Prudential Regulation Authority Rulebook

5.1

The SREP is a process by which the PRA, taking into account the nature, scale and complexity of a firm’s activities, reviews and evaluates the:

• arrangements, strategies, processes and mechanisms implemented by a firm to comply with its regulatory requirements laid down in PRA rules and the CRR;
• risks to which the firm is or might be exposed;
• risks that the firm poses to the financial system; and
• further risks revealed by stress testing.

5.2

As part of the SREP, the PRA will review the firm’s ICAAP and have regard to the risks outlined in the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1, the firm’s vulnerabilities under reverse stress testing, the governance arrangements of firms, its corporate culture and values, and the ability of members of the management body to perform their duties. The degree of involvement of the management body of the firm will be taken into account by the PRA when assessing the ICAAP, as will the appropriateness of the internal processes and systems for supporting and producing the ICAAP.

5.2A

The PRA will consider whether it has reasonable grounds to suspect that money laundering or terrorist financing is being undertaken, or has been committed or attempted, or there is increased risk thereof in connection with that institution. If the PRA has reasonable grounds to suspect such activity or increased risk, it will take appropriate steps.

5.3

When the PRA reviews an ICAAP as part of the SREP, it does so as part of the process of determining whether all of the material risks have been identified and that the amount and quality of capital identified by the firm is sufficient to cover the nature and level of the risks to which it is or might be exposed.

5.4

The PRA may request a firm to submit the design and results of its reverse stress tests and any subsequent updates as part of its risk assessment.

5.5

The SREP will also consider:

• the results of stress tests carried out in accordance with the CRR by firms that use an internal ratings-based (IRB) approach or internal models for market risk capital requirements;
• the exposure to, and management of, concentration risk by firms, including their compliance with the requirements set out in Part Four of the CRR and Chapter 6 of the ICAA rules;
• the robustness, suitability and manner of application of policies and procedures implemented by firms for the management of the residual risk associated with the use of credit risk mitigation techniques;
• the extent to which the capital held by firms in respect of assets which it has securitised is adequate, having regard to the economic substance of the transaction, including the degree of risk transfer achieved;
• the exposure and management of liquidity risk by firms, including the development of alternative scenario analyses, the management of risk mitigants (including the level, composition and quality of liquidity buffers), and effective contingency plans;
• the impact of diversification effects and how such effects are factored into firms’ risk measurement system;
• the geographical location of firms’ exposures;
• risks to firms arising from excessive leverage;
• whether a firm has provided implicit support to a securitisation; and
• the exposure to and management of foreign currency lending risk to unhedged retail and SME borrowers by firms, in line with Title 6, section 2 paragraphs 158–59 of the EBA’s Guidelines on common procedures and methodologies for the SREP;⁴²
• the extent to which the allocation of the total amount of financial resources, own funds and internal capital between different parts of the consolidation group reflects the nature, level, and distribution of the risks to which the consolidation group is subject;
• the extent to which any capital requirements or buffers set on an entity established outside the United Kingdom, on an individual or sub-consolidated basis, exceed the requirements or buffers applicable at the consolidated group level to cover the same risk; and
• where a firm is a member of a group in which a qualifying parent undertaking has a double leverage ratio above 100%, or is projecting one above 100%, the extent to which the firm is managing the risks of double leverage, and the credibility of its related stress testing and scenario analysis.

5.5A

Where groups contain an RFB sub-group, the SREP will also consider RFB group risk.

5.6

The PRA also assesses as part of the SREP the risks that the firm poses to the financial system.

5.7

The PRA may need to request further information and meet with the management body and other representatives of a firm in order to evaluate fully the comprehensiveness of the ICAAP and the adequacy of the governance arrangements around it. The management body should be able to demonstrate an understanding of the ICAAP consistent with its taking responsibility for it. And the appropriate levels of the firm’s management should be prepared to discuss and defend all aspects of the ICAAP, covering both quantitative and qualitative components.

