Supervisory Review Process (Pillar 2)

The Supervisory Review Process (SRP), commonly referred to as Pillar 2, is a core component of the international banking regulatory framework aimed at strengthening the safety and soundness of banks. Alongside minimum capital requirements (Pillar 1) and market discipline (Pillar 3), Pillar 2 focuses on supervisory oversight and internal risk management practices of banks. In the Indian economy, the Supervisory Review Process plays a vital role in maintaining financial stability, ensuring prudent banking behaviour, and supporting sustainable economic growth.
Pillar 2 recognises that not all risks faced by banks can be adequately captured through standardised capital formulas. It therefore emphasises qualitative supervision, internal assessment, and regulatory intervention where necessary.

Concept and Meaning of the Supervisory Review Process

The Supervisory Review Process is a regulatory mechanism through which banking supervisors evaluate whether banks have adequate capital to support all material risks inherent in their operations. It goes beyond numerical capital ratios to assess the overall risk profile, governance standards, and risk management systems of banks.
Under Pillar 2, banks are required to conduct an Internal Capital Adequacy Assessment Process (ICAAP), through which they assess their capital needs in relation to their risk exposure and business strategy. Supervisors then review and evaluate these assessments to determine whether additional capital or corrective measures are required.

Pillar 2 within the Basel Framework

Pillar 2 forms an integral part of the Basel regulatory framework developed by international banking authorities to promote global financial stability. While Pillar 1 prescribes minimum capital requirements for credit, market, and operational risks, Pillar 2 addresses risks that are either difficult to quantify or not fully covered under Pillar 1.
These risks include:

• Interest rate risk in the banking book
• Liquidity risk
• Concentration risk
• Strategic and reputational risk
• Governance and internal control weaknesses

By addressing such risks, Pillar 2 ensures a more comprehensive approach to bank supervision.

Regulatory Framework in India

In India, the implementation of the Supervisory Review Process is overseen by the Reserve Bank of India, which acts as the primary banking regulator. The RBI has issued detailed guidelines requiring banks to implement ICAAP and subject themselves to supervisory evaluation.
Indian banks are expected to:

• Identify all material risks they face
• Assess capital adequacy under normal and stressed conditions
• Integrate risk management with strategic planning
• Maintain capital buffers above regulatory minimums

The RBI uses the SRP to ensure that banks remain resilient under adverse economic conditions.

Internal Capital Adequacy Assessment Process (ICAAP)

ICAAP is the cornerstone of Pillar 2 implementation at the bank level. It requires banks to adopt a forward-looking approach to capital planning rather than relying solely on regulatory minima.
Key elements of ICAAP include:

• Comprehensive risk identification
• Stress testing and scenario analysis
• Capital planning aligned with business growth
• Board and senior management oversight

In the Indian context, ICAAP has improved accountability and strengthened the role of bank boards in risk governance.

Role of Supervisory Authorities

Under Pillar 2, supervisory authorities are empowered to review, evaluate, and intervene in bank operations where necessary. Supervisors assess the adequacy of a bank’s ICAAP and its ability to manage risks effectively.
Supervisory actions may include:

• Requiring additional capital buffers
• Mandating improvements in risk management systems
• Restricting certain business activities
• Enhancing supervisory monitoring

This proactive approach helps prevent the build-up of systemic risks within the banking system.

Importance for Indian Banks

For Indian banks, Pillar 2 has significant implications for capital management and strategic decision-making. Banks with higher risk profiles or weaker controls may be required to hold capital above minimum regulatory levels.
The process:

• Encourages prudent risk-taking
• Discourages excessive leverage and concentration
• Promotes long-term financial stability

Public sector banks, private banks, and foreign banks operating in India are all subject to the Supervisory Review Process, ensuring uniform regulatory standards.

Impact on Financial Stability

At the macroeconomic level, Pillar 2 strengthens the resilience of the Indian banking system. By ensuring that banks maintain adequate capital buffers, it reduces the probability of bank failures and systemic crises.
The broader benefits include:

• Improved depositor and investor confidence
• Stable credit flow to productive sectors
• Reduced fiscal burden from bank bailouts

These outcomes are crucial for sustaining economic growth and protecting financial stability in a developing economy like India.

Pillar 2 and Risk-Based Supervision

The Supervisory Review Process supports the transition towards risk-based supervision in India. Rather than adopting a one-size-fits-all approach, regulators tailor supervisory intensity based on the risk profile of individual banks.
This approach:

• Improves regulatory efficiency
• Focuses resources on high-risk institutions
• Encourages continuous improvement in risk management

Risk-based supervision under Pillar 2 has become increasingly relevant as Indian banks expand into complex financial products and markets.

Challenges in Implementation

Despite its benefits, the implementation of Pillar 2 poses challenges. Smaller banks may face difficulties in developing sophisticated risk assessment models and conducting comprehensive stress tests. Ensuring consistency and comparability across banks also remains a regulatory challenge.
Additionally, Pillar 2 relies heavily on supervisory judgement, which requires strong institutional capacity and skilled regulators to avoid regulatory arbitrage or inconsistency.