CP16/22 – Implementation of the Basel 3.1 standards: Interactions with the PRA’s Pillar 2 framework

Overview

10.1 This chapter describes, at a high level, the implications of the proposed changes to the Pillar 1 risk-weighting framework, as set out in this Consultation Paper (CP), for the Prudential Regulation Authority’s (PRA) Pillar 2 framework. The PRA’s Pillar 2 framework consists of two distinct variable components: Pillar 2A and Pillar 2B. Pillar 2A is a firm-specific minimum capital requirement that covers a range of risks not addressed under Pillar 1 (eg credit concentration risk, and interest rate risk in the banking book), or not adequately addressed by the Pillar 1 framework. Pillar 2B, also known as the PRA buffer, is an amount of capital firms should maintain in addition to their total capital requirements and the combined buffer to absorb the losses that may arise in a severe, but plausible, stress scenario. The PRA’s methodologies for setting Pillar 2 capital requirements are set out in full in PRA Statement of Policy – ‘The PRA’s methodologies for setting Pillar 2 capital’ (‘Pillar 2 SoP’).

10.2 This chapter does not contain any specific new policy proposals. The PRA intends to review its Pillar 2A methodologies more fully by 2024, so that Pillar 2 requirements and any corresponding reporting requirements are updated as necessary before the changes to the Pillar 1 framework set out in this CP are implemented. However, this chapter sets out a range of topics the PRA is currently considering. By doing so, the PRA is intending to: give firms additional clarity on how it intends the overall going-concern capital framework to operate; flag Pillar 2 policy areas that would need further development; and give firms an opportunity to raise any additional concerns and provide any feedback at this stage. The topics included in this chapter are:

• how Pillar 2A operational risk, market risk and credit risk methodologies, set out in full in the Pillar 2 SoP interact at a high level with the proposed changes to Pillar 1 risk-weighted asset (RWA) approaches set out within this CP;
• at a high level, the consequential impacts to capital buffers including the PRA buffer; and
• the timing and setting of firm-specific capital requirements.

10.3 The PRA considers the proposed improvements to the measurement of the Pillar 1 risk weights and the introduction of the output floor to generally complement its existing Pillar 2 framework. However, it recognises the interactions can be complex. As a principle, the PRA would not double count capital requirements for the same risks in Pillar 1 and Pillar 2A. This means that, to the extent that the proposals set out in this CP improve risk-capture in Pillar 1, the Pillar 2A capital requirements would be adjusted accordingly. The PRA’s existing Pillar 2A framework adjusts mechanically in some areas, such as operational risk, however, others would require policy changes.

10.4 This chapter is relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial holding companies or mixed financial holding companies (‘firms’). For firms in scope of the strong and simple framework (see Chapter 1 – Overview and Chapter 2 – Scope and levels of application), future policy proposals that simplify the framework may have further implications.^{footnote [1]}

Pillar 2A – Operational risk

10.5 The PRA’s methodology for setting Pillar 2A capital requirements for operational risk is set out in the Pillar 2 SoP. As set out in the SoP, operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, and includes legal risk. The PRA’s existing Pillar 1 standardised approach for operational risk uses gross income as a measure of risk. This is not risk-sensitive. The PRA therefore assesses operational risk as part of its Pillar 2A review of firms’ capital adequacy and, where appropriate, applies a Pillar 2A capital add-on.

10.6 In summary, the PRA undertakes an overall assessment of a firm’s operational risk informed by, among other factors, historical losses, a firm’s Internal Capital Adequacy Assessment Process (ICAAP), and conduct and non-conduct loss estimates. From that overall assessment, supervisory judgement is used to determine a firm-specific operational risk capital requirement.

10.7 The PRA’s proposals to implement the new operational risk standardised approach (SA), set out in the Basel 3.1 standards, is outlined in Chapter 8 – Operational risk. For some firms, moving to the SA may result in an increase in Pillar 1 RWAs for operational risk. The PRA’s Pillar 2A methodology for setting any operational risk add-ons already takes into account Pillar 1 operational risk RWAs. All else being equal, the PRA considers most firms’ total Pillar 1 and Pillar 2A operational risk capital requirements would remain unchanged, so any Pillar 2A add-on would be reduced in line with any Pillar 1 RWA increase. The PRA also considers the inverse to hold true: should a firm’s Pillar 1 RWAs for operational risk fall as a result of moving to the SA, all else being equal, any Pillar 2A add-on would consequently increase. Departures from this result may however occur for individual firms, consistent with the overarching objective that firms should have sufficient capital for the operational risks to which they are exposed.