5.8

5.8A

In applying the principle of proportionality to the SREP, the PRA adheres to the approach in section 2.4 of the EBA Guidelines on common procedures and methodologies for the SREP which relates the frequency and intensity of the SREP to firms’ nature, scale and complexity. The PRA categorises firms according to their significance to the stability of the UK financial system, in accordance with the criteria set out in ‘The PRA’s approach to banking supervision’.⁴³ The PRA has additional criteria for applying the principle of proportionality to particular aspects of the SREP:

• Smaller firms have fewer reporting requirements under the Pillar 2 reporting part of the Rulebook.⁴⁴
• A proportionate approach is applied to the operational risk Pillar 2A add-for non-Category 1 firms.
• The PRA provides more proportionate scenarios for smaller firms’ own stress testing. For example, the approach applied to the PRA buffer for new banks takes into account their recent entry to the market.⁴⁵

5.9

On the basis of the SREP, the PRA will determine whether the arrangements implemented by a firm and the capital held by it provide sound management and adequate coverage of its risks. If necessary, the PRA will require the firm to take appropriate actions or steps at an early stage to address any future potential failure to meet its prudential regulatory requirements, or to prevent or mitigate the risk of business failure revealed by reverse stress testing. The PRA recognises that not every business failure is driven by lack of financial resources and will take this into account when reviewing a firm’s reverse stress-test design and results.

5.10

There are two main areas that the PRA considers when assessing a firm’s capital adequacy under a SREP: (i) risks to the firm which are either not captured, or not fully captured, under the CRR (eg IRRBB and concentration risk); and (ii) risks to which the firm may become exposed over a forward-looking planning horizon (eg due to changes to the economic environment). The PRA refers to the first area as Pillar 2A and the second as Pillar 2B.

5.11

To assess the capital adequacy of a firm under Pillar 2A, the PRA has developed capital methodologies. The methodologies are published in PRA Statement of Policy, ‘The PRA’s methodologies for setting Pillar 2 capital’.

5.12

The PRA will set Pillar 2A capital requirements in light of both the calculations included in a firm’s ICAAP and the results of the PRA’s own Pillar 2A methodologies. In considering the level of capital that is necessary to capture risks to which the firm is or might be exposed, the PRA also takes into account the extent to which those risks are mitigated by macroprudential buffers. Setting a Pillar 2A capital requirement is subject to peer group reviews to ensure consistency of decisions across firms.

5.12A

For firms using the standardised approach (SA) for credit risk, the PRA will assess whether the capital held by them exceeds the amount necessary to ensure a sound management and coverage of their risks. To this end, the PRA will make an overall assessment of the adequacy of capital, taking into account the outcome of the application of the PRA’s own Pillar 2A methodologies, the firm’s ICAAP, business model, and whether the firm is considered relatively low-risk and well-managed. The PRA will also conduct a peer group review, including with those firms that use the IRB approach, by using the upper range of the credit risk IRB benchmarks which are set out in the Statement of Policy ‘The PRA’s methodologies for setting Pillar 2 capital’.⁴⁶

5.12B

Following this, the PRA will calculate the level of capital that is necessary, in addition to the capital the firm must hold to comply with the CRR (Pillar 1), to capture risks to which the firm is or might be exposed. This may lead to the PRA adjusting the firm’s Pillar 2A add-ons, as assessed in accordance with the PRA’s own methodologies, downward, taking into consideration how firms’ capital relates to the IRB benchmarks considered as part of the peer review. The comparison to the benchmarks is not mechanistic and will depend on the extent to which it reflects firm-specific risk profiles, considering for example differences in Pillar 2A credit concentration risk add-ons between firms using the SA and IRB models.

5.12C

For firms using IFRS 9, the PRA will also consider the extent to which expected credit losses, over a twelve month period, are covered by the Pillar 1 charge under the SA, to inform the setting of Pillar 2A capital requirements.

5.13

The PRA will review the firm’s records referred to in Internal Adequacy Assessment 13.1 as part of its SREP to judge whether a firm will be able to continue to meet its CRR requirements and the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1 throughout the time horizon used for the capital planning exercise.

5.14

Following the SREP, including both a review of the ICAAP and any further interactions with the firm, the PRA will normally set the firm a Pillar 2A capital requirement on an individual basis, for the amount and quality of capital that the PRA considers the firm should hold, in addition to the capital it must hold to comply with the CRR (Pillar 1 capital) to meet the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1. The PRA will additionally set Pillar 2A capital requirements for firms which must comply with the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1 on a consolidated basis and, where groups contain an RFB sub-group, on a sub-consolidated basis.

