 Basel Committee on Banking Supervision, June 2006: International Convergence of Capital Measurement and Capital Standards
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36 formulation in pillar II is due to the fact, that there are many different local circumstances that influence the interaction between the institutions and the supervising authorities in the
corresponding countries. This gives the authorities the possibility to take e.g. tax and accounting standards into account when a proper level of capital requirement has to be determined.