Regulatory
For an indication of what first order
"In Pillar 2, there's a couple of really key things that regulators already can use and should have been using for decades," said Mayra Rodriguez Valladares, managing principal of the consultancy MRV Associates.
Pillar 2 was first introduced in the second iteration of the Basel framework, known as Basel II, which was adopted by U.S. regulators in 2007. While Pillar 1 of the framework set minimum capital requirements for participating regulatory agencies, Pillar 2 established the ability for supervisors to address issues within individual banks through other means, including applying additional capital requirements to offset specific risks.
"Pillar 1 is a rule," David Zaring, professor of legal studies and business ethics at the University of Pennsylvania's Wharton School of Business, said. "Pillar 2 is a license for regulators to go beyond the requirements of that rule."
Fed Vice Chair for Supervision Michael Barr has noted that some post-crisis regulatory reforms — including
But, Barr has also emphasized that the supervisors have unused tools at their disposal. He has not invoked the Basel framework by name, but experts say his commentary on how to improve the "speed, force and agility" of the Fed's bank oversight reflects elements of Pillar 2.
"Today, for example, the Federal Reserve generally does not require additional capital or liquidity beyond regulatory requirements for a bank with inadequate capital planning, liquidity risk management, or governance and controls," Barr said in his written testimony to Congress earlier this month. "I believe that needs to change in appropriate cases. Higher capital or liquidity requirements can serve as an important safeguard until risk controls improve, and they can focus management's attention on the most critical issues."
Adam Gilbert, senior global regulatory advisor in PricewaterhouseCoopers' Financial Services Risk and Regulatory Practice, said Barr's remarks to Congress and his report on the failure of Silicon Valley Bank last month should be viewed as a warning to banks that the Fed has other tools at its disposal and its not afraid to use them.
"It's a way of saying, 'Look, we have other levers to pull if we're not comfortable with the way you're managing,'" Gilbert said. "And capital is one."
The Fed's ability to issue capital requirements as part of its supervisory regime likely predates Pillar 2, policy experts say, as its general safety and soundness authorities were broad before the Basel Committee issued its first accord in 1988.
Yet, the Fed has largely left these capabilities dormant, preferring instead to keep its capital requirements standardized and rules-based, leaning on mechanisms such as the
Meanwhile, other Basel members have gone a different way. Zaring said regulators in the U.K. have taken a more "clubby," principle-based approach to supervision, rather than rule-based regime in the U.S.
"For better or worse," he said, "Pillar 2 permits different approaches."
In Europe, supervisors regularly issue firm-level capital requirements based on qualitative concerns about capital planning, risk management, governance and other factors. Chen Xu, a regulatory lawyer with firm Debevoise & Plimpton said he expects the Fed to move more in this direction after the failures of Silicon Valley Bank, Signature Bank and First Republic Bank.
"There's nothing stopping the U.S. from taking a more European approach to supervision," Xu said. "Barr, in his report, signals the possibility of mandatory triggers based on more qualitative factors. So, that's what you might see in the U.S. and it wouldn't necessarily require rulemaking depending on the nature of the consequences. But even if it does, it's certainly within the Fed's statutory powers to pass those types of regulations."
Karen Petrou, managing partner of Federal Financial Analytics, said Pillar 2 was created to address safety and soundness concerns that are difficult to control uniformly via top-down, standardized capital or liquidity requirements. It grants supervisors broad jurisdiction over concerns not explicitly addressed in Pillar 1 capital framework — namely credit risk, market risk and operational risk.
"When the Basel Committee was figuring out how to handle interest rate risk in the express capital standards, they said supervisors and regulators need to do this themselves, either by express interest rate risk capital requirements suitable for their jurisdiction or supervision," Petrou said. "Same thing with sovereign risk concentrations and a number of other governance issues. When regulators issue core principles for bank governance, those are Pillar 2 standards."
Some regulatory and supervisory practices at the Fed already fall under Pillar 2, including its stress testing regime and resolution requirements for large banks. But analysts say some under-utilized provisions of the law are likely to be revisited.
Rodriguez Valladares pointed to the Internal Capital Adequacy Assessment Process, or ICAAP, provision of Pillar 2, which sets standards on how regulators should oversee internal stress testing at the banks they supervise. In accordance with ICAAP, she said, the Fed could exercise more control over how banks measure certain risk factors, rather than leaving it up to each individual institution.
Pillar 2 also directs supervisors to make sure banks remain sufficiently above minimum capital and liquidity ratios based on certain risks, Rodriguez Valladares said, noting that the Fed could use it to create more uniform standards for modeling risks, such as rising interest rates.
"There's definitely room for things to be asked for under Pillar 2," she said. "You don't have to go through some huge notice [of] proposed rulemaking."
Some in and around the banking sector see a risk in drifting too far away from the Fed's rules-based tradition for capital requirements. Gilbert said the Fed should have clear policies for when supervisors can force a bank to increase capital and how those requirements can be lifted.
"If you're going to do something like that, you need to be transparent about how it's going to be captured, how it's going to be measured, how it's going to be calculated and how do I get out of it?" Gilbert said. "Is it a roach motel, where I can get into higher capital requirements idiosyncratically, but I can't get out?"
Greg Lyons, a partner at Debevoise & Plimpton, said if the Fed takes a more discretionary stance on its capital and regulatory regime, it could lead to uncertainty in the banking industry at a time when the sector can ill afford it.
"It's trading off consistency for an ability to find more issues on a particular basis," Lyons said. "I worry a little bit about that because these examiners are human beings, after all. I worry there'll be more pressure to actually find things and raise issues just to ensure people aren't criticized afterwards."
