Second and Third pillar of the Basel Capital Accord: an opportunity for change for the

Italian banking supervisory system

Marcello Luberti ∗

[Abridged version of the paper “Secondo e Terzo Pilastro dell‘Accordo di Basilea: un’opportunità
di cambiamento per il sistema di vigilanza bancaria in Italia” published in BANCA IMPRESA
SOCIETA’, Anno XXVI , n. 2, agosto 2007]
Abstract

The paper discusses the potential benefits deriving from a supervisory system focused on
greater transparency and timeliness of corrective action and a lesser degree of discretion. As a
consequence of the complexity and rapidity of banks’ changing risk profiles, as well as of limited
resources available, banking supervisors will necessarily have to resort to market discipline. Some
countries that borne the consequences of generalised forbearance by supervisory authorities
reformed their systems in line with the two pivotal principles included in Basel II: commitment to
ex-ante established procedures in the supervisory process and the market discipline. The paper finds
that: 1) the Basel Accord does not trace a clear distinction between the minimum capital
requirement set by the first pillar and the overall capital requirement based on the ICAAP-SREP;
2) the new Italian supervisory regulations maintain a certain vagueness concerning the conditions
that trigger supervisory corrective actions. It would be useful to follow, in a consistent manner, the
principles of prompt corrective action and effective market discipline, just to respond to the needs
that emerged in the Italian supervisory system over recent years and to the challenges posed by
increasingly competitive and integrated markets at the international level.

1. Main features of the Second and Third pillar of the new Basel Capital Accord

The new Basel Capital Accord (Basel II) establishes that “when deficiencies are identified,
prompt corrective action can be taken by the supervisory authorities to reduce risk or restore
capital”. The Basel Committee document on the implementation of the Accord states that “each
supervisor should clarify the steps that it will need to follow in the event of a decline in a bank’s
capital level toward the minimum …”.
The new EU directive on capital places emphasis on the concept of proportionality, i.e. it
establishes a link between frequency and conditions of the Supervisory Review Process (SREP) and
banks’ riskiness and complexity; the same principle applies to the requirements regarding the
Internal Capital Adequacy Assessment (ICAAP). The application of the proportionality principle is
tantamount to the implicit introduction of an objective of losses minimisation among banking
supervision’s goals, also in those legislative frameworks, like the Italian one, that do not expressly
provide for it.
According to the Committee of European Banking Supervisors (CEBS), it is important for the
authorities to adopt procedures encouraging transparency, as the new capital framework will
introduce more complex rules, which rely - much more than in the past - on supervisors’ qualitative
judgement. This will increase the room for supervisors’ discretionary action in a number of areas.
More complex rules reduce the degree of transparency and can lead to increased regulatory arbitrage
and forbearance. This is the reason why Basel II requires a greater level of
transparency/accountability from the supervisor.
The Accord offers only few clues as to the role assigned to market discipline. The document on
the implementation states that the objective is “to encourage market discipline by requiring banks
to make disclosures that will allow market participants to assess capital adequacy”.

∗
Bank of Italy. Banking and Financial Supervision, Supervision Inspectorate. The views expressed in the paper are
solely the responsibility of the author and should not be interpreted as reflecting the views of the Bank of Italy.
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2. The evolution of supervisory systems: Prompt Corrective Action (PCA) and Market
Discipline (MD)

