The Pillar 2 capital requirement is an amount of capital, set individually for each bank by its supervisor, that the bank must hold in addition to the common minimums. It addresses risks that the standard formulas of the Pillar 1 capital requirement either leave out or underestimate for that particular institution. Where Pillar 1 applies the same rules to all, Pillar 2 is tailored: two banks of similar size can receive quite different requirements depending on their business model, risk profile and quality of management.
Pillar 2 is the second of the three pillars of the Basel framework, known as the supervisory review process. It rests on two activities: the bank's own assessment of the capital it needs, and the supervisor's review of that assessment and of the bank as a whole. The capital add-on is the most visible outcome, but supervisors may also respond with qualitative measures such as demands to strengthen controls or reduce particular exposures.
Risks covered
Pillar 2 deals with two kinds of gap. The first is risk that Pillar 1 does not address at all. The main examples are interest rate risk in the banking book, concentration of lending in single borrowers, sectors or regions, pension obligation risk, and business model and strategic risk. The second is risk that Pillar 1 covers in principle but may understate for a given bank, for instance where a standardised risk weight is too low for an unusual portfolio, where an internal model has known deficiencies, or where operational and conduct losses have been heavy.
Weaknesses in governance and internal control can also lead to an add-on, on the reasoning that a poorly controlled bank is more likely to suffer unexpected losses of every kind.
The bank's own assessment
Each bank must carry out an internal capital adequacy assessment process, usually abbreviated ICAAP. In it, the bank identifies all its material risks, estimates the capital needed to cover them using its own methods, projects its capital position over several years under baseline and stressed conditions, and explains how it would respond to a shortfall. The board must approve the document, and the bank is expected to use it in running the business, including in setting its risk appetite. A parallel assessment covers liquidity.
Supervisory review
The supervisor then forms its own view. In the European Union this is done through the Supervisory Review and Evaluation Process, carried out annually for significant banks by the European Central Bank and for others by national authorities, following guidelines from the European Banking Authority. Supervisors assess the business model, governance and risk management, risks to capital, and risks to liquidity, assign scores, and decide on capital and other measures.
The European framework divides the capital outcome into two parts:
- Pillar 2 requirement (P2R). A legally binding requirement covering risks underestimated or not covered by Pillar 1. It sits directly on top of the Pillar 1 minimum, and a breach has the same legal consequences. It must be met with capital of at least the same quality mix as Pillar 1, so that a minimum of 56.25 per cent is Common Equity Tier 1.
- Pillar 2 guidance (P2G). A non-binding expectation indicating the capital a bank should hold to withstand stress, informed by supervisory stress tests. It sits above the combined buffer, and falling below it leads to closer supervision rather than automatic restrictions.
Place in the capital stack
A bank's overall requirement is built in layers. At the bottom is the 8 per cent Pillar 1 minimum. The Pillar 2 requirement is added to give the total supervisory requirement. Above that comes the combined buffer requirement, comprising the capital conservation buffer, any countercyclical capital buffer and buffers for systemic importance such as the systemic risk buffer. The point at which a bank must restrict dividends, bonuses and coupons on capital instruments therefore depends partly on its Pillar 2 requirement. Guidance sits at the top.
Requirements under Pillar 2 are also inputs to the loss-absorbing capacity that resolution authorities require under the minimum requirement for own funds and eligible liabilities.
Practice in other jurisdictions
The United Kingdom's Prudential Regulation Authority uses the terms Pillar 2A for the binding requirement covering risks not captured by Pillar 1, and PRA buffer, formerly Pillar 2B, for an additional firm-specific amount covering stress and governance weaknesses. It publishes its methodologies for the main Pillar 2A risks. In the United States there is no separately labelled Pillar 2 add-on; the largest banks are instead subject to a stress capital buffer derived from the Federal Reserve's annual stress test, which performs a similar function.
Transparency and criticism
Pillar 2 decisions were for many years confidential. Since 2020 the European Central Bank has published the Pillar 2 requirement of each bank it supervises, and banks disclose it to investors because it affects the threshold for distribution restrictions; guidance is generally not published bank by bank. Critics note that the process relies on supervisory judgement, which makes outcomes hard to predict or compare and may differ between supervisors, and that it can overlap with buffers intended to cover similar risks. Its defenders regard that flexibility as the purpose of the pillar, since no formula can anticipate every bank's risks.