## _cr10124

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### Overall Conclusion
- FBAs are conducting a high quality implementation of the advanced approaches for core banks.
- Skills and resources being brought to bear are "impressive and substantial."
- Inter-agency coordination between the FRB and OCC is "of high quality and a model for other inter-agency endeavors," despite some unresolved inter-agency disagreement in policymaking regarding Basel II.
- Banks face uncertainty about the status of Basel II going forward, including:
  - whether banks will ever be permitted to exit parallel runs or the floors;
  - the extent to which FBAs will use Pillar 2 assessments performed by banks or treat them as compliance exercises;
  - what, if any, of the standardized approach will be implemented.
- Assessment team view: agencies should adopt policies and processes to reduce these uncertainties; FBAs are continuing to work domestically and with the Basel Committee to strengthen the Basel II framework.
- Assessors caution that allowing banks to choose capital regimes beyond Basel II options "may open up arbitrage possibilities" that authorities need to consider.
- Recommendation: FBAs should finalize the rest of their Basel II adoption/implementation process to reduce uncertainty.
- Short-term suggestions (next one to two years):
  - ensure sufficient ongoing resources;
  - conduct cross-system detailed reviews of implementation in various areas;
  - use the Pillar 2 process to enhance capital adequacy assessments by banks.
- Findings cited:
  - No Basel II implementation ratings were assigned as part of the FSAP technical note.
  - Findings for some Core Principles (CPs) in the FSAP are relevant for Basel II implementation and were taken into account in this note.

### Plans and Resources
- Rule adoption and scope:
  - On December 7, 2007, the FBAs issued a final rule (advanced approaches rule) implementing the advanced approaches of the Basel Committee’s Basel II capital adequacy framework.
  - The advanced approaches rule is mandatory for certain banking organizations (core banks) and voluntary for others (opt-in banks). (See 72 FR 69288).
  - Core banks are required to implement the advanced Internal-Ratings Based (AIRB) approach, Advanced Measurement Approach (AMA), and the market risk rule in Pillar 1; they also must implement Pillar 2 and Pillar 3 requirements.
  - Core banks account for a substantial portion of the banking system assets in the United States.
- Threshold criteria for mandatory application:
  - Banks and BHCs are subject to the advanced approaches rule if they meet either of two independent threshold criteria:
    - (i) consolidated total assets of US$250 billion or more; or
    - (ii) consolidated total on-balance sheet foreign exposures of US$10 billion or more,
    - each as reported on the most recent year-end regulatory reports.
  - As at the time of assessment, there are 14 banking groups that meet these core criteria.
  - The advanced approaches rule allows other banks who meet the Basel II qualifying criteria to opt in.
    - FBAs indicated "two to three banks that have indicated their intention to opt in" and "two to three more have expressed an interest in doing so."
  - Each Depository Institution (DI) subsidiary of a core or opt-in bank/BHC is itself required to apply the advanced approaches rule unless specifically exempted by its primary federal supervisor.
- Implementation timing and parallel run:
  - Under the rule, a core bank must plan to complete its parallel run within 36 months of becoming subject to the rule.
    - For the initial group of core banks, this implies beginning parallel run no later than April 2010.
  - After a bank successfully exits its parallel run (which requires approval), the advanced approaches become the formal minimum capital requirements for the bank, subject to floors that are in place for a minimum three-year period.
  - At the time of assessment, one bank had commenced its parallel run period.
  - For the initial group of core banks, adopting implementation plans by October 2009 was implied.
  - Approval is required to exit parallel run and to move between floor stages and to exit the floor period.
- Guidance and related proposals:
  - In July 2008, the FBAs issued qualification guidance addressing systems and processes prior to parallel run, implementation plans, validation, and embedded options/approvals.
  - FBAs also issued guidance on Pillar 2 in 2008.
  - In 2007, FBAs proposed for comment a rule to allow non-mandatory banks to adopt the Basel II standardized approach for credit risk and the basic indicator approach for operational risk; the proposed rule was optional and would permit banks to remain on the current risk-based capital rule (Basel I based).
    - The U.S. proposed standardized approach contained a more granular treatment of residential mortgage exposures based on loan-to-value (LTV) ratio bands; for some LTV ratios, the proposed capital treatment would be higher than under Basel II standardized.
    - The standardized rule remains at the proposal stage; comments have been received but there is no indication of intention as to whether or when the proposal will be adopted.
- Resource commitments and capacity:
  - Assessors saw evidence that material amounts of resources have been deployed; level appears appropriate for mandatory banks.
  - Each of the two main FBAs involved (FRB and OCC) has allocated some five or six FTEs per core bank in implementation efforts.
  - Considerable high-quality expertise in risk quantification and risk analytics is available to the teams.
  - FBAs face a "hump" of assessments (implementation plans, parallel run periods, approvals relating to floor periods) coinciding with continued high supervisory intensity following the financial crisis.
  - FBAs believe efficiencies from experience with initial cases can reduce resource demands, but assessors believe FBAs may be underestimating the resource challenge.
  - Recommendation: In 2010, FBAs should more explicitly consider the likely multi-year resource demands for Basel II implementation and ensure sufficient resources are available.
  - Basel II implementation and Pillar 2 typically require permanent additional supervisory resources; management recognizes ongoing supervisory resources for core banks will have to be higher than pre-Basel II.
  - FBAs tend to use a current year and one-year forward budget process; assessors recommend explicitly accounting—in each budget cycle for the next few years—of resources used in Basel II implementation and assessing adequacy against experience to date.
- Supervision structure and coordination:
  - FBAs have robust plans and processes for oversight of Basel II implementation and qualification, including program managers and dedicated staff.
  - Individuals are responsible for developing and communicating agency supervisory strategies and ensuring consistency across FBAs and firms.
  - Each agency has a well-articulated overall Basel II strategy disseminated to supervisory staff and communicated to relevant banking organizations.
  - At the largest institutions, dedicated staff have developed firm-specific supervisory strategies focusing on implementation status, issues, knowledge gaps, and concerns.
  - High-quality examination documentation requirements ensure examiners address all aspects of the rule and provide a common framework for readiness summaries.
  - FRB and OCC demonstrated a very high degree of cooperation and coordination in implementation efforts; commentators noted these efforts were a model for supervisory cooperation.
  - It will be important to extend this cooperation framework to other FBAs as banks they supervise opt in to advanced approaches.
  - Supervisory on-site teams are responsible for ongoing supervision, including Basel II, and appeared to have skills commensurate with the institutions they supervise; teams are augmented by policy and quantification experts and other specialized staff.
  - Supervisory team leaders view Basel II implementation as a top priority.

Note: This technical note relates to Basel II rules and implementation as they existed at the time of the assessment in October 2009.