5.15

In many cases the PRA may decide to set Pillar 2A capital requirements on an individual basis by undertaking a detailed individual assessment, calculating the relevant Pillar 2A add-ons according to the individual firm’s risk profile. Alternatively, the PRA may decide to set Pillar 2A capital requirements on an individual basis calibrated so that its TCR represents a share of the UK consolidated group or sub-consolidated group (where relevant) TCR where the firm is able to demonstrate that capital has been adequately allocated among subsidiaries, the members of the group or RFB sub-group are strongly incentivised to support each other, and there are no impediments to the transfer of capital within the group or RFB sub-group. Where a firm is not considered to have significant systemic impact, or where it has a very similar risk profile to the UK consolidation group (or RFB sub-consolidation group), the PRA may decide to set Pillar 2A on an individual basis by applying the same Pillar 2A add-on rate as calculated for the UK consolidated (or RFB sub-consolidated) Pillar 2A capital requirement to the individual total RWAs of the firm.

5.16

Where the PRA sets a firm-specific Pillar 2A capital requirement it will generally specify an amount of capital (Pillar 2A) that the firm should hold at all times in addition to the capital it must hold to comply with the CRR (Pillar 1). It will usually do so by stating that the firm should hold capital of an amount equal to a specified percentage of the firm’s Pillar 1 RWAs (the total risk exposure amount calculated in accordance with Article 92(3) of the CRR), plus one or more static add-on in relation to specific risks in accordance with the overall Pillar 2 rule in Internal Capital Adequacy Assessment 3.1. The PRA requires firms to meet Pillar 2A with at least 56.25% CET1 capital, no more than 43.75% additional Tier 1 (AT1) capital and no more than 25% Tier 2. For these purposes, firms should follow the provisions on the definition of capital set out in the Definition of Capital Part of the PRA Rulebook and Supervisory Statement 7/13.⁴⁷

5.17

It is for firms to ensure that they comply with the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1. If a firm holds the level of capital required under its TCR that does not necessarily mean that it is complying with the overall financial adequacy rule. Deviation by a firm from the terms of the Pillar 2A and TCR given to it by the PRA does not automatically mean that the firm is in breach of the overall financial adequacy rule or that the PRA will consider the firm is failing, or likely to fail, to satisfy the Threshold Conditions (TCs). However, firms should expect the PRA to investigate whether any firm is failing, or likely to fail, to satisfy the TCs, with a view to taking further action as necessary.

5.18

The PRA expects a firm not to meet the CRD buffers with any CET1 capital maintained to meet its TCR. If a firm agrees with its TCR, the PRA will expect the firm to apply for a requirement under section 55M of the Financial Services and Markets Act 2000 (FSMA) to set the amount and quality of the Pillar 2A capital requirement and prevent the firm from meeting any of the CRD buffers that apply to it with any CET1 capital maintained to meet Pillar 2A. The firm will normally be invited to apply for such a requirement at the same time as it is advised of its Pillar 2A capital requirement. If a firm does not apply for such a requirement the PRA will consider using its powers under section 55M(3) to impose one of its own initiative.

5.19

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5.20

Following the SREP, the PRA will also notify the firm of an amount of capital that it should hold as a PRA buffer, over and above the level of capital required to meet its TCR and over and above the CRD buffers. The PRA buffer, based on a firm-specific supervisory assessment, should be of a sufficient amount to allow the firm to continue to meet the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1. This should be the case even in adverse circumstances, after allowing for realistic management actions that a firm could, and would, take in a stress scenario.

5.21

In setting a PRA buffer for a firm the PRA will not just consider whether the firm would meet its CET1 capital requirements under the CRR and its Pillar 2A capital requirement in the stress scenario. Other factors informing the size of the PRA buffer include but are not limited to: the maximum change in capital resources and requirements under the stress; the firm’s leverage ratio; the extent to which the firm has used up its CRD buffers (eg the systemically important financial institution (SIFI) and capital conservation buffers); Tier 1 and total capital ratios; and the extent to which potentially significant risks are not captured fully as part of the stress.

5.22

Where the PRA assesses a firm’s risk management and governance (RMG) to be significantly weak, it may also set the PRA buffer to cover the risks posed by those weaknesses until they are addressed. This will generally be calibrated in the form of a scalar applied to the amount of CET1 required to meet the firm’s TCR. The scalar could be to up to 40% of the total CET1 TCR (variable). If the PRA sets the PRA buffer to cover the risk posed by significant weaknesses in risk management and/or governance or applies a suspended scalar, the PRA will identify those weaknesses to the firm and expect the firm to address those weaknesses within an appropriate timeframe. Once the identified weaknesses have been remedied, the PRA will remove the scalar. If new weaknesses emerge that are not adequately addressed by the scalar or if remedial action taken by the firm has led to its removal a new scalar may be applied.

