The Three Pillars of Banking Capital

Picture Source: https://www.bis.org/bcbs/basel3/b3summarytable.pdf

The three pillars of banking capital are:

Pillar 1:?Minimum capital requirements

Pillar 2:?Supervisory review

Pillar 3:?Market discipline?

These pillars are part of the Basel III framework, a global regulatory framework for banking capital and liquidity.?The Basel III framework aims to strengthen the banking sector's risk management, supervision, and regulation.?

Here's more information about each pillar:?

Pillar 1 of Basel III: Minimum Capital Requirements

Pillar 1 of the Basel III framework sets minimum capital requirements for banks to ensure their financial stability and ability to absorb losses. These requirements are based on the bank's risk profile, which is assessed by considering various factors such as:

• Credit risk: The risk of borrowers defaulting on loans and other credit obligations.
• Market risk: The risk of losses due to fluctuations in market prices, such as interest rates, foreign exchange rates, and equity prices.
• Operational risk: The risk of losses arising from internal processes, people, or systems, including fraud, legal disputes, and systems failures.

Key components of Pillar 1 include:

• Capital ratios: Tier 1 capital ratio: Measures the core capital of a bank relative to its risk-weighted assets. Total capital ratio: Measures the total capital of a bank relative to its risk-weighted assets.
• Leverage ratio: A simple measure of a bank's capital relative to its total assets, designed to limit excessive leverage.
• Risk-based capital requirements: Banks are required to hold capital in proportion to their risk exposures. This is typically calculated using a risk-weighting system that assigns different weights to different types of assets and off-balance sheet exposures.

The goal of Pillar 1 is to ensure that banks have sufficient capital to absorb losses and maintain their financial stability, even during periods of economic stress. By setting minimum capital requirements, regulators aim to protect depositors, creditors, and the overall financial system.

Pillar 2 of Basel III: Supervisory review

Outlines supervisory monitoring and review standards.?It also addresses firm-wide governance and risk management.?Under this pillar, the Bank needs to produce an Internal Capital Adequacy Assessment Process (ICAAP), different supervisory reviews, and evaluation processes. Other reports on specific risk areas, such as stress testing, liquidity risk management, or governance.

Key aspects of Pillar 2 include:

• ICAAP: Banks must develop an ICAAP to assess their capital needs based on their risk profile, business strategy, and economic outlook. This includes stress testing to evaluate the bank's resilience to adverse events.
• Supervisory review: Regulatory authorities conduct regular reviews of banks to assess their compliance with regulatory requirements, the effectiveness of their risk management practices, and the adequacy of their capital.
• Capital add-ons: If a bank's risk profile is deemed to be more significant than the standard approach, regulators may impose additional capital requirements, known as capital add-ons.
• Governance and risk management: Pillar 2 also addresses the bank's governance structure, risk culture, and risk management framework.

The goal of Pillar 2 is to ensure that banks have a sound risk management framework in place and that they are adequately capitalized to withstand potential losses. By conducting supervisory reviews and imposing capital add-ons where necessary, regulators aim to protect the financial system and prevent bank failures.

Pillar 3 of Basel III: Market discipline?

Promotes market discipline through prescribed public disclosures.?The idea is that banks that follow better practices will get lower-cost funding from the market

Here are the key areas of disclosure under Pillar 3:

Capital Adequacy

• Capital ratios: Tier 1 capital ratio, total capital ratio, and leverage ratio.
• Capital requirements: Minimum capital requirements based on risk factors.
• Capital adequacy assessment: The bank's assessment of its capital adequacy and any identified capital gaps.

Risk Exposures

• Credit risk: Exposures to different types of credit risk, such as corporate, sovereign, and retail.
• Market risk: Exposures to market risk factors, such as interest rates, foreign exchange, equity prices, and commodities.
• Operational risk: Exposures to operational risk, including internal fraud, external fraud, and systems failures.

Risk Management

• Risk management framework: The bank's approach to risk management, including its risk appetite, risk identification, measurement, and control processes.
• Stress testing: The bank's stress testing methodology and results.
• Liquidity risk management: The bank's liquidity risk management framework and liquidity risk metrics.

Governance and Risk Culture

• Governance structure: The bank's governance structure, including the roles and responsibilities of the board of directors and management.
• Risk culture: The bank's risk culture, including its approach to risk-taking and risk awareness.

Financial Performance

• Financial statements: The bank's financial statements, including the balance sheet, income statement, and cash flow statement.
• Key performance indicators: Key performance indicators relevant to the bank's business and risk profile.

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