How the Pillar 2 requirement is set
The Pillar 2 requirement is a bank-specific capital requirement which applies in addition to the minimum capital requirement (known as Pillar 1) where this underestimates or does not cover certain risks.
ECB Banking Supervision uses a four-step approach to determine the Pillar 2 requirement for individual banks on a risk by risk basis. Each of the four steps is equally important. Together, they yield an initial, holistic Pillar 2 requirement based on an overall assessment of the bank’s risk profile that is later combined with a more in-depth look at each individual risk driver to derive the final Pillar 2 requirement risk-by-risk.
In Step 1, the Joint Supervisory Team (JST) for the bank determines an initial Pillar 2 requirement, taking into consideration the outcomes of elements 1, 2 and 3 of the Supervisory Review and Evaluation Process (SREP):
- the business model and profitability assessment;
- the internal governance and risk management assessment;
- the assessment of risks to capital on a risk-specific basis (credit risk, market risk, operational risk and interest rate risk in the banking book).
In this step, the JST selects the appropriate initial Pillar 2 requirement from a bucket of possible values based on the assessment of the overall risk to the bank’s capital. This assessment is performed by applying weighting factors for Pillar 2 risks to the scores of the aforementioned SREP elements, and by using expert judgement to take into account the bank’s specific situation, including the reliability of the bank’s internal capital adequacy assessment process (ICAAP).
This initial Pillar 2 requirement is only a starting point, which can be different from the final Pillar 2 requirement that is ultimately decided for the bank. Changes can occur as a result of the risk-by-risk assessments carried out in the subsequent steps.
In Step 2, the JST breaks down the initial Pillar 2 requirement into several risk-by-risk add-ons. The aim is to provide a base of initial add-ons for the risks linked to the bank’s business model, internal governance and risk management, and risks to capital.
The risk-by-risk breakdown takes into consideration information from the bank’s ICAAP and its Pillar 1 requirement. This is to ensure that risks already covered by Pillar 1 are not counted twice.
Since ICAAP practices differ across banks, it is at the discretion of the JST to decide how to reflect its assessment of an individual bank’s ICAAP in the overall level of the Pillar 2 requirement and its risk-by-risk composition.
The ICAAP is becoming an ever more important part of this process as the ECB promotes improved ICAAP practices. To find out more about how the ECB is encouraging banks to enhance their ICAAP arrangements, see the ECB report on banks’ ICAAP practices and related Supervision Newsletter article.
In Step 3, the JST challenges the initial risk-by-risk add-ons resulting from Step 2. To do so, it considers different sources of information, such as key risk indicators, the bank’s ICAAP outcomes, peer analysis and findings from on-site inspections and deep dives. This step involves considering all available information with a view to ensuring that individual risk-by-risk add-ons sufficiently cover all relevant risks and are consistent across banks carrying out similar activities.
Dedicated tools that bring together the information from the various sources and enable thorough horizontal benchmarking are employed when challenging the initial risk-by-risk add-ons.
In Step 4, the JST determines the final risk-by-risk add-ons that lead to the definitive Pillar 2 requirement. In this step, it uses its expert judgement, based on the outcome of Step 3, to decide on the appropriate size of each risk-by-risk add-on. These decisions are substantiated by the Pillar 2 risk drivers behind each risk-by-risk add-on.
When considering the final risk-by-risk add-ons, the JST focuses on the bank’s specific situation. For example, the credit risk add-on might reflect shortcomings detected in a recent on-site inspection. Alternatively, individual add-ons might be adjusted to eliminate any possible double-counting where the same risk drivers are addressed simultaneously under different risk categories, or consideration might be given to other supervisory measures taken to address the bank’s specific situation.
The ECB communicates the key concerns and main drivers of individual Pillar 2 requirements to banks in the SREP decision and also summarises them in the Executive Letter that accompanies the SREP decision. The purpose of that letter is to sharpen the focus and increase transparency regarding the key supervisory concerns and main risk drivers of the bank’s Pillar 2 requirement.
Are we planning to review our methodology?
The ECB’s Pillar 2 requirement methodology is compliant with the EBA’s SREP Guidelines. We are also constantly working to enhance our methodology in order to increase risk-by-risk sensitivity. This follows on from the regular updates of the methodology that are based on the lessons learned from each SREP cycle. It also reflects further investigations into the possible impacts of specific individual risk drivers on banks’ capital. In addition, we are committed to undertaking a structural review of the effectiveness and efficiency of our Pillar 2 requirement methodology in the near future. Given the complexity of this topic, the review will most likely take the whole of 2024 to complete.