### Training and Qualification of Supervisory Staff
- FBAs have developed a comprehensive training program, targeted across skill and experience levels.
- Classes aligned along risk dimensions: high level introductory and overview courses to in-depth and advanced seminars.
- Staff access online training tools covering the breadth of the framework.
- Classroom and individual training augmented by applied workshops pairing risk experts with field staff.
- Ongoing qualification requirements are described in Section 23 of the advanced approaches rule.
- Each agency has developed, or is developing, processes for decisions involved in initial and ongoing qualification; staff are made aware through discussions and training.
- Assessors encourage FBAs to finalize ongoing adjustments in supervisory processes necessitated by Basel II during 2010.

### Supervisory Experience, Challenge, and Due Process
- Supervisors have experience and expertise to analyze bank implementation plans and provide detailed feedback.
- The advanced approaches rule articulates high expectations for implementation plans; qualification guidance addresses implementation plans specifically.
- FBAs reviewed all core banks’ implementation plans and provided detailed feedback; modifications/amendments were often requested and received.
- Assessors were satisfied FBAs could exercise effective challenge of banks’ plans and implementation.
- Due process and review systems:
  - FBAs have processes to review and analyze each banking organization’s implementation during and after parallel run.
  - FBAs provide notice and response opportunities to banks on review results.
  - On-site examination work has been conducted at one banking organization during its parallel run period.
- Ongoing challenges:
  - Ensuring consistency is more challenging as banks are not in parallel run simultaneously.
  - Consistency requires same standards plus processes to enhance confidence that standards and judgments are applied consistently.
  - International experience suggests peer comparison is helpful but more difficult in a sequential process.
  - Constancy of core staff and a strong review process can partially compensate.
- Recommendation: As more Basel II responsibility transfers to on-site teams, FBAs should review internal review and oversight processes to ensure high quality and consistent implementation.
- Banks reported some issues of inconsistency; not out of line with experience elsewhere.
- As other FBAs become more active, links should be built with FRB and OCC to ensure ongoing consistency.

### Capital Definition, Scope of Application, and Consolidation
- U.S. implementation meets consolidation requirements of Basel II or is more conservative in general.
- Advanced approaches rule excludes assets held in an insurance underwriting subsidiary of a BHC from the asset threshold criterion; insurance subsidiaries and their assets must be consolidated for determining BHC risk-weighted assets and capital requirements.
- Statute: assets and liabilities of a financial subsidiary of a DI are not consolidated with those of the DI for risk-based capital purposes; DI must deduct its equity investment in the financial subsidiary from regulatory capital—50 percent from Tier 1 capital and 50 percent from Tier 2 capital.
- BHC generally fully consolidates assets/liabilities of financial subsidiaries of its subsidiary DIs and does not deduct the DI’s equity investments in their financial subsidiaries.
- FRB can exempt any BHC from mandatory application based on asset size, complexity, risk profile, or scope; primary federal supervisor may exempt any DI on same factors.
- To date, no exemptions have been approved across FBAs, though several requested; FBAs advised exemptions would be rare.
- U.S. subsidiaries of foreign banks on Basel II at home are not required to be on Basel II in the United States unless they meet core bank criteria; such subsidiaries may opt in.
- As Basel II standardized and foundation approaches are not available in the United States, subsidiaries of foreign banks use the Basel I-based rule and perform adjustments to calculate Basel II capital at the parent level, often necessitating two capital calculations for the subsidiary.
- Criteria on significant minority interests and consolidations: advanced approaches rule’s consolidation and deduction requirements are substantially consistent with Basel II; departures result in more conservative capital calculation.
- Each DI subsidiary of a core or opt-in bank is required to apply the advanced approaches rule unless specifically exempted.
- Supervisory process expects examiners to evaluate capital separately at the BHC and at each DI in the banking group.
- Public quarterly reporting of capital ratios is required at each DI and the top-tier U.S. banking holding company.
- The U.S. rule requires an Internal Capital Adequacy Assessment Process (ICAAP) at each level in the banking group.

### Quantitative Impact Studies (QIS), Data Collection, and Impact Assessment
- FBAs initiated several QIS prior to implementation.
- A fourth QIS was initiated in 2004 to understand potential effects of Basel II on U.S. institutions.
- Subsequent analysis focused on reasons for reduction and dispersion in minimum risk-based capital requirements: institution risks, data systems readiness, and framework aspects.
- FBAs committed by regulation to undertake a study to evaluate the advanced approaches and determine material deficiencies; an institution would generally not be permitted to exit the third transitional floor period if material deficiencies cannot be addressed.
- FBAs developed extensive supervisory reports to collect data in addition to Pillar 3 disclosures from banking organizations using the advanced approaches.
- Currently, one banking organization is in parallel run and is submitting these reports; a number are expected to follow in 2010.
- Assessors noted considerable high-quality pre-rulemaking work but observed some of it is dated.
- Recent stress conditions highlighted the importance of ensuring data inputs represent economic downturns and supervisory formulas are calibrated appropriately.
- Once multiple banks are in parallel run, FBAs can update impact assessments; such assessment should be possible at year-end 2010 and 2011.
- No aggregate assessment exists of adopting Basel II standardized approaches for smaller banks; if authorities proceed, it would be desirable to perform impact assessments and evaluate potential arbitrage between approaches.
- In 2008, FBAs participated in an Operational Risk Loss Data Collection Exercise (LDCE) sponsored by the Basel Committee's Standards Implementation Group; participants included 23 U.S. financial institutions.
- LDCE collects data on individual loss events and loss scenarios, as well as capital estimates, for benchmarking capital estimates against actual operational risk exposures.

### Capital Definition Specifics and Transitional Allowances
- Tier 1, Tier 2, and total capital are defined in the advanced approaches rule; they incorporate elements of capital and many deductions in the general risk-based capital rules and are generally consistent with paragraph 41 of the New Accord.
- The general risk-based capital rule, and thus the advanced approaches rule, allows certain intangibles to count for a very high portion of Tier 1 capital.
- Additionally, until March 31, 2011, banks under the advanced approaches rule are allowed to continue to have up to 25 percent of their Tier 1 capital in so-called innovative or hybrid instruments, compared to the international standard of 15 percent.