10.8 The PRA does not, therefore, intend to make significant changes to its Pillar 2A methodology for operational risk as a consequence of the changes in the Pillar 1 framework at present. But there may be some areas that could benefit from further clarification or changes to ensure the methodology remains consistent with the Pillar 1 operational risk proposals set out in this CP (eg updating references to Pillar 1 operational risk approaches in line with the proposals set out in this CP if adopted). These would be considered as part of the PRA’s Pillar 2A review.

Pillar 2A – Market risk

10.9 The PRA’s methodology for setting Pillar 2A capital requirements for market risk is set out in full in the Pillar 2 SoP. As set out in the SoP, market risk is the risk of losses resulting from adverse changes in the value of positions arising from movements in market prices across commodity, credit, equity, foreign exchange, and interest rates risk factors. Under the existing Pillar 2A methodology for market risk, the PRA may require firms to maintain additional capital under Pillar 2A to cover risks likely to be underestimated or not covered under Pillar 1. The majority of such risks relate to illiquid, one-way, and concentrated positions (referred to collectively as ‘illiquid risks’).

10.10 To inform the setting of Pillar 2A capital, the PRA relies on a firm’s own methodologies for assessing illiquid and concentrated positions. This is because market risk is specific to firms’ individual positions. The PRA’s focus is on the quality of firms’ methodologies, including the magnitude of market shocks applied to assess illiquidity risks. The PRA also assesses the firm’s abilities to manage the risk.

10.11 As set out in Chapter 6 – Market risk, the PRA proposes significant changes to the Pillar 1 market risk framework. Overall, those changes would improve the existing market risk framework by ensuring market risk capital requirements are more commensurate with the risks faced by firms, most notably in the context of illiquid risks by increasing the time horizon for less liquid risk factor types to beyond 10 days.

10.12 The Pillar 2A capital add-on for illiquid risks is set such that the sum of Pillar 1 and Pillar 2A capital requirements would be sufficient to cover losses at a 99.9% confidence level. In line with the existing methodology set out in the Pillar 2 SoP, the PRA would reduce Pillar 2A capital add-ons if appropriate to reflect the extent that illiquid risks are partially captured in the proposed Pillar 1 framework for market risk.

10.13 While illiquidity risk capture would improve significantly under the new approach set out in this CP, the Pillar 1 capital requirements cannot be designed to capture every possible risk profile. Some market risks would likely remain underestimated or not covered in Pillar 1. The PRA’s Pillar 2A framework also captures more extreme price movements. The PRA considers its existing Pillar 2A framework is sufficiently flexible to identify, and where necessary, capitalise, such risks, notwithstanding changes in the Pillar 1 approach.

10.14 The PRA is therefore not considering significant changes at the moment to its Pillar 2A methodology for market risk as a consequence of the proposed changes to the Pillar 1 framework, as set out in this CP.

Pillar 2A – Credit risk

10.15 The PRA’s methodology for setting Pillar 2A credit risk add-ons is set out in full in the Pillar 2 SoP. As set out in the SoP, credit risk is the risk of losses arising from a borrower or counterparty failing to meet its obligations as they fall due. The PRA considers that there are asset classes for which the existing Pillar 1 credit risk standardised approach (SA) underestimates risk. The PRA therefore assesses credit risk as part of its Pillar 2 review of firms’ capital adequacy, applying Pillar 2A add-ons in some instances.

10.16 The PRA has developed an internal ratings based (IRB) benchmark for different asset classes with which to compare SA credit risk weights. Where the IRB benchmark suggests that the SA risk weight for a particular portfolio is too low, additional capital may be required under Pillar 2A. Similarly, where the SA risk weight is too conservative for the risk, this is recognised when setting additional capital under Pillar 2A. Supervisory judgement is then used to determine whether any Pillar 2A credit risk add-ons are required, taking into account considerations such as firms’ own assessments, the IRB benchmark range, the PRA’s confidence in the benchmarks, and supervisory knowledge of the credit risk portfolios.

