During the third quarter of 2015, the Prudential Regulation Authority (PRA) set out Supervisory1 and Policy statements2 outlining the new capital framework and Pillar 2 (P2) methodologies that would be rolled out across PRA regulated firms. As of January 2016,3 supervisory teams have adopted the new capital framework and methodologies for their Supervisory Review and Evaluation Processes (SREPs) when assessing and setting Individual Capital Guidance (ICG).
The PRA has been transparent as to the methodologies used in calculating Pillar 2A (P2A) and 2B (P2B) when setting an ICG for firms in order to attain consistent outcomes across peers.4 Where appropriate, we have seen the PRA set an ICG across peer groups in the same period in order to provide further consistency from a timing perspective. This approach has already been adopted by the major UK depositors.
The prudential intention of the capital framework remains unchanged; and thus the PRA expects firms to comply with Capital Requirements Regulation and Directive (CRR/CRD IV) and hold adequate capital to support their business risks. They also expect firms to have appropriate risk management, monitoring, controls and governance in place.
The capital framework focuses on the same risks as previous SREPs; however the new methodologies for credit concentration risk and operational risk appear to provide punitive results for P2A capital add-ons. We have seen this lead to higher ICGs.
- Credit Concentration Risk: Though spelled out in policy, the use of the Herfindahl-Hirschman Index (HHI) methodology, adopted for credit concentration risk, penalizes firms whose business models cater to a particular business segment (e.g. broker/dealer model). The affected firms may face high single name counterparty exposure, sector or geographic concentrations, these concentrations may result in a punitive P2A add-on.
- Possible mitigants: development/improvement of credit risk appetite and control framework; business model evolution; exposure reduction or diversification.
- Operational Risk: A capital range tool has been developed to help guide supervisory teams in assessing the P2 add-on. The inputs include: internal and external loss data, loss appetite, loss scenarios and conduct risk losses. For firms that experienced significant historical operational/conduct risk losses, the tool could provide a significant range for the P2A capital add-on for the operational risk charge.
- Possible mitigants: development/improvement of operational risk framework and management systems/unauthorized trading controls; seamless front to back systems reducing operational errors; obtaining an Advance Model Approach (AMA) model.
The new methodology and approach could be seen as prescriptive, however supervisory judgement of the firm’s Internal Capital Adequacy Assessment Process (ICAAP) assessment is pivotal. A well-crafted ICAAP and proactive involvement in the SREP can provide evidence that could differentiate the firm in terms of risk appetite, mitigants, risk management, controls and governance.
Pillar 2A Methodologies5
The PRA has been transparent with its P2A methodologies for assessing risks that are not appropriately captured in P1. The main drivers are outlined below:
- Credit Risk
- The PRA has adopted an “over and under” methodology where excesses and shortfalls of the Standardized Approach (SA) against the institutional review board (IRB) benchmark for different loan portfolios can be offset.
- As a result of the “over and under” methodology, relatively few firms will receive a credit risk add-on. However, firms which hold significant exposures to sovereigns, high loan-to-value (LTV) mortgages, credit cards and commercial real estate are more likely to be assessed for a credit risk P2 add-on.
- Market Risk
- The PRA assesses the firms illiquid risks (illiquid, one-way and concentrated positions) by reviewing risk identification, stress testing and design, risk mitigation and tail risk.
- In addition to the risk measurement assessment, the PRA will assess the market risk systems and controls in considering a P2 add-on.
- Operational Risk
- For category 1 firms,6 the PRA has adopted a capital range tool which uses a firm’s historical loss (conduct and operational risk losses), loss appetite and loss scenario data in calculating a range for the Pillar 2 capital add-on.
- This approach has been adopted by the PRA with the aim of applying a fair and consistent treatment across peers. We have observed that a firm’s assessment and supervisory judgement are important in determining the final add-on in reference to the range calculated by the tool.
- Counterparty Credit Risk (CCR)
- Firms with material derivatives, margin lending, securities lending, repurchase and reverse repurchase or long settlement transaction businesses would be relevant to CCR.7
- The PRA methodology for CCR has not changed and focuses on wrong-way risk, settlement risk and collateral management.
- Credit Concentration Risk
- The HHI methodology approach has been adopted for calculating credit concentration risk measure for all portfolios (single name, sector and geography). To map into the HHI table, the PRA uses different methodologies for single name and sector/geographic concentrations:
- For single name concentration, the Gordy-Lütkebohmert (GL) methodology is used to quantify the single name risk in a portfolio to suggest a capital add-on.
- For sector and geographic credit concentration risk the PRA uses published multi-factor capital methodologies such as Düllmann and Masschelein.