### Standardized Approach to Credit Risk
- The standardized approach is not currently allowed in the United States.
- A 2006 proposal would implement the standardized approach optionally for banks not subject to the advanced approaches; the proposal has not been finalized.
- FBAs advised they are developing another version of the standardized approach for public comment.
- Assessment found the proposed standardized approach consistent with the New Accord and more conservative in some respects.
- Material difference: proposal’s treatment of residential mortgages is based on LTV ratios, with risk weights ranging from 20 percent to 150 percent depending on LTV.
- As proposed, significantly more mortgages would receive a higher than 35 percent risk weight than under the New Accord; FBAs believe the wider range is more risk sensitive and conservative; assessors support this approach.
- U.S. proposal is more conservative than the Accord in national discretion items related to retail exposures and commercial real estate:
  - For retail exposures other than residential mortgages, a 75 percent risk weight would be assigned only where such exposures do not exceed US$1.0 million and where the exposure is part of a well-diversified portfolio.
  - The proposal sought public comment on appropriate measures of concentration for regulatory retail portfolios.
  - Commercial real estate exposures would not be eligible for a 50 percent risk weight.
- U.S. continuous supervision approach should be relatively easy to adapt to implementation of the standardized approach, if decided.
- Certain supervisory/reporting/off-site analysis adjustments will be needed to verify periodic appropriateness of institutions’ use of credit risk mitigation techniques not currently permitted.
- If the standardized approach proceeds on an optional basis, authorities should consider cherry-picking opportunities (e.g., banks with mortgage exposures choosing regimes based on asset treatment).

### Internal Ratings-Based (IRB) Approach to Credit Risk
- Advanced approaches rule does not deviate materially from Basel II; national discretion choices are few and generally more conservative.
- Approval requirements to exit parallel run or move between floors afford ample opportunity for FBAs to assess IRB in practice.
- FBAs developed ongoing processes to verify bank compliance with AIRB requirements established by the advanced approaches rule.
- Goals: ensure at each stage and on an ongoing basis that the bank meets rule requirements, systems work as intended, and bank is prepared before moving phases.
- Review process includes:
  - reports by validation groups and internal audits within the bank;
  - the annual assessment of controls around Basel II presented to the institution’s board of directors;
  - supervisory verification via Basel II-specific and non-Basel II-specific reviews.
- Only one bank in parallel run at assessment time; assessors could not view process fully in practice.

### Supervisory Organization, Qualification, and Reporting (Largest Banking Organizations)
- Supervisory process led by on-site supervisory team and supported by FRB and OCC qualification teams (QTs), policy and quantification resources.
- QTs were developed by FRB and OCC to ensure consistency across the largest core banks; teams cover wholesale, retail, securitization, trading book/counterparty credit risk, Pillar 2, and operational risk and use a standardized supervisory program.
- Ability to file accurate, complete, and timely regulatory reports on advanced approaches calculations is critical to compliance assessment.
- Bank calculation accuracy reviewed through on-site examination work and off-site surveillance based on regulatory reports.
- Observation: Maintaining qualification-period focus is difficult; when more banks enter qualification the United States should develop and communicate more formal expectations for supervisory teams about the extent and nature of high-level and in-depth reviews and their cycle.

### Validation of Models and Supervisory Review
- Validation responsibility lies with banking organizations; FBAs have a robust system for reviewing validation results and commenting when inadequate.
- Advanced approaches rule requires ongoing validation; supervisory review of validation conducted prior to parallel run (if available), during parallel run, and post-parallel run when institution has qualified.
- Review activities: process reviews, material drill-down reviews on selected models, review when significant model changes occur.
- Section 23 of the advanced approaches rule requires institutions to notify FBAs when changes materially affect risk-weighted asset amounts or modeling assumptions.
- Recommendation: FBAs should ensure consistency in expectations among them going forward.
- Supervisors should verify models are actually used by banks in capital planning and risk management, and are not primarily a compliance exercise.

### Use of IRB/AMA Systems in Risk Management and Capital Planning
- Advanced approaches rule requires systems and processes used for risk-based capital to be consistent with a bank’s internal risk management and management information reporting systems.
- Examiners are expected to identify differences between AIRB systems and other internal risk management systems and understand materiality.
- Supervisors expect AIRB and AMA systems to identify, monitor, measure, and control risk at the bank.
- Supervisors should evidence effective internal challenge functions (risk management/internal audit) and supervisory challenge, and articulate strategies for testing rating systems for reasonableness.

### Validation Process Specifics and Downturn Treatment
- Validation must be independent of system development or subjected to independent review; includes conceptual soundness, ongoing monitoring, outcomes analysis, and back-testing.
- Supervisory examination of AIRB ongoing validation includes rating process and parameter estimation, reasonability of rating/segmentation systems, transaction testing, replication testing of ratings, and examination of override experience.
- FBAs verify downturn methodologies; bank approaches generally include statistical tests to identify downturn periods, significant portfolio segmentation, use of internal and external data, back-testing, and validation subject to FBA review.
- Recommendation: FBAs should ensure adequate room for judgment in identifying major portfolios requiring downturn adjustments.

### Advanced Measurement Approach (AMA) for Operational Risk
- A bank must meet an extensive and stringent set of quantitative and qualitative standards to be permitted to use the AMA.
- A bank must satisfy AMA requirements in the advanced approaches rule before qualifying to use the advanced approaches for regulatory capital.
- A bank must meet AMA requirements during the "four (or more) quarters" that make up its parallel run period; as a condition of exiting parallel run, the bank must demonstrate ongoing compliance.
- Supervisors systematically monitored banks' progress on AMA since 2004; FBAs conducted/participated in several operational risk LDCEs, most recent in 2008. The 2008 LDCE collected internal operational loss event data, scenario data, exposure estimates, and range of practice information.
- Supervisors monitor AMA frameworks during and after parallel run to ensure systems estimate unexpected operational losses with reasonable accuracy based on internal/external data, scenario analysis, and bank-specific inputs, and that systems support economic capital allocation across business lines.
- FBAs have staff directly responsible for AMA in each core bank relationship team, AMA quantification experts, and policy experts assisting examinations and interpretative matters.
- The AMA benchmarking process will continue after implementation and guide examiners in ongoing reviews.

### Pillar 2: Supervisory Review Process (ICAAP and Stress Testing)
- Advanced approaches rule requires banking organizations subject to the rule to have an ICAAP; in July 2008 FBAs issued final supervisory guidance describing a satisfactory ICAAP covering Pillar 2’s four elements.
- Guidance emphasizes:
  - sound risk management foundation;
  - estimating capital needs during stress;
  - recognition that certain capital instruments do not absorb losses in stress like common equity;
  - strong corporate governance including validation and internal audit;
  - holding capital buffers above minimum regulatory capital requirements.
- Assessors found the guidance comprehensive but formalized Pillar 2 assessments were not yet available at assessment time.
- Recommendation: FBAs should use the Pillar 2 assessment process as a tool to ensure major banks hold adequate capital and avoid Pillar 2 becoming merely a compliance exercise.
- Recommendation: Conduct cross-system, cross-agency Pillar 2 reviews as soon as sufficient Pillar 2 approaches by banks are available, and at regular intervals (at least annually).
- FBAs expect banks to have a fully-functioning Pillar 2 process before entering parallel run; ongoing capital planning and the SCAP exercise have assisted Pillar 2 development, but assessors noted bank stress testing needs further development.
- Concern: FBAs’ approach may encourage a compliance-oriented Pillar 2 adoption; cross-system reviews should ensure effectiveness.
- Proposed standardized approach lacks well-elaborated Pillar 2 requirement; further guidance needed if standardized approach proceeds.
- Pillar 2 guidance includes risks not in Pillar 1 (interest rate risk in the banking book, credit concentration risk, counterparty credit risk, stress testing); FBAs emphasize stress testing and expect capital buffers above estimated capital needs.