The major weaknesses of Basel II are the little emphasis placed on the second and third pillars
as compared to the first and, above all, the poor analysis of the connections existing between
supervisory process and market discipline. The Accord is the result of a compromise solution
between heterogeneous, if not antithetical, supervisory systems and juridical-administrative contexts
– which can be traced back, to put it simply, to the US system, on the one hand, and that of
continental Europe, on the other. The former, characterised by a greater degree of automatism and
accountability (mainly as a consequence of the FDICIA of 1991), is more centred on market
discipline, while the latter is marked by a wider recourse to discretion and a lesser degree of
disclosure.
In broad terms, the main difference between the two systems lies in the role played by market
discipline and in the reliance on its mechanisms. The US model, as a matter of fact, seeks to address
both market and regulatory failures and to ensure effective supervisory action by entrusting the
supervisory authority with the task of mirroring controls typical of market discipline, when these
cannot work, as a consequence of the peculiarity of the banking industry. The other model, instead,
takes market failures as a fundamental rationale for public controls and considers supervisory
discretion instrumental to the structural role played by regulation. The first approach is theoretically
represented in the study by Barth, Caprio and Levine, which also contributed to a comparative
analysis of the role played by banking regulation around the world 1.
It is well known that some countries that borne the consequences of generalised forbearance by
supervisory authorities reformed their systems in line with the two pivotal principles included in
Basel II: commitment to ex-ante established procedures in the supervisory process and the market
discipline, inclusive of disclosure of the supervisory action. They have acknowledged that delaying
the solution of banks’ troubles does not reduce the overall cost of banking crises.
The study goes on to describe the main features of PCA as applied in the US and also reports
the criticism against it.
The Basel Accord implicitly recognizes that sound and safe banking cannot be ensured
exclusively by means of regulation and supervisory controls. Regulation needs to be backed by
market discipline. However, as Basel II lacks a clear indication on requisites of effective market
discipline, the paper reports main conclusions of the literature on the subject.
According to the theory supporting MD, uninsured and informed creditors (above all other
banks) and, in some instances, rating agencies have resources, incentives, expertise and market
knowledge necessary to monitor banks. Market discipline enhances incentives for banks themselves
to behave in a prudent and efficient manner.
A precondition for effective MD is the existence of some stakeholders at risk. A way to
enhance the role of creditors interested in monitoring banks, is to oblige them to issue a minimum
amount of subordinated loans, regular issues of limited amounts so that issuing banks frequently
pass the test of the market.
The supervisor is not omnipotent and could make use of information produced by the market.
The information can go both ways, from the market to the supervisor and from the supervisor to the
market, i.e. with a sort of disclosure of the assessments made and the actions taken by the
supervisory authority. Transparency in the banking industry aims at reducing information
asymmetries and minimising private information. One way to achieve this is to increase the
information banks have to supply to the public; another is to disclose the supervisors’ actions and
decisions, be they positive or negative. The paper reviews the studies carried out on the subject.
There is a complementary relationship between MD and supervisory controls of the PCA type.
Sanctions established in the PCA scheme for troubled banks replicate the sanctions the market
would generally impose to firms of other industries facing similar financial distress. The purpose of

1
“Rethinking Banking Regulation” (2006).

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corrective actions is not to punish the bank, but to provide incentives for owners and managers to
restructure the bank and restore profitability and sound capitalisation. The incentives to market
participants and to supervisors should be closely aligned. A strengthening of the mechanisms of
market discipline could enhance PCA credibility and supply relevant information to supervisory
authorities for deciding to adopt the measures foreseen in the PCA framework.
Supervision should play an active role in encouraging MD. This is one of the recommendations
suggested by Barth, Caprio and Levine.

3. The Italian market context and the main factors of bank crises

In present markets the most likely factors of bank troubles are not the same as in the past, when
they were connected with downturns in the economic cycle, sectorial and territorial imbalances or
pretty fraudulent mismanagement. Now there emerge causes of a different nature, mainly linked
with risky growth strategies, failures in corporate governance and in risk control systems. Although
traditional aspects, such as risk concentration, are still present, there is an increasing incidence of
operational, reputation and legal risks, deriving, among other things, from markedly speculative
strategies. It becomes difficult to mark a clear distinction between fraudulent management and
expansion strategies that make intensive use of financial engineering. The task of supervisory
authorities becomes even more difficult where market discipline is lacking.
The timeliness of analyses and the promptness of corrective measures become thus a key factor.
Due to difficulties in identifying actual risk conditions and interfering with the entrepreneurial
autonomy of supervised banks, external controls are likely to arrive too late. The “wait and see”
attitude, typical of banking supervision, can imply high costs for deposit guarantee schemes,
taxpayers and may also have a negative impact on the reputation of the supervisory authorities
themselves. Ambiguity is not productive, if banks understand that forbearance is likely and finally a
bail-out will take place. The reasons often alleged to justify forbearance appear nowadays less well-
founded than in the past.
The process of concentration and the diversification beyond national boundaries by Italian
banking groups will enhance, on the one hand, the “too-big-to-fail” problem with growing moral
hazard for intermediaries and their creditors and, on the other, intervention and coordination
problems among authorities of various countries. Both factors, if not properly dealt with, could
increase the likelihood of supervisory forbearance. The introduction of the International Accounting
Standards, oriented to the principle of fair value, will reduce the time available to supervisory
authorities to react, due to increased volatility in the profitability and capital of those banks whose
solvency ratios are very close to the minimum threshold.
Recommendations on the need for more prompt supervisory action and to improve enforcement
can also be found in the latest Financial System Stability Assessment carried out by the IMF on the
Italian banking supervisory system in 2004-05. The IMF remarks mainly focus on issues such as
enforcement, transparency and prompt monitoring and invite to reflect on the exercise of
discretionary powers by Italian authorities in performing their supervisory functions.

