CP12/25 – Pillar 2A review – Phase 1

Privacy statement

By responding to this consultation, you provide personal data to the Bank of