### Pillar 3: Disclosure and Market Discipline
- Pillar 3 fully incorporated into the advanced approaches rule; disclosures in the rule are consistent with Basel II Accord Pillar 3 requirements.
- Each consolidated banking organization (except certain subsidiaries of non-U.S. banking organizations subject to comparable home-country disclosure requirements) is subject to disclosure requirements once they have qualified to use the advanced approaches rule for regulatory capital purposes.
- Disclosures are quarterly; qualitative disclosures that do not typically change each quarter are disclosed annually (unless significant interim changes occur).
- FBAs have not dictated specific location or medium for disclosures.
- Proposed standardized approach: Pillar 3 disclosure requirements are generally consistent with the Basel II Accord.
- The primary FBA determines compliance with Pillar 3 disclosure requirements through ongoing supervision; institutions must have a formal disclosure policy approved by the board addressing internal controls, disclosure controls, and procedures.
- One or more members of senior management must attest that disclosures meet advanced approaches rule requirements.
- It is too early for assessors to observe the disclosure validation process in action; once a significant number of mandatory banks are making Pillar 3 disclosures, FBAs should conduct cross-system, cross-agency reviews of these disclosures and repeat such reviews periodically.

*IMF staff summary extracted from the provided content unit.*

### 1.      As part of the Financial Sector Assessment Program (FSAP) of the United

### _cr10124 - 1.      As part of the Financial Sector Assessment Program (FSAP) of the United

### Overall Conclusion
- The FBAs are conducting a high quality implementation of the advanced approaches for core banks.
- Skills and resources being brought to bear are "impressive and substantial."
- Inter-agency coordination between the FRB and OCC is "of high quality and a model for other inter-agency endeavors," despite some unresolved inter-agency disagreement in policymaking regarding Basel II.
- Banks face uncertainty about the status of Basel II going forward, including:
  - whether banks will ever be permitted to exit parallel runs or the floors;
  - the extent to which FBAs will use Pillar 2 assessments performed by banks or treat them as compliance exercises;
  - what, if any, of the standardized approach will be implemented.
- Assessment team view: agencies should adopt policies and processes to reduce these uncertainties; FBAs are continuing to work domestically and with the Basel Committee to strengthen the Basel II framework.
- Assessors caution that allowing banks to choose capital regimes beyond Basel II options "may open up arbitrage possibilities" that authorities need to consider.
- Recommendation: FBAs should finalize the rest of their Basel II adoption/implementation process to reduce uncertainty.
- The note contains suggestions for the next one to two years to enhance review of progress, including:
  - ensuring sufficient ongoing resources;
  - conducting cross-system detailed reviews of implementation in various areas;
  - using the Pillar 2 process to enhance capital adequacy assessments by banks.

*Findings cited in this section:*
- No Basel II implementation ratings were assigned as part of the FSAP technical note.
- Findings for some Core Principles (CPs) in the FSAP are relevant for Basel II implementation and were taken into account in this note.

### Plans and Resources
- Rule adoption and scope:
  - On December 7, 2007, the FBAs issued a final rule (advanced approaches rule) implementing the advanced approaches of the Basel Committee’s Basel II capital adequacy framework.
  - The advanced approaches rule is mandatory for certain banking organizations (core banks) and voluntary for others (opt-in banks). (See 72 FR 69288).
  - Core banks are required to implement the advanced Internal-Ratings Based (AIRB) approach, Advanced Measurement Approach (AMA), and the market risk rule in Pillar 1; they also must implement Pillar 2 and Pillar 3 requirements.
  - Core banks account for a substantial portion of the banking system assets in the United States.
- Threshold criteria for mandatory application:
  - Banks and BHCs are subject to the advanced approaches rule if they meet either of two independent threshold criteria:
    - (i) consolidated total assets of US$250 billion or more; or
    - (ii) consolidated total on-balance sheet foreign exposures of US$10 billion or more,
    - each as reported on the most recent year-end regulatory reports.
  - As at the time of assessment, there are 14 banking groups that meet these core criteria.
  - The advanced approaches rule allows other banks who meet the Basel II qualifying criteria to opt in.
    - The FBAs indicated that there are "two to three banks that have indicated their intention to opt in" and "two to three more have expressed an interest in doing so."
  - Each Depository Institution (DI) subsidiary of a core or opt-in bank/BHC is itself required to apply the advanced approaches rule unless specifically exempted by its primary federal supervisor.
- Implementation timing and parallel run:
  - Under the rule, a core bank must plan to complete its parallel run within 36 months of becoming subject to the rule.
    - For the initial group of core banks, this implies beginning parallel run no later than April 2010.
  - After a bank successfully exits its parallel run (which requires approval), the advanced approaches become the formal minimum capital requirements for the bank, subject to floors that are in place for a minimum three-year period.
  - At the time of assessment, one bank had commenced its parallel run period.
  - For the initial group of core banks, adopting implementation plans by October 2009 was implied.
  - Approval is required to exit parallel run and to move between floor stages and to exit the floor period.
- Guidance and related proposals:
  - In July 2008, the FBAs issued guidance related to the overall qualification process (qualification guidance) addressing:
    - systems and processes functioning prior to start of parallel run;
    - the need for a robust and dynamic implementation plan as a key communication tool;
    - robust qualitative and quantitative validation;
    - numerous options and approvals embedded in the rule.
  - FBAs also issued guidance on Pillar 2 in 2008.
  - In 2007, the FBAs proposed for comment a rule to allow non-mandatory banks to adopt the Basel II standardized approach for credit risk and the basic indicator approach for operational risk; the proposed rule was optional and would permit banks to remain on the current risk-based capital rule (Basel I based).
    - The U.S. proposed standardized approach contained a more granular treatment of residential mortgage exposures based on loan-to-value (LTV) ratio bands; for some LTV ratios, the proposed capital treatment would be higher than under Basel II standardized.
    - The standardized rule remains at the proposal stage; comments have been received but there is no indication of intention as to whether or when the proposal will be adopted.
- Resource commitments and capacity:
  - Assessors saw evidence that material amounts of resources have been deployed in the implementation effort; the level appears appropriate for mandatory banks.
  - Each of the two main FBAs involved (FRB and OCC) has allocated some five or six FTEs per core bank in implementation efforts.
  - Considerable high-quality expertise in risk quantification and risk analytics is available to the teams.
  - FBAs face a "hump" of assessments (implementation plans, parallel run periods, approvals relating to floor periods) that will coincide with continued high supervisory intensity following the financial crisis.
  - FBAs believe efficiencies from experience with initial cases can reduce resource demands, but assessors believe FBAs may be underestimating the resource challenge.
  - Recommendation: In 2010, FBAs should more explicitly consider the likely multi-year resource demands for Basel II implementation and ensure sufficient resources are available.
  - Basel II implementation and Pillar 2 typically require permanent additional supervisory resources; management recognizes that ongoing supervisory resources for core banks will have to be higher than pre-Basel II.
  - FBAs tend to use a current year and one-year forward budget process; assessors recommend explicitly taking account—in each budget cycle for the next few years—of resources used in Basel II implementation and assessing adequacy against experience to date, based on explicit monitoring of resource implications for supervisory teams and specialist resources.
- Supervision structure and coordination:
  - FBAs have robust plans and processes for oversight of Basel II implementation and qualification, including program managers and dedicated staff.
  - Individuals involved are responsible for developing and communicating agency supervisory strategies and ensuring consistency across FBAs and firms.
  - Each agency has a well-articulated overall Basel II strategy disseminated to supervisory staff and communicated to relevant banking organizations.
  - At the largest institutions, dedicated staff have developed firm-specific supervisory strategies focusing on implementation status, issues, knowledge gaps, and concerns.
  - High-quality examination documentation requirements ensure examiners address all aspects of the rule and provide a common framework for readiness summaries.
  - FBAs involved (FRB and OCC) demonstrated a very high degree of cooperation and coordination in implementation efforts; commentators noted these efforts were a model for supervisory cooperation.
  - It will be important to extend this cooperation framework to other FBAs as banks they supervise opt in to advanced approaches.
  - Supervisory on-site teams are responsible for ongoing supervision, including Basel II, and appeared to have skills commensurate with the institutions they supervise; teams are augmented by policy and quantification experts and other specialized staff.
  - The United States appears to be managing the hand-off and coordination challenge between groups within each FBA well; supervisory team leaders view Basel II implementation as a top priority.