10.17 As set out in Chapter 3 – Credit risk - standardised approach, Chapter 4 – Credit risk - internal ratings based approach, and Chapter 5 – Credit risk mitigation, the PRA proposes significant changes to the Pillar 1 credit risk framework. Overall, those changes would improve risk capture, however, some deficiencies may remain. For example, as set out in Chapter 3, the PRA has concerns that some SA risk weights for central governments, central banks, regional governments and local authorities can continue to potentially result in underestimation of RWAs. Therefore, the PRA considers a Pillar 2A methodology for credit risk would likely continue to be required. The PRA does not propose any policy changes within this CP and intends to reflect further on its Pillar 2A methodology to credit risk as part of its Pillar 2A review. A number of areas that the PRA intends to consider in its review are discussed below, and the PRA welcomes feedback on these or other areas that may require consideration.

Use of IRB benchmarks

10.18 The use and reliance on the IRB benchmarks in the PRA’s existing Pillar 2A methodology to credit risk would need to be reviewed as part of the PRA’s Pillar 2A review. The IRB benchmarks are drawn from data the PRA has on the risk weights generated by firms’ IRB models. There are two issues that need to be considered: (a) the proposals set out in this CP would likely change some of those models and associated risk weights, and (b) the proposals set out in this CP would require some exposures that can currently be modelled under IRB to be moved to SA, so there would no longer be IRB benchmarks on which to rely.

Interaction with the output floor

10.19 The output floor applies at a firm-wide level (or ring-fenced body), and not to individual asset classes, models or risk weights. But in instances where it is the binding RWA constraint on an IRB firm, that firm would have higher RWAs than its models alone suggest. The PRA intends to consider how, or if, this should be taken into account in any revised IRB benchmark and Pillar 2A add-on.

Refined methodology

10.20 The PRA’s Pillar 2A credit risk methodology was updated in 2017, updating the Pillar 2 SoP and Supervisory Statement 31/15 – 'The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP)’ as set out in Policy Statement (PS) 22/7 – ‘Refining the PRA’s Pillar 2A capital framework’, to allow some SA firms that meet specified criteria to compare their SA risk weights with those derived from typical IRB models. When making an overall assessment of the adequacy of their total capital requirements, the firm and the PRA can consider that comparison and assess whether there is any excess conservatism inherent in some aspects of the existing Pillar 1 SA.

10.21 For example, residential mortgages with a low loan to value (LTV) ratio attract a 35% risk weight in the existing framework. As set out in this CP, the PRA proposes to significantly reduce the SA risk weight, from 35% to 20%, for some residential mortgage exposures with LTV ratios of 50% or below. This would significantly reduce any higher degree of conservatism of the SA compared to IRB models for lower risk assets in this asset class.

10.22 The PRA will be considering whether it is appropriate to retain the existing refined methodology in its current form.

Combined buffer and Pillar 2B

10.23 In addition to Pillar 1 and Pillar 2A capital requirements, the PRA’s capital framework includes a series of buffers. The capital conservation buffer (CCoB), which applies to all firms at all times, is set at 2.5% of a firm’s RWAs. The countercyclical capital buffer (CCyB) also applies to all firms at all times. The CCyB rate is set by each national authority and applied to private sector credit exposures. The CCyB rate applied to UK exposures (the UK CCyB rate) is set by the Financial Policy Committee (FPC). The FPC has stated that it expects to set the level of the UK CCyB rate in the region of 2% in a standard risk environment.^{footnote [2]} Systemically important firms may have further buffers applied. Together, all of these buffers are sometimes referred to as the ‘combined buffer’. The PRA also sets a firm-specific buffer referred to as the PRA buffer or Pillar 2B.^{footnote [3]}

10.24 This CP, consistent with the Basel 3.1 standards, does not contain any proposed changes to the combined buffer or the PRA buffer frameworks. However, the proposed changes to Pillar 1 risk weight methodologies and their cyclicality would have consequential effects to both buffer frameworks.