- The HHI is a new methodology for credit concentration risk; firms whose business models cater to a particular business segment such as financials (broker/dealer business model), may face significant P2 add-ons.
- Interest Risk on the Banking Book (IRRBB)8
- Large or complex IRRBB risk firms are subject to a comprehensive risk assessment for IRRBB. There have been no significant changes to the methodology.9
- Pension Obligation Risk
- Risks related to defined benefit pension schemes and defined contribution schemes whose guaranteed returns are not fully matched by underlying investments.
- The PRA has set out two stress scenarios10 that firms must calculate their pension risk against, as well as providing their own assessment. The PRA will consider the scenarios as well as any appropriate offsets and management actions.
Pillar 2B – The PRA Buffer
The Capital Planning Buffer (CPB) has been replaced by the PRA Buffer, which incorporates the various Capital Requirements Directives (CRD) IV buffers as well as considering the existing CPB methodology.
- The PRA Buffer11
- In previous SREP methodologies the PRA calculated P2B by assessing an appropriate CPB. This buffer was required so that the firm would maintain capital adequacy in the event of a severe but plausible stress scenario. These stress scenarios are reviewed during the SREP for appropriateness and severity. Stress scenarios12 that are relevant to the balance sheet of the firm would be well received by the PRA.
- The CPB has now been replaced by the PRA buffer, the assessment of the buffer remains unchanged, however the PRA buffer only becomes binding if the assessment is larger than the CRD IV buffers (capital conservation buffers, systemic buffers, countercyclical buffer and sectoral capital requirements). Where the CRD IV buffers are deemed sufficient, as illustrated below, there will be no PRA buffer.
- Management and Governance scalars: The Management, Governance and Controls (MGC) scalars are now applied to the PRA buffer in order to maintain confidentiality of MGC issues (the increased transparency of the P2A methodologies would lead to further transparency in Pillar 3 disclosures), the scalar (if assessed by supervision) will be applied to the PRA buffer.
i Capital conservation buffer of 2.5% CET1 phased in from 2016 through 2019 http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf
ii Macro-prudential buffer is made up of the counter-cyclical buffer and sectorial capital requirements
Source: The PRA’s methodologies for setting Pillar 2 capital, Prudential Regulation Authority, July 2015. Access at: http://www.bankofengland.co.uk/pra/Documents/publications/sop/2015/p2methodologies.pdf
- “The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP),” Prudential Regulation Authority, Supervisory Statement, SS31/15, July 2015. Access at: http://www.bankofengland.co.uk/pra/Documents/publications/ss/2015/ss3115update.pdf.
- “The PRA’s methodologies for setting Pillar 2 capital,” Prudential Regulation Authority, Statement of Policy, July 2015. Access at: http://www.bankofengland.co.uk/pra/Documents/publications/sop/2015/p2methodologies.pdf. “Assessing capital adequacy under Pillar 2, Prudential Regulation Authority, Policy Statement, PS17/15, updated August 2015. Access at: http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps1715update.pdf.
- In the fourth quarter of 2015 firms undertook a voluntary requirement (VREQ), converted their existing capital planning buffers (CPBs) and any fixed capital buffers into a percentage of Pillar 1 risk-weighted assets (RWAs), these individual capital guidance (ICG) came into effect in January 2016.
- Supervisory judgement and a firm’s own assessments will be used for setting an ICG.
- “The PRA’s methodologies for setting Pillar 2 capital,” Prudential Regulation Authority, Statement of Policy, July 2015, Access at: http://www.bankofengland.co.uk/pra/Documents/publications/sop/2015/p2methodologies.pdf.
- For category 1 firms that do not have an Advance Model Approach (AMA) permission for operational risk.
- CCR is the risk of losses arising from the default of the counterparty to derivatives, margin lending, securities lending, repurchase and reverse repurchase or long settlement transactions before the final settlement of the transaction’s cash flows and where the exposure at default is crucially dependent on market factors.
- IRRBB is the risk of losses arising from changes in the interest rates associated with banking book items.
- The PRA will review duration risk, basis risk and optionality risk.
- “The PRA’s methodologies for setting Pillar 2 capital,” Prudential Regulation Authority, Statement of Policy, July 2015. Access at: http://www.bankofengland.co.uk/pra/Documents/publications/sop/2015/p2methodologies.pdf.
- “The Pillar 2 framework – background,” Prudential Regulation Authority. Access at: http://www.bankofengland.co.uk/pra/Documents/pillar2framework.pdf.
- Note that the PRA benefits from the results of the concurrent stress testing. The PRA has been carrying out Concurrent Stress Testing across “the major UK banks.” The results of this yearly exercise provides the PRA with insightful peer analysis.
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