5.23

Where the PRA sets a PRA buffer it will generally do so stating that the firm should hold capital of an amount equal to a specified percentage of the firm’s Pillar 1 RWAs (the total risk exposure amount calculated in accordance with Article 92(3) of the CRR). The PRA expects firms to meet the PRA buffer with 100% CET1. The PRA expects firms to meet the PRA buffer with additional CET1 capital to the CET1 capital maintained to meet its CRD buffers.

5.24

The PRA may set a firm’s PRA buffer either as an amount of capital which it should hold from the time of the PRA’s notification following the firm’s SREP or, in exceptional cases, as a forward-looking target that a firm should build up over time. Where the general stress and scenario testing rule, as part of the ICAAP rules, applies to a firm on a consolidated and/or sub-consolidated basis the PRA may notify the firm that it should hold a PRA buffer on a consolidated and/or sub-consolidated basis (as applicable). The PRA may in certain circumstances notify a firm that it should hold a PRA buffer on an individual basis.

5.25

If a firm considers that the proposed Pillar 2A capital requirement or the PRA buffer advised to it by the PRA is inappropriate to its circumstances it should notify the PRA of this, consistent with Fundamental Rule 7. If, after discussion, the PRA and the firm do not agree on an adequate level of capital, the PRA may consider using its own initiative powers under section 55M of FSMA to impose a requirement on the firm to hold capital in accordance with the PRA’s view of the capital necessary to comply with the overall financial adequacy rule in Internal Capital Adequacy Assessment 2.1. In deciding whether it should use its powers under section 55M, the PRA will take into account the amount of capital that the firm should hold for its PRA buffer.

5.25ZA

The PRA’s expectations for Pillar 2B of new and growing banks are set out in the SS3/21 ‘Non-systemic UK banks: The PRA’s approach to new and growing banks'.⁴⁸

5.25A

When setting the PRA buffer on an individual basis, the PRA’s standard approach is to undertake a full assessment on the individual basis. Where the firm is part of a UK consolidation group or RFB sub-group (ie ‘a subsidiary’), the PRA will set the PRA buffer in a similar way to the PRA approach to setting Pillar 2A capital requirements on an individual basis.⁴⁹ The approach depends upon: the transferability of group resources; the nature and extent of integration of the subsidiary; the likelihood of group support; and the significance of the entity and the risk profile of its business relative to the group.

5.25B

The PRA’s framework for applying the PRA buffer to subsidiaries takes the group-level PRA Buffer assessment as a starting point.

5.25C

The PRA may set the PRA buffer for a subsidiary such that, when aggregated with the TCR and combined buffer, the total capital it is expected to hold is the same as the internal capital the firms determines in its internal capital assessment to be sufficient. Where the sum of TCR and combined buffer exceeds the capital the firm has determined in its internal assessment, the PRA expects to set a PRA Buffer of zero. Internal capital must be sufficient to cover all the risks to which it is exposed and to absorb potential losses from stress scenarios. Subject to supervisory judgement, this will be the case when the following conditions are met:

• on a UK consolidated basis, the PRA buffer plus combined buffers and TCR is the same as the internal capital the group considers to be adequate (eg, when the PRA buffer is zero and the group considers regulatory requirements for capital are sufficient); and
• on an individual basis, the PRA has not identified it as having materially different capital needs in a medium-term stress, or to be exposed to materially different risks, to those of the group.

5.25D

The PRA may also calibrate the PRA buffer on an individual basis in this way where these conditions are not met but the firm is not considered to be material to its consolidation group or RFB sub-group, and the PRA considers financial resources to be transferable between the group entities and judges the parent to be likely to support a failing subsidiary. A subsidiary is considered not material if it comprises less than 5% of the UK consolidation group RWAs, leverage exposures and operating income.

5.25E

Where a firm has a very similar risk profile to its consolidation group or RFB sub-group (for example, where a subsidiary comprises more than 80% of the UK consolidation group’s RWAs and the rest of the group undertakes similar activities as the subsidiary), the PRA may decide to set the PRA buffer on an individual basis by reference to the UK consolidated (or RFB sub-consolidated) PRA buffer calculation. Where consolidated or sub-consolidated PRA buffer calculations include add-ons for group risk, these will not be included in the calculation of the subsidiary’s PRA buffer.