10.25 As required by the Capital Buffers (CRR) Part of the PRA Rulebook, firms must calculate the nominal amount of capital required to meet their combined buffer by multiplying their relevant buffer rates by Pillar 1 RWAs. Under the proposals set out in other chapters in this CP, many firms’ Pillar 1 RWAs would change. Some firms’ RWAs would increase, while some would decrease. The PRA considers such changes would be relatively modest (see aggregated cost benefit analysis in Chapter 1 and Appendix 7 - Aggregated cost benefit analysis). But any changes to the level of RWAs would, in turn, affect the nominal amounts of capital required to meet the combined buffers. The PRA considers such consequential changes in the size of the buffers in nominal terms to reflect the overall improved risk-sensitivity of the PRA’s proposals.

10.26 The PRA buffer is set differently to the other buffers. Its size is informed by a range of factors including the results of relevant stress-testing and supervisory judgement.^{footnote [4]} It is generally calibrated to absorb losses that may arise under a severe stress scenario, while avoiding duplication with the combined buffer. To the extent that changes in Pillar 1 RWAs lead to nominal increases or decreases in a firm’s combined buffer, the PRA buffer-setting policy already takes into account the quantum of capital calculated to meet the combined buffer.^{footnote [5]}

10.27 Moreover, the PRA anticipates the combined set of measures set out in this CP might lead to a decrease in the capital drawdown of some UK firms in a severe scenario. Therefore the total quantum of Pillar 2B buffer capital assessed through the stress impact set by the PRA may also decrease. The PRA recognises this is a complex area to assess. The PRA intends to keep its buffer-setting regime under review and intends to continue to exercise appropriate forward-looking supervisory judgement. The PRA welcomes any suggestions or reflections firms, and market participants may have in this area.

Timing implementation of firm-specific capital requirements

10.28 As set out earlier in this chapter, under the PRA’s existing Pillar 2 framework, some potential changes in Pillar 1 RWAs as a result of the proposals set out in this CP are likely to be offset by corresponding adjustments in Pillar 2A add-ons (eg for operational risk). Potential changes in the quantum of capital calculated to meet the combined buffer may also lead to adjustments in the PRA buffer, all else being equal.

10.29 However, the Pillar 1 policy proposals (and thus RWA changes) set out in this CP are proposed to come into effect from the PRA’s proposed implementation date of 1 January 2025 (see Chapter 1). Firm-specific Pillar 2A add-ons and PRA buffers typically change after a Supervisory Review and Evaluation Process (SREP), which happens once every 1-3 years depending on a firm’s SREP cycle.

10.30 This could mean that either on the PRA’s proposed implementation date of 1 January 2025 (‘day 1’) or during the phase-in of any transitional arrangements, Pillar 2A add-ons and PRA buffers would not be calibrated to firms’ revised Pillar 1 RWAs, based on the implementation of the proposals set out in this CP, until a firm’s next SREP cycle. In some instances, this may be immaterial. In others, it could result in disproportionately high capital requirements and buffers, or requirements and buffers that are too low to deliver on the PRA’s primary objective of safety and soundness.

10.31 As part of the PRA’s review of its Pillar 2A methodologies, the PRA intends to consider how to avoid gaps or duplications in the Pillar 1 and Pillar 2 capital frameworks on day 1 of the implementation of the proposals set out in this CP. The PRA welcomes any responses on these matters.

Interaction with the strong and simple framework

10.32 As set out in Chapter 1 and Chapter 2, the PRA proposes that firms meeting the Simpler-regime criteria as of 1 January 2024 do not have to apply the proposed implementation of the Basel 3.1 standards set out in this CP.^{footnote [6]} Instead, these firms could enter the Transitional Capital Regime, with requirements that are substantively the same as the existing Pillar 1 framework in the CRR, until the implementation date for a permanent risk-based capital regime for the simpler regime. Effectively, this means those firms, which would all be smaller SA firms, would be able to continue using the existing Pillar 1 risk weights.

10.33 The existing Pillar 2A framework is designed to complement the existing Pillar 1 framework, and the PRA currently intends to retain it (including the 2017 refinements) for firms in the Transitional Capital Regime. Doing so would maintain the existing capital framework for those firms until the adoption of the permanent risk-based capital regime for the simpler regime. This may require the PRA to run and apply two Pillar 2 frameworks. The PRA intends to reflect on this further, and welcomes insights from firms and market participants on this topic.