*This technical note relates to Basel II rules and implementation as they existed at the time of the assessment in October 2009.*

### 35.      The FBAs have developed a comprehensive training program, with training

### _cr10124 - 35.      The FBAs have developed a comprehensive training program, with training

### Training and qualification of supervisory staff
- FBAs have developed a comprehensive training program, with training targeted across skill and experience levels.
- Classes are generally aligned along risk dimensions, ranging from high level introductory and overview courses, to in-depth and advanced level seminars.
- Staff within each agency has access to online training tools covering the breadth of the framework.
- Classroom and individual training is in some cases augmented by applied workshops that partner risk experts with field staff to discuss specific institutional issues and challenges, and to share experiences and knowledge across teams and FBAs.
- The ongoing qualification requirements are described in Section 23 of the advanced approaches rule.
- Each agency has developed, or is developing, processes for reaching the numerous decisions involved in initial and ongoing qualification.
- Staff involved with the Basel II qualification decision process is made aware of these processes through discussions and training.
- Assessors encourage FBAs to finalize ongoing adjustments in supervisory processes necessitated by Basel II during 2010.

### Supervisory experience, challenge, and due process
- Criteria: Supervisors should have the experience and expertise to analyze bank plans for Basel II implementation, and effectively challenge them, when appropriate. Assessors should ask for examples of such challenges.
- Staff at each of the FBAs is experienced in reviewing, analyzing, and providing detailed feedback on banking organizations’ draft implementation plans.
- The advanced approaches rule articulates high expectations for implementation plans and is supported by the qualification guidance that includes a section specifically addressing implementation plans.
- The FBAs view the implementation plan as an important benchmark for measuring compliance with the advanced approaches rule.
- To date, the FBAs have reviewed all core banks’ implementation plans and provided detailed feedback on draft implementation plans and gap analyses; in many cases modifications or amendments were requested and received.
- Staff met by assessors demonstrated a high degree of expertise in Basel II and related matters; assessors were satisfied that FBAs were able to exercise effective challenge of banks’ plans and implementation.
- Criteria: Supervisors should have adequate systems to ensure due process, analysis and review of banks’ Basel II options and models, as well as quality control over treatment of banks applications for use of Basel II options and models.
- FBAs have developed processes to review and analyze each banking organization’s implementation of the advanced approaches during and after the parallel run.
- FBAs have due process in place to allow for notice and response to banks of results from review and analysis.
- On-site examination work has been conducted at one banking organization during its parallel run period; staff with appropriate expertise have reviewed each approach subject to approval and provided applicable feedback.
- Assessors are satisfied the FBAs’ approach to ensuring consistency of approach in reviewing implementation plans was effective, while noting ongoing challenges:
  - Ensuring consistency will be more challenging as banks are not in the parallel run period at the same time.
  - Consistency requires not only the same standards, but also processes to enhance confidence that standards and judgments are being applied consistently, and that differences in treatment are commensurate to differences between banks.
  - International experience suggests peer comparison across several banks is helpful but is more difficult in a sequential process.
  - Having constancy of core staff and a strong review process, as the FBAs have, can partially compensate.
- Assessors discussed review processes for supervisory and approval decisions and are satisfied that they are effective and robust.
- As more Basel II responsibility transfers to on-site supervisory teams and continuous supervision, FBAs should review internal review and oversight processes to ensure continued goals for high quality and consistent implementation are met.
- Banks met by the assessment team reported some issues of inconsistency, but these did not seem out of line with experience elsewhere.
- As other FBAs become more active in Basel II implementation, it will be important for links to be built with the FRB and OCC to ensure ongoing consistency.

