Basel III, Pillar 2: the role of banks’ internal control systems

Analysis of the financial crisis has revealed not only major market and regulatory failures, but also shortcomings in supervisory approaches and in banks’ systems of internal and external controls. These failures and shortcomings played a significant role in the origin and evolution of the crisis. In some important cases, the crisis revealed that banks’ internal governance, and their internal control functions in particular, were ineffective or even unsuitable when faced with the demands of overseeing the growing levels of risk undertaken by intermediaries, and especially the interrelations between these exposures. The aim of this chapter is to investigate banks’ internal control functions, as a part of internal governance, in the light of the crisis and the subsequent regulatory and supervisory measures, first and foremost Basel 3. Ai nostri fini “internal controls” is used with its extensive meaning, comprendendo anche the risk mangement function mainly in the two phases of assesment and identification of risks.. Therefore “internal control system” comprende: risk management, internal audit, compliance and risk control. L’analisi affronterà anche alcuni aspetti della corporate governance since internal control systems are considered part of the internal governance., The main research question is related to the implications of the crisis, the regulatory innovations now being implemented, and the changes in supervisory policies and practices, for banks’ internal control systems. The first step will be to survey internal control systems, ICS, within the regulatory and supervisory context at the international level. Given the role of internal control functions in risk-based supervision, it is important to investigate the exact relationship between supervisor and supervised as defined by Basel 3, Pillar 2, with regard to ICAAP and SREP.This will be followed by an investigation of the main regulatory failings and supervisory shortcomings which played a key role in the origin and evolution of the crisis, to identify the extent to which banks’ internal control functions can be blamed for the events which unfolded. In some cases the quality of these control functions, and the supervisory procedures adopted, made the crucial difference in terms of the impact of the crisis. The next topic to be examined will be the changes now being made at the international level to both regulation and the supervisory function, with specific reference to the European Union and the new supervisory pan-European architecture based on macro-prudential supervision and micro-prudential supervison, introduced in 2011. These changes are the outcome of the failures and shortcomings that emerged during the crisis. Within the framework being formed by Basel 3, points will be identified for comment and evaluation concerning the implications for internal governance and internal controls, in the context of the risk-based approach and Pillar 2. Attention will be focused in particular on the role of internal control functions in overseeing banks’ risk exposure, since it was these functions’ inability to monitor the ever-increasing risks undertaken, and their failure to consider or even understand the interrelations between them and thus their combined weight in a firm-wide perspective, that prevented them from providing effective protection against excessive levels of risk.