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Basel Framework

courtesy: Gemini 2.5 Flash

The Basel Framework, developed by the Basel Committee on Banking Supervision (BCBS), provides international standards for banking regulation. It is built upon three pillars:

  • Pillar 1: Minimum Capital Requirements
  • Pillar 2: Supervisory Review Process
  • Pillar 3: Market Discipline

Here's a breakdown of the differences between Pillar 1 and Pillar 2:

Pillar 1: Minimum Capital Requirements

  • Focus: This pillar sets out the minimum amount of capital that banks must hold to cover specific, quantifiable risks.
  • Risks Covered: Primarily covers:
    • Credit Risk: The risk of loss due to a borrower's failure to repay a loan or meet contractual obligations.
    • Market Risk: The risk of losses in on- and off-balance-sheet positions arising from movements in market prices (e.g., interest rates, exchange rates, equity prices, commodity prices).
    • Operational Risk: The risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events (e.g., fraud, system failures, legal risks).
  • Calculation: Banks can use either standardized approaches (prescribed by regulators) or, if approved, internal models (developed by the bank itself) to calculate their risk-weighted assets (RWAs) for these risks. The minimum capital requirement is typically a percentage (e.g., 8%) of these RWAs.

  • Nature: More rules-based and quantitative. It provides a standardized baseline for capital adequacy across banks.

  • Primarily set out in the Capital Requirements Regulation (CRR). The CRR (Regulation (EU) No 575/2013, and its subsequent amendments like CRR II and CRR III) is a directly applicable EU law that lays down the detailed rules for banks' capital requirements, including the calculation of Risk-Weighted Assets (RWAs) for credit, market, and operational risks. It's a regulation because it's uniformly applied across all EU member states without needing national transposition.

Pillar 2: Supervisory Review Process

  • Focus: This pillar addresses risks not fully captured by Pillar 1 and ensures that banks have adequate capital to support all material risks in their business, as well as robust risk management processes. It's about a more holistic and qualitative assessment of a bank's risk profile.
  • Risks Covered:
    • Includes risks already covered in Pillar 1, but with a deeper assessment of how well the bank manages them (e.g., concentration risk within credit risk).
    • Crucially, it also covers other material risks not fully or adequately captured by Pillar 1, such as:
      • Interest Rate Risk in the Banking Book (IRRBB)
      • Liquidity Risk
      • Strategic Risk
      • Reputational Risk
      • Business Model Risk
      • Pension Risk
      • Environmental, Social, and Governance (ESG) risks (increasingly relevant)
  • Process: This involves:
    • Internal Capital Adequacy Assessment Process (ICAAP): Banks are required to conduct their own comprehensive assessment of their risks and determine the appropriate level of capital needed to cover them, along with a strategy for maintaining that capital.
    • Supervisory Review and Evaluation Process (SREP): Supervisors review the bank's ICAAP and its overall risk profile. Based on this review, supervisors can require banks to hold additional capital above the Pillar 1 minimum (known as Pillar 2 capital requirements or add-ons), address deficiencies in their risk management, or take other supervisory actions.
  • Nature: More principles-based, qualitative, and tailored to the individual bank's specific circumstances. It allows for supervisory judgment and flexibility.
  • Primarily set out in the Capital Requirements Directive (CRD). The CRD (Directive 2013/36/EU, and its subsequent amendments like CRD V) is an EU directive, which means member states must transpose its provisions into their national laws. The CRD provides the legal basis for the supervisory review process (SREP), including the requirement for banks to conduct an Internal Capital Adequacy Assessment Process (ICAAP) and for supervisors to assess these and potentially impose additional capital requirements (Pillar 2 Requirements - P2R) or guidance (Pillar 2 Guidance - P2G).

Key Differences Summarized:

Feature Pillar 1: Minimum Capital Requirements Pillar 2: Supervisory Review Process
Primary Goal To set a minimum, quantitative capital floor for specific, common risks. To ensure holistic capital adequacy and sound risk management.
Scope of Risks Credit, Market, and Operational Risks (quantifiable). All material risks (including those not fully captured by Pillar 1).
Approach Rules-based, standardized (or internal model-based but still prescriptive). Principles-based, judgmental, and bank-specific.
Tool/Process Calculation of Risk-Weighted Assets (RWAs) and minimum capital ratios. Internal Capital Adequacy Assessment Process (ICAAP) and Supervisory Review and Evaluation Process (SREP).
Output Minimum capital ratios. Bank-specific capital requirements (P2R), and supervisory guidance (P2G) on top of Pillar 1, and requirements for improved risk management.
Enforcement Binding minimum capital ratios. Binding Pillar 2 requirements (P2R) and non-binding guidance (P2G).

In essence, Pillar 1 provides the foundational minimum capital rules, while Pillar 2 acts as a crucial complement, ensuring that banks not only meet these minimums but also proactively manage all their risks and hold sufficient capital for their specific risk profile, under the oversight of supervisors.