### Capital definition, scope of application, and consolidation
- Criteria: Supervisors should require the framework to be applied to internationally active banks on a fully consolidated basis consistent with paragraphs 20–39 of the Basel II framework; the consolidation perimeter should include any holding company that is the parent entity in a banking group which includes banking, insurance, and/or other financial subsidiaries.
- In general, U.S. implementation of the advanced approaches rule meets the consolidation requirements of the Basel II Accord, or is more conservative.
- The advanced approaches rule excludes assets held in an insurance underwriting subsidiary of a BHC from the asset threshold criterion because the rule was not designed to address insurance underwriting exposures; however, insurance subsidiaries and their assets must be consolidated for purposes of determining the BHC’s risk-weighted assets and calculating its capital requirements under the advanced approaches rule.
- As required by statute, assets and liabilities of a financial subsidiary of a depository institution (DI) are not consolidated with those of the DI for risk-based capital purposes; moreover, the DI must deduct its equity investment (including retained earnings) in the financial subsidiary from regulatory capital—50 percent from Tier 1 capital and 50 percent from Tier 2 capital. Conversely, a BHC generally fully consolidates the assets and liabilities of financial subsidiaries of its subsidiary DIs, and does not deduct from its regulatory capital the DI’s equity investments in their financial subsidiaries.
- The rule allows the FRB to exempt any BHC from mandatory application of the advanced approaches based on asset size (including subsidiary DI asset size relative to total BHC asset size), level of complexity, risk profile, or scope of operation; similarly, a primary federal supervisor may exempt any DI under its jurisdiction from mandatory application based on the same factors.
- To date, no exemptions from the advanced approaches rule have been approved across the FBAs, but several have been requested; FBAs advised any exemptions would be rare.
- U.S. subsidiaries of foreign banks that are on Basel II in their home country are not required to be on Basel II in the United States, unless the subsidiary meets the criteria for a core bank; such subsidiaries may opt in to the advanced approaches rule, and a few will do so in future.
- As Basel II standardized and foundation approaches are not available in the United States, subsidiaries of foreign banks are using the Basel I-based rule and performing various adjustments to calculate Basel II capital at the parent company level, often necessitating two capital calculations for the subsidiary.
- Criteria: Significant minority interests in these types of financial institutions, as well as significant investments in commercial entities, should be consolidated to the extent envisaged by the framework, and deductions from capital made according to the framework.
- The advanced approaches rule’s consolidation and deduction requirements are substantially consistent with Basel II; departures result in more conservative capital calculation, as noted above.
- Criteria: Supervisors should require application of the framework to any internationally active bank at the sub-group level (paragraph 22).
- Each DI subsidiary of a core or opt-in bank is required to apply the advanced approaches rule unless it receives a specific exemption from its primary federal supervisor.
- Criteria: Supervisors should also be able to demonstrate that they periodically test the adequacy of capital of banks on a stand-alone basis.
- U.S. supervisory process expects examiners to evaluate an institution's capital separately at the BHC and at each DI in the banking group.
- Public quarterly reporting of capital ratios is required at each DI in the banking group, as well as the top-tier U.S. banking holding company.
- The U.S. rule works to require an Internal Capital Adequacy Assessment Process (ICAAP) at each level in the banking group, though the bank-ICAAP can be based on relevant parts of the group-wide ICAAP; assessors were not able to review how the ICAAP assessment within a group works in practice at this stage of implementation.

### Quantitative impact studies (QIS), data collection, and impact assessment
- Criteria: Supervisors should have performed one or more quantitative impact studies (QIS), within or outside the Basel-sponsored framework, to assess the impact of Basel II on banks’ capital adequacy levels; results should have been analyzed in advance of implementation, and thereafter through ongoing analysis during parallel running.
- The FBAs initiated several quantitative impact studies prior to implementation of the advanced approaches rule in the United States.
- A fourth quantitative impact study was initiated in 2004 with the objective of gaining a better understanding of the potential effects of a Basel II risk-based capital regime on U.S institutions.
- Subsequent analytical work focused on identifying the extent to which the reduction and dispersion in minimum risk-based capital requirements indicated by the study reflected the risks facing institutions, differences in the state of institutions’ data systems, and their overall readiness to implement the Basel II framework, as well as aspects of the framework itself that might produce results that did not appropriately reflect underlying risks.
- FBAs committed by regulation to undertake a study to evaluate the advanced approaches and determine if there are any material deficiencies; an institution would generally not be permitted to exit the third transitional floor period if the study determines there are material deficiencies that cannot be addressed by then-existing tools or by amendment to the advanced approaches.
- FBAs developed extensive supervisory reports to collect data in addition to the disclosures required under Pillar 3 from banking organizations using the advanced approaches.
- Currently, one banking organization is in parallel run and is submitting these reports; a number of banking organizations are expected to follow suit in 2010.
- Assessors noted considerable, high-quality work done by FBAs in the period leading up to rulemaking to assess impacts, but observed some of this work is now dated.
- Recent stress conditions have underscored the importance of ensuring data inputs are representative of economic downturns and that supervisory formulas are calibrated appropriately.
- Once a number of banks are in parallel run, FBAs can update their assessment of impacts; such an assessment should be possible at year-end 2010 and 2011.
- There has been no assessment on an aggregate basis of the impact of adopting the Basel II standardized approaches for smaller banks (there were specific analyses of competitive impacts done previously); if authorities proceed to implement the standardized approaches for smaller banks, it would be desirable to perform some assessment of impacts and the possibility for arbitrage between approaches.
- In 2008, the FBAs participated in an Operational Risk Loss Data Collection Exercise (LDCE) sponsored by the Basel Committee's Standards Implementation Group; LDCE participants included 23 U.S. financial institutions.
- The LDCE collects data on individual loss events and loss scenarios, as well as capital estimates, and is being used to benchmark capital estimates to make sure they fully reflect banks' actual operational risk exposures.

### Capital definition specifics and transitional allowances
- Criteria: The capital definition should be set out in regulations, and be consistent with paragraph 41 of the framework. Where supervisors allow the inclusion of non-traditional capital elements, they should satisfy themselves that they meet, in substance, the relevant criteria for inclusion set out in the Basel framework and associated documents.
- Tier 1, Tier 2, and total capital are defined in the advanced approaches rule; they incorporate by reference the elements of capital and many of the deductions in the general risk-based capital rules, and are generally consistent with paragraph 41 of the New Accord.
- As noted in the BCP assessment, the general risk-based capital rule, and thus the advanced approaches rule, allows certain intangibles to count for a very high portion of Tier 1 capital.
- Additionally, until March 31, 2011, banks under the advanced approaches rule are allowed to continue to have up to 25 percent of their Tier 1 capital in so-called innovative or hybrid instruments, compared to the international standard of 15 percent.

