Pillar 2 (Supervisory Review)
Pillar 2, known as the Supervisory Review Process, is a core component of the Basel regulatory framework for banking supervision. It complements minimum capital requirements by emphasising the role of regulators in assessing banks’ internal risk management systems, capital adequacy, and overall financial resilience. In the Indian context, Pillar 2 plays a crucial role in strengthening banking stability, enhancing risk governance, and safeguarding the broader financial system, especially in a complex and evolving economic environment.
Conceptual Framework of Pillar 2
Pillar 2 is designed to ensure that banks maintain adequate capital not only for risks explicitly covered under minimum capital norms but also for additional risks that may not be fully captured under standardised regulatory formulas. It focuses on supervisory judgment, forward-looking assessment, and the quality of internal risk management processes within banks.
Under Pillar 2, banks are required to implement an Internal Capital Adequacy Assessment Process (ICAAP). This process enables banks to assess their overall capital needs in relation to their risk profile and business strategy. Supervisors, in turn, evaluate the robustness of ICAAP through the Supervisory Review and Evaluation Process (SREP), allowing them to intervene when capital levels or risk management practices are deemed inadequate.
Objectives of the Supervisory Review Process
The primary objectives of Pillar 2 are to promote sound risk management, ensure adequate capital buffers, and encourage banks to adopt a comprehensive approach to risk identification and control. It aims to:
- Ensure that banks hold capital commensurate with their entire risk profile
- Encourage improvements in governance, internal controls, and risk culture
- Enable early supervisory intervention to prevent financial distress
- Strengthen systemic stability and depositor confidence
These objectives reflect a shift from rule-based supervision to risk-based and judgment-driven oversight.
Types of Risks Addressed Under Pillar 2
Pillar 2 extends beyond credit, market, and operational risks covered under minimum capital requirements. It includes risks such as interest rate risk in the banking book, liquidity risk, concentration risk, strategic risk, reputational risk, and model risk. In the Indian banking system, exposure to sectors such as infrastructure, agriculture, and small enterprises increases the relevance of concentration and credit cycle risks.
By requiring banks to assess these risks internally and hold additional capital where necessary, Pillar 2 addresses gaps that could otherwise threaten financial stability.
Role of the Reserve Bank of India
The implementation of Pillar 2 in India is overseen by the Reserve Bank of India, which acts as both regulator and supervisor of the banking system. The Reserve Bank evaluates banks’ ICAAP frameworks, governance structures, stress-testing practices, and risk appetite statements.
Based on supervisory assessments, the RBI may require banks to maintain capital levels above the regulatory minimum, impose corrective measures, or strengthen internal controls. This discretionary power is essential in addressing institution-specific vulnerabilities and systemic risks within the Indian financial system.
Pillar 2 and the Indian Banking Sector
Pillar 2 has particular significance for India due to the dominance of public sector banks, historical issues related to asset quality, and exposure to macroeconomic fluctuations. The supervisory review process has been instrumental in identifying weaknesses in credit appraisal, risk concentration, and governance practices, especially during periods of rising non-performing assets.
By emphasising stress testing and forward-looking assessments, Pillar 2 enables supervisors to evaluate how banks would respond to adverse economic scenarios such as growth slowdowns, interest rate shocks, or sectoral stress. This approach supports proactive supervision rather than reactive crisis management.
Implications for Financial Stability and the Economy
At the macroeconomic level, Pillar 2 contributes to financial stability by reducing the probability and severity of banking crises. Well-capitalised and well-supervised banks are better positioned to absorb shocks and continue lending during economic downturns, supporting growth and employment.
For the Indian economy, effective supervisory review helps maintain confidence in the banking system, protects depositors, and ensures efficient financial intermediation. It also aligns Indian banking regulation with international standards developed under the aegis of the Bank for International Settlements, enhancing the credibility of India’s financial system in global markets.
Challenges and Criticism
Despite its benefits, Pillar 2 faces several challenges in implementation. Supervisory assessments involve a degree of subjectivity, which can lead to inconsistency across institutions. Banks may also find ICAAP processes complex and resource-intensive, particularly smaller institutions with limited technical capacity.
In the Indian context, balancing supervisory rigor with the developmental role of banks remains a key challenge. Excessively conservative capital requirements under Pillar 2 could constrain credit growth, while insufficient supervision may increase systemic risk.