Keywords: Basel II, Second pillar, supervision, systemic financial institutions, stress tests
The paper focuses on Basel 2's Second Pillar, showing how the shortcomings of its design crucially render the whole framework ineffective. Although a principlesbased regulation gives ample discretionary powers to supervisory authorities, a regulatory methodology based on fine measurement of risks is not consistent with an arms-length supervision. Supervisors are inevitably captured by industry's practices and evaluations, especially those of large and complex financial institutions. Furthermore, stress testing aimed at capturing really extreme events would rise regulatory costs without significantly increasing systemic resilience and would make the international level playing field disappear.