The three pillar approach
The Basel capital requirements are based on three main pillars: Pillar 1 with the minimum capital requirements, Pillar 2 with the risk management requirements and supervisory review procedures and Pillar 3 with market discipline through disclosure requirements.
The first pillar covers the risk-based minimum capital requirements for credit, market, counterparty and operational risk. For each of the types of risk, institutions have various risk-measurement processes for determining capital requirements at their disposal: on the one hand, relatively simple and standardised approaches and, on the other, approaches that are more risk-sensitive and based on internal bank measurement processes. The latter regularly result in lower capital requirements from a risk sensitivity viewpoint, which can, nevertheless, be greatly limited by the output floor.
In addition, a non-risk-sensitive leverage ratio (LR) was introduced in order to prevent individual institutions from building up excessive on- and off-balance sheet leverage and to cushion potential inadequacies associated with risk-based capital requirements.
The supervisory framework for large exposures also supplement the risk-based capital requirements in order to protect institutions against high-volume losses as a result of a customer default.
Liquidity coverage ratio (LCR)
The minimum capital requirements are supplemented by minimum liquidity rules. The aim of the minimum liquidity rules is to ensure that institutions have sufficient liquidity at all times. The LCR helps to ensure short-term liquidity by requiring an institution to maintain a stock of high-quality liquid assets sufficient to cover its liquidity needs for 30 calendar days in a severe liquidity stress scenario by selling them on private capital markets. These high-quality liquid assets may also include covered bonds such as Pfandbriefe.
Net stable funding ratio (NSFR)
In addition, the NSFR is designed to ensure the institution’s longer-term liquidity. This is accomplished by way of a balanced maturity structure for the institution’s assets and liabilities. For this purpose, the available stable funding (weighted liabilities) must exceed the required stable funding (weighted assets, including off-balance sheet items).
The second pillar supplements the quantitative minimum capital requirements in Pillar 1 and the minimum liquidity rules by including both qualitative elements and other quantitative aspects for risks not taken into consideration by Pillar 1, such as interest-rate risk in the non-trading book.
The Pillar 2 requirements are directed at institutions on the one hand and supervisory authorities on the other. Institutions are required to establish, on the basis of an internal process, a level of capital (Internal Capital Adequacy Assessment Process, ICAAP) and a level of liquidity (Internal Liquidity Adequacy Assessment Process, ILAAP) commensurate with their risk profile. This is also the aim of the principles for effective risk data aggregation and risk reporting (BCBS 239).
Supervisory authorities have the task of evaluating how well institutions are assessing their capital and liquidity levels in relation to their risks and intervening if necessary (such as by determining additional own funds requirements specifically for an institution). They do so by means of the Supervisory Review and Evaluation Process (SREP) and by supervisory stress tests, in which they identify an institution’s overall risk exposure and the key factors influencing its risk situation and prudentially evaluate them (see also Supervisory practice).
Supplementing Pillars 1 and 2, the third pillar is intended to reinforce market discipline. The expectation is that institutions will be disciplined by the fear of changes to the market prices of their issued securities in case of negative information (investor reaction). Other stakeholders (e.g. institutional clients) should also be informed by Pillar III. Thus, disclosure obligations are especially important. They enable market participants to obtain information about capital, liquidity, risk exposures, and risk assessment processes and evaluate whether capital and liquidity are adequate. This allows market discipline to be reinforced. However, for institutions that are not active in the capital market these requirements are a heavy bureaucratic burden.