5.25F

The PRA will set the PRA buffer according to a comprehensive individual assessment if none of the above approaches is applicable. The PRA may also set the PRA buffer according to the full assessment process where a supervisor identifies any factors that mean the above approach is not appropriate, such as:

• material impediments to the transferability of capital within the group;⁵⁰
• the subsidiary is a specialist subsidiary containing a high concentration of a group’s business that could lead to a negative outcome in a stress, but this concentration is offset at a group wide level;
• there are significant weaknesses in the risk management or governance of the subsidiary;
• the subsidiary has significant weaknesses that call into question the adequacy of existing capital requirements; or
• other material supervisory concerns lead the supervisor to consider the firm’s internal capital to be insufficient.

5.26

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5.27

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5.28

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5.29

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5.30

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5.31

The PRA expects every firm to hold at least the level of capital it is required to meet its TCR at all times. If a firm’s capital has fallen or is expected to fall below that level it should inform the PRA as soon as practicable explaining why this has happened or is expected to happen. The firm will also be expected to discuss the actions that it intends to take to increase its capital and/or reduce its risks (and therefore capital requirement), and any potential modification that it considers should be made to the Pillar 2A capital requirement.

5.32

Where this has happened, the PRA may ask a firm for alternative and more detailed proposals or further assessments of capital adequacy and risks faced by the firm. The PRA will seek to agree with the firm the appropriate timescales and the scope for any such additional work.

5.33

Use of the PRA buffer is not itself a breach of capital requirements or TCs. The PRA expects firms to use their PRA buffer (and indeed other capital buffers⁵¹) in times of stress. Use of buffers (including both the combined buffer and PRA buffer) are what firms and the PRA model as part of their stress tests. The PRA does not expect or require firms to finance themselves with more capital than the total of their regulatory requirements and buffers. However, where a firm has a PRA buffer in place, it should not use that buffer in the normal course of business or enter into it as part of its base business plan.

5.34

Consistent with Fundamental Rule 7, a firm should notify the PRA as early as possible where it has identified that it would need to use its PRA buffer (even if the firm has not accepted the PRA’s assessment of the amount of capital required for the PRA buffer). The firm’s notification should state as a minimum:

• what adverse circumstances are likely to lead the firm to draw down its PRA buffer;
• how the PRA buffer will be used up in line with the firm’s capital planning projections; and
• the plan and timeframe to restore the PRA buffer.

5.35

A firm which does not meet its PRA buffer can expect enhanced supervisory action, and should prepare a capital restoration plan⁵². If the PRA is satisfied with the rationale presented, the PRA will be content for firms to rebuild their buffers over a reasonable period of time. In exercising its judgement on what constitutes a reasonable time to rebuild the PRA buffer (and potentially other capital buffers) and other potential supervisory action, the PRA will take into account how far the firm has run into its buffers, the expected duration of the stress, the drivers of that stress, the context of that stress (whether firm-specific or systemic) and macroeconomic and financial conditions. If the PRA is not satisfied with the capital restoration plan or with the firm’s reasons for using the buffer it may consider using its powers under section 55M of FSMA to require the firm to raise sufficient capital to meet the buffer within an appropriate timeframe.

5.36

The automatic distribution constraints associated with the CRD buffers do not apply to the PRA buffer.

5.37

Firms should disclose the PRA’s SREP feedback letter setting Pillar 2A capital requirements and, where applicable, the PRA buffer to their auditors. The PRA expect firms to publicly disclose the amount and quality of TCR which apply to them at the highest level of consolidation in the UK. The PRA also expects RFBs to disclose their TCR on a sub-consolidated basis where an RFB sub-group is established. In those circumstances in which Pillar 2A has not been set as a requirement, the PRA expects firms to disclose their total Pillar 1 plus Pillar 2A capital guidance. Otherwise, the PRA expects firms to treat all other information relating to TCR, including details of its constituent parts, and all information relating to the PRA buffer, as confidential unless they are required to disclose it by law. If firms wish to disclose the PRA’s SREP feedback letter or any part of it to any third parties (other than their auditors) they should, consistent with Fundamental Rule 7, provide appropriate prior notice to the PRA of the proposed form, timing, nature and purpose of the disclosure.

5.38

Where an immediate market disclosure obligation exists, prior notification to the PRA should not lead to any delay in disclosure. But any firm intending to disclose information relating to TCR (except the total figure) or the buffers should (consistent with Fundamental Rule 7), where reasonably practicable, provide appropriate notice in advance of the proposed disclosure and the reasons for it.

The PRA does not advise firms on their market disclosure obligations and firms should seek their own advice on this matter. The FCA is responsible for oversight of issuers’ compliance with their market disclosure obligations.