4. The implementation of the Second and Third pillars into the Italian supervisory system

As concerns the second pillar, the Supervisory Instructions issued by Banca d’Italia in
December 2006 included a large part of the innovative contents of Basel II and the Capital Ratio
Directive.
For the time being, however, previous regulations on supervisory action remain in force. They
contain only vague connections between degrees of anomaly of a bank’s financial condition and
corrective measures to be adopted by the authority. Nor has Banca d’Italia exercised, so far, the
options set out in the Basel Accord, such as the provision concerning trigger capital thresholds,
applicable to the entire banking system, which would automatically determine the adoption of
corrective actions of increasing degree of severity. As a consequence, the recommendation by the
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Basel Committee to supervisors to clarify “steps to be necessarily followed when the level of
capitalisation of a bank falls below the minimum …” has not been implemented. The same holds
true for some of the recommendations made by the CEBS on SREP and on supervisory disclosure.
It is worth underling that the Italian regulation replicates the Basel provision according to which
banks have to disclose information only on the methods used in the ICAAP and not on the outcome
of the process.
As is well known, the first pillar capital requirements is devoted to address credit, counterparty,
market and operational risks. ICAAP, on the contrary, is oriented towards quantifying the capital
needed also to cover concentration risk, interest rate risk on the banking book, liquidity risk and
other risk typologies such as, for example, reputation and strategic risks. Therefore there can be
even material differences between minimum requirements set by the first pillar and adequate
capital calculated according to the ICAAP. In addition, it is likely that the SREP will also
encompass other kind of risks, when identifying capital requirements appropriate to individual
banks and could set, when needed, capital thresholds higher than the minimum (first pillar).
Are those cases of banks for which the information on the minimum capital requirement,
officially disclosed pursuant to the third pillar, is different from the effective capital requirement,
established by the authority in the context of ICAAP-SREP. It is worth noting that Banca d’Italia
has not kept a provision from its previous Supervisory Instructions; according to it, if the
supervisory authority required higher capital ratios, the bank had to disclose the information in the
annual financial statements. For such banks, the market will therefore lack fundamental information
to evaluate the actual riskiness and to exercise market discipline.
The Italian supervisory authority has to be prepared to manage the impact on the market and on
individual banks of detailed information that will be disclosed to the public for the first time: the
supervisory authority is no longer the only depository of information. As a general rule, in Italy MD
should be accompanied by accurate controls on correctness, fairness and transparency of financial
statements, which would require a proactive role by the supervisory authority.
In the end, the Accord and the new Italian supervisory regulations do not trace a clear
distinction between the minimum capital requirement set by the first pillar and the overall capital
requirement based on the SREP, and maintain a certain vagueness concerning the conditions that
trigger supervisory corrective actions.

5. Conclusions

Basel II is based on the two principles which inspired the recent evolution of supervisory
systems – commitment to ex-ante established procedures in the supervisory process and market
discipline - and that are the result of lessons learnt from the banking crises of the last twenty years.
They should be followed and further developed with determination. The framework of prompt
corrective action, combined with effective market discipline, responds to the needs that emerged in
the Italian supervisory system over recent years and to the challenges posed by increasingly
competitive and integrated markets at the international level. In particular, the SREP and the Article
124 of Capital Ratio Directive, which require timely actions on banks, represent a step forward in
the right direction for reducing the likelihood of forbearance and for the effective adoption of
corrective measures by the supervisor, when banks do not meet capital requirements.
It is therefore necessary to establish criteria for the adoption of corrective measures, to
introduce some automatisms, make the criteria behind supervisory measures more objective and
subject to disclosure and to make use of market discipline. It is paramount to put markets in the
condition to appreciate the actual capital adequacy of banks: effectiveness and reliability of banking
supervision will be improved. Paradoxical though it may seem, the most effective way to exercise
supervisory discretion is for the authority to commit itself to some ex-ante established rule.