The Application of the Supervisory Review Process under Pillar 2 (CP03 Revised)

Start Date: 20/06/2005 | Deadline: 21/10/2005

Executive Summary and consultation process

This paper is a revised and expanded version of CEBS' consultation paper "The Application of the Supervisory Review Process under Pillar 2" (the first consultation on CP03), which closed for comment on 31 August 2004. These new proposals are still subject to revision, most especially if changes are made to the draft Capital Requirements Directive (CRD) before it is adopted.

CEBS has redrafted its proposals to include some of the suggestions it received in the consultation. The paper has been expanded to include guidelines on the general application of internal governance (IG) and how it applies to an institution's internal capital adequacy assessment process (ICAAP). There is also more detail on how the dialogue between the institution and its supervisor should be conducted, and how supervisors should use their internal Risk Assessment Systems (RAS) in the Supervisory Review and Evaluation Process (SREP).

CEBS recognises the increased need for supervisory cooperation, to address industry concerns that a lack of coordination could give rise to duplication of supervisory effort. These guidelines are designed to promote convergence of supervisory practice and consistency of approach, taking into account market trends and national practices, to achieve a sound and efficient market.

Principal aims of Pillar 2

The underlying aim of the Pillar 2 processes is to enhance the link between an institution's risk profile, its risk management and risk mitigation systems, and its capital. Institutions should themselves develop sound risk management processes that accurately monitor, measure and aggregate their risks. Institutions are expected to have an adequate assessment process that encompasses all the key elements of capital planning and management and generates an adequate amount of capital to set against those risks.

Institutions should 'own', develop and manage their risk management processes; the ICAAP belongs to the institution and supervisors should not dictate how it is applied. The task of the supervisory authority is to review and evaluate the ICAAP and the soundness of the internal processes within which it is used.

Internal governance is central to an institution's ICAAP. The guidelines now include a section explaining what supervisors will expect to find when they evaluate the adequacy of an institution's internal governance.

The dialogue between an institution and its supervisor is a key part of the supervisory review process. This paper highlights the respective involvement of supervisory authorities and institutions and the interaction between them, with the aim of making this dialogue clear and consistent. The dialogue should embrace all aspects of business risk and control risk, including risk management systems, internal control systems and internal governance. In order to ensure transparency and consistency in the dialogue, and to 3 promote convergence of supervisory practices, the supervisory processes have been laid out in detail.

The intensity and depth of the dialogue should be proportional to the nature scale, complexity and systemic importance of the institution. For example, a small noncomplex institution would not be expected to have a sophisticated ICAAP, and its supervisor should not necessarily subject it to an intense and comprehensive dialogue. CEBS is doing further work on the concept of proportionality, which will be made available in due course.

The CRD provides supervisors with several tools for correcting weaknesses in the ICAAP, including setting a Pillar 2 capital requirement. However, capital may not always be the best mitigant of risk. Depending on the circumstances, it may be used on its own, in combination with other supervisory measures, or other measures be taken instead.

Further work

Further detail will be added in due course on the full set of Pillar 2 Building Blocks; that is, the stepbystep components that supervisors will use to perform their review and evaluation process, and the individual Pillar 2 risk buckets (i.e. specific risk factors) identified in chapter 4.

This set of guidelines will in due course be incorporated into a compendium of guidance - or handbook - for institutions and supervisory authorities on how to approach their obligations under the Banking Directive. CEBS plans to publish the final version of these guidelines in early 2006.

Request for comments

CEBS solicits comments on all aspects of this consultation paper, but is particularly interested in comments on the new elements that have been added since the initial version of this paper (CP03) was published in 2004. CEBS would especially expect to receive answers on the key questions highlighted below:

  • Is there agreement on the importance of internal governance and should it be a key focus of the evaluation of the ICAAP?
  • How could the proposed 'dialogue' between institutions and supervisors be made more effective?
  • Would smaller, less complex institutions find additional optional guidance on the ICAAP helpful, and what might such guidance cover?
  • It would also be useful to have views on the concept of proportionality, both as it relates (i) to the size and complexity of institutions and (ii) to the intensity of the dialogue between institutions and supervisors.

CEBS considers this to be a high priority project, and the timetable for completing it is tight. Nevertheless, the consultation period will be the full three months normally reserved for a first consultation, even though this is the second consultation on CP03, as new elements have been added and the 4 original paper has been substantially revised. An additional month has also been added because the summer months make up part of the consultation period. Comments should be submitted by Friday 21 October 2005 to

Comments will be published on CEBS' website (unless a respondent requests otherwise). After the consultation is closed an explanation will be published of how the major points raised were addressed. CEBS also refers readers to the separate publication of feedback to the first consultation on CP03.

CEBS' consultation papers on common reporting (CP04, 26 January 2005) and supervisory disclosure (CP05, 23 March 2005) also refer to Pillar 2. Feedback comments on these issues will be dealt with separately in the followup to those papers.