### Standardized approach to credit risk
- Criteria: Regulations and a supervisory process should be in place to require banks to meet the requirements and risk weights for calculating capital for credit risk using the standardized approach for individual claims, in a way which is consistent with the Basel II framework. Any differences should reflect a more conservative approach based on local default experiences.
- The standardized approach is not currently allowed in the United States.
- A proposal was made in 2006 to implement the standardized approach on an optional basis for banks not subject to the advanced approaches; the proposal has not been finalized and the status of the proposed rule is not clear.
- FBAs advised they are in the process of developing another version of the standardized approach for public comment.
- The assessment team reviewed the proposed standardized approach at a high level and found it consistent with the New Accord and more conservative in some respects.
- Material difference: the proposal’s treatment of residential mortgages is based on LTV ratios, with risk weights for residential mortgages ranging from 20 percent to 150 percent, depending on the LTV for a given residential mortgage exposure.
- As proposed, significantly more mortgages would receive a higher than 35 percent risk weight than would be the case under the New Accord; FBAs believe the wider range is more risk sensitive and conservative than the single 35 percent risk weight in the New Accord; the assessment team supports this approach.
- The U.S. standardized approach proposal is more conservative than the Accord in treatment of national discretion items related to retail exposures and commercial real estate lending:
  - For retail exposures other than residential mortgages, a 75 percent risk weight would be assigned only where such exposures do not exceed US$1.0 million and where the exposure is part of a well-diversified portfolio.
  - The proposal sought public comment on appropriate measures of concentration for regulatory retail portfolios.
  - Commercial real estate exposures would not be eligible for a 50 percent risk weight.
- The U.S. continuous supervision approach already allows considerable verification of capital position of banks and should be relatively easy to adapt to implementation of the standardized approach, should it be decided to proceed.
- Certain adjustments in supervisory approach/reporting/off-site analysis will be needed to verify, on a periodic basis, the appropriateness of institutions’ use of various credit risk mitigation techniques not currently permitted under risk-based capital rules.
- If authorities proceed with the standardized approach on an optional basis, they should give careful consideration to inherent cherry-picking opportunities (e.g., banks with mortgage exposures could decide whether or not to adopt the new rule based on its treatment of these assets compared to the current risk-based capital rule).

### Internal ratings-based (IRB) approach to credit risk
- Criteria: Supervisors should have an effective process in place for determining that banks are meeting the requirements for calculating capital for credit risk using the internal ratings-based (IRB) Approach, including the mechanics of the IRB Approach; rules for corporate, sovereign, bank, retail, and equity exposures; rules for purchased receivables and treatment of expected losses; and recognition of provisions, consistent with the Basel II framework. To meet the criteria, there are three requirements:
  - (i) the country’s rules must not deviate materially from the framework;
  - (ii) the country must have an effective approach for verifying bank compliance with the rules; and
  - (iii) the country must have an approach for verifying the accuracy of bank calculations.
- The advanced approaches rule does not deviate materially from the Basel II framework; national discretion choices are few and generally result in more conservative capital treatment.
- Approval requirements to exit parallel run or to move between floors in the qualification period afford ample opportunity for FBAs to assess how the IRB is working in practice.
- FBAs have developed an ongoing process to verify bank compliance with the AIRB requirements established by the advanced approaches rule.
- The goal of the process in each FBA is to ensure that, at each stage of implementation and on an ongoing basis, the bank has met the requirements of the advanced approaches rule, has systems that are working as intended, and is fully prepared before moving to the next phase of qualification.
- The review process appears robust and includes:
  - reports by validation groups and internal audits within the bank;
  - the annual assessment of the controls around Basel II that is presented to the institution’s board of directors;
  - supervisory verification in the form of both Basel II-specific and non-Basel II-specific reviews that evaluate whether the bank continues to satisfy the rule requirements.
- As only one bank is now in parallel run, it was not possible for assessors to view this process in practice.

*Source: _cr10124 - 35.      The FBAs have developed a comprehensive training program, with training*

### 77.      At the largest banking organizations, the Basel II process is led by the on-site

### At the largest banking organizations, the Basel II process is led by the on-site supervisory team

### Supervisory organization, qualification, and reporting
- Supervisory process is led by the on-site supervisory team and supported by FRB and OCC qualification teams (QTs), agency policy and quantification resources.
- QTs were developed by the FRB and OCC to ensure consistency across the largest core banks; teams comprise staff from multiple areas covering wholesale, retail, securitization, trading book/counterparty credit risk, Pillar 2, and operational risk and use a standardized supervisory program.
- The ability to file accurate, complete, and timely regulatory reports on advanced approaches calculations is a critical consideration in assessing a bank’s compliance with the qualification requirements.
- Bank calculation accuracy is reviewed through on-site examination work and off-site surveillance based on the regulatory reports.
- Criteria: "Assessors should be satisfied that the supervisor has processes in place for ensuring that the banks meet the appropriate IRB requirements at the outset and on an ongoing basis (paragraph 388), and that the mechanics of computing the IRB numbers meet the specific rules set out in the framework."
- Observations: Maintaining the degree of focus used in the qualification period is difficult; when more banks enter qualification the United States should develop and communicate a more formal expectation for supervisory teams about the extent and nature of high-level and in-depth reviews and their cycle.

### Validation of models and supervisory review
- Criteria: "Assessors should seek evidence from supervisors of a robust system to validate the models and outputs of rating systems at the approval stage and when models are modified."
- Validation is the responsibility of banking organizations; FBAs have a robust system for reviewing validation results and providing comments when validation efforts are inadequate.
- The advanced approaches rule requires ongoing validation of advanced systems; supervisory review of the validation function is conducted prior to parallel run (if available), during parallel run, and post-parallel run when the institution has qualified.
- Review activities include process reviews, material drill-down reviews on selected models, and review when there are significant model changes.
- As required by Section 23 of the advanced approaches rule, institutions must notify the FBAs when changes are made to advanced systems that would result in a material change in the bank’s risk-weighted asset amount for an exposure type, or when the bank makes any significant change to its modeling assumptions.
- Recommendation: FBAs should ensure consistency in expectations among them going forward.
- Criteria: "Supervisors should verify that the IRB (and AMA) models are actually used by the banks in the context of their capital planning and risk management, and are not primarily a compliance exercise."

### Use of IRB/AMA systems in risk management and capital planning
- The advanced approaches rule requires systems and processes used for risk-based capital purposes to be consistent with a bank’s internal risk management processes and management information reporting systems.
- Examiners are expected to identify differences between AIRB systems and other internal risk management systems and to understand the materiality of these differences.
- Supervisors expect use of AIRB and AMA systems to identify, monitor, measure, and control risk at the bank.
- Criteria: "Supervisors should have in place a methodology for satisfying themselves that IRB banks’ own validation processes are robust."
- Supervisors should evidence effective challenge functions exercised by banks internally (e.g., risk management and/or internal audit) and by supervisory authorities, and articulate their strategy for testing rating systems for reasonableness and show how this strategy operates in practice.

