The underlying intent of the Supervisory Review Process in Pillar 2 of the new Basel Framework is to promote and support a more rigorous process in banks for determining the adequacy of the actual capital held and to make this process subject to a somewhat more focused supervisory review. Pillar 2 requires SAMA to satisfy itself as to the appropriateness of banks capital adequacy assessment processes and the adequacy of capital and to intervene, if appropriate, under the authority of the Banking Control Law. Where SAMA determine there are weaknesses in the banks’ internal capital adequacy assessment processes and strategies, SAMA will require that they be remedied. SAMA will not necessarily require additional capital; however, increased capital might be used as a measure including other measures to improve the banks’ position.

Pillar 1 defines the minimum capital requirements for Banks operating Saudi Arabia. Banks face risks not explicitly included under Pillar 1 and many banks’ choose to operate at capital levels above those implied by Pillar 1 minimums. Pillar 2 thus expresses an expectation that all banks should operate above the Pillar 1 minimum.

Saudi banks are expected to conduct their own internal capital adequacy assessment process and establish their own internal target capital levels taking account of their risk profile and capital strategy. SAMA supervisory staff will assess whether such capital adequacy assessment processes and internal target capital levels are commensurate with the banks’ risk profiles. There is no single correct approach to a capital adequacy assessment process; the expectation is that a bank conducts its assessment in a comprehensive, well thought out manner. An economic capital model is not required; however, it is one option available to help more complex banks’ develop their judgment in support of their capital adequacy assessment process. Judgment continues to be important in this process and banks’ are expected to ensure that its use is adequately recorded and documented. While the approaches may vary from bank to bank, it is expected that all material risks to the bank and its subsidiaries would be considered and that the approach would have integrity. SAMA anticipates initially that internal banks’ practices, procedures and systems to establish an internal target would vary depending on the complexity and range of business. It is expected banks would use appropriate stress and scenario testing to determine for them the level of capital necessary to mitigate the risk. While a bank may employ an economic capital model to set its own internal target, SAMA does not expect to employ an explicit model approval process under Pillar 2.

The level of sophistication in internal assessments of target capital levels for small domestic banks should be commensurate with the more focused and less complex nature of their business. Many of these banks’ will likely continue to be constrained by the assets-to-capital multiple. Therefore, their internal capital assessments may be materially simpler although they will need to demonstrate that they have analyzed the risks not covered by Pillar 1 and those risks are adequately covered by a reasonable cushion above the minimum.

A foreign banks’ branch may be able to employ the methodology used by its parent bank. However, the foreign banks’ branch would be responsible for explaining how the data and methodology have been modified to reflect its business strategy and the risks to which it is exposed in Saudi Arabia.

The capital ratio itself is an important factor in the SAMA's assessment of capital, but it is not the only factor. Assessment criteria include, for example: the quality of capital; the adequacy of capital to support the bank business plans and risk profile; the ability to access capital at reasonable rates to meet projected needs; and the strength of the bank’s capital management processes. Trends and the outlook regarding a company’s capital and earnings are also relevant in assessing the adequacy of a company’s current capital position. The various factors should all be considered in the context of the nature, scope, complexity and risk profile of the particular bank.

SAMA expects banks’ capital processes to encompass all major Pillar 1 and Pillar 2 risks and related risk mitigants to estimate a target capital level or range. It is expected that all banks will take a view on the level of additional capital to be provided for Pillar 1 risks beyond the Basel II calculations. The banks are expected to demonstrate the adequacy of the process and the methodology to SAMA. SAMA will make an independent assessment to arrive at additional capital for each bank.

SAMA will also consider information from a bank’s own internal assessments of risk or individual risks in its assessment of target capital levels; and evaluate how relevant and comprehensive a bank internal stress testing is, based on the nature of its risk-taking activities. SAMA expects the rating criteria will not become a formula-driven process of add-ons. Expert judgment will continue to be necessary for operationalizing the assessment criteria and integrate those results into the overall assessment.