### Validation process specifics and downturn treatment
- Advanced approaches rule emphasizes robust validation processes; validation must be independent of system development/implementation or subjected to independent review.
- Validation includes evaluation of conceptual soundness, ongoing monitoring, and outcomes analysis including back-testing.
- Supervisors examine ongoing validation of the AIRB framework, including risk rating process and parameter estimation, reasonability of risk rating/segmentation systems via credit risk management and rating process examination, transaction testing, replication testing of ratings, and examination of override experience.
- Criteria: "Supervisors should be satisfied that AIRB banks have a methodology for the treatment of downturn conditions that is reasonable and prudentially sound, and produces acceptable results in terms of capital held by banks (see paragraph 468 and Basel Committee documents on downturn conditions)."
- FBAs verify downturn methodologies; bank approaches generally include statistical tests to identify downturn periods, significant segmentation of portfolios, use of internal and external data, back-testing, and validation subject to FBA review.
- Recommendation: FBAs should ensure adequate room for judgment in identifying major portfolios requiring downturn adjustments.

### Advanced Measurement Approach (AMA) for operational risk
- Criteria: "A bank must be required to meet an extensive and stringent set of quantitative and qualitative standards to be permitted to use the AMA, and must have monitored the performance of its internal operational risk management for a sufficient period of time before applying the AMA to its operations."
- A banking organization must satisfy AMA requirements in the advanced approaches rule before qualifying to use the advanced approaches to calculate risk-based capital requirements.
- A bank must meet the AMA requirements during the "four (or more) quarters" that make up its parallel run period; as a condition of exiting parallel run, the bank must demonstrate it can meet the criteria on an ongoing basis.
- Supervisors systematically monitored banks' progress on AMA since 2004; FBAs conducted/participated in several operational risk LDCEs, the most recent in 2008. The 2008 LDCE collected internal operational loss event data, scenario data, exposure estimates, and range of practice information.
- Criteria: "A bank’s AMA should be subject to a period of initial monitoring by its supervisors before it can be used for regulatory purposes."
- Supervisors monitor AMA frameworks during and after parallel run to ensure systems estimate unexpected operational losses with reasonable accuracy based on internal and external data, scenario analysis, and bank-specific inputs, and that systems support economic capital allocation across business lines.
- Criteria: "Depending on the operational risk variants used by banks in their jurisdiction, supervisors must have a sufficient number of staff adequately trained in operational risk approaches and must also have a process that allows them to assess on an ongoing basis whether banks continue to meet the quantitative and qualitative standards for application of the AMA."
- FBAs have staff directly responsible for AMA in each core bank relationship team, AMA quantification experts, and policy experts assisting examinations and interpretative matters.
- The AMA benchmarking process will continue after implementation and guide examiners in ongoing reviews.

### Pillar 2: Supervisory review process (ICAAP and stress testing)
- Criteria: "Supervisors should have appropriate processes, evidenced by plans and actions, for review of bank processes to assess capital adequacy, risk positions, and quality of capital held. These reviews should cover the four elements referred to in this Principle (adequacy of risk assessment, assessment of capital adequacy, assessment of control environment, compliance with minimum standards)."
- The advanced approaches rule requires banking organizations subject to the rule to have an ICAAP; in July 2008 FBAs issued final supervisory guidance describing a satisfactory ICAAP covering the four elements of Pillar 2.
- Guidance emphasizes a sound underlying risk management foundation, estimating capital needs during stress, recognition that certain capital instruments do not absorb losses in stress like common equity, strong corporate governance including validation and internal audit, and holding capital buffers above minimum regulatory capital requirements.
- Assessors found the guidance comprehensive but noted formalized Pillar 2 assessments were not yet available at assessment time.
- Recommendation: FBAs should use the Pillar 2 assessment process as a tool to ensure major banks hold adequate capital and to avoid Pillar 2 becoming merely a compliance exercise.
- Recommendation: Conduct cross-system, cross-agency Pillar 2 reviews as soon as sufficient Pillar 2 approaches by banks are available, and at regular intervals (at least annually).
- FBAs expect banks to have a fully-functioning Pillar 2 process before entering parallel run; ongoing capital planning and the SCAP exercise have assisted Pillar 2 development, but assessors noted bank stress testing needs further development.
- Concern: FBAs’ approach may encourage a more compliance-oriented Pillar 2 adoption; FBAs should take stock of implementation and use cross-system reviews to ensure effectiveness.
- Standardized approach: proposed rule does not contain a well-elaborated Pillar 2 requirement; further Pillar 2 guidance would be required if standardized approach proceeds, particularly for small and medium-size banks.
- Criteria: "Supervisors should be able to demonstrate how banks are required to manage important risks not directly addressed in Pillar 1."
- Pillar 2 guidance includes risks not in Pillar 1 (interest rate risk in the banking book, credit concentration risk, counterparty credit risk, stress testing); FBAs place particular emphasis on risk concentrations (single-name and sectoral/geographic) and cross-risk concentrations.
- FBAs emphasize stress testing as integral to assessing overall capital adequacy and expect capital buffers above estimated capital needs due to inherent uncertainty.

### Pillar 3: Disclosure and market discipline
- Criteria: "Supervisors should be able to demonstrate to assessors that rules have been put in place, not necessarily by the regulator, to require banks to make qualitative and quantitative Pillar 3 disclosures with at least the minimum frequency..."
- Pillar 3 has been fully incorporated into the advanced approaches rule; disclosures in the rule are consistent with Basel II Accord Pillar 3 requirements.
- Each consolidated banking organization (except certain subsidiaries of non-U.S. banking organizations subject to comparable home-country disclosure requirements) is subject to disclosure requirements once they have qualified to use the advanced approaches rule for regulatory capital purposes.
- Disclosures are quarterly; qualitative disclosures that do not typically change each quarter are disclosed annually (provided significant interim changes are disclosed).
- FBAs have not dictated specific location or medium for disclosures.
- Proposed standardized approach: Pillar 3 disclosure requirements are generally consistent with the Basel II Accord.
- Criteria: "Supervisors should have a periodic process in place to satisfy themselves that they, or qualified third parties, validate the comprehensiveness and accuracy of bank disclosures relative to Pillar 3 standards, and that banks are provided with any appropriate feedback."
- The primary FBA determines compliance with Pillar 3 disclosure requirements through ongoing supervision; institutions must have a formal disclosure policy approved by the board addressing internal controls, disclosure controls, and procedures.
- One or more members of senior management must attest that disclosures meet advanced approaches rule requirements.
- It is too early for assessors to observe this process in action; once a significant number of mandatory banks are making Pillar 3 disclosures, FBAs should conduct a cross-system, cross-agency review of these disclosures and repeat such reviews from time to time.

*IMF staff summary extracted from the provided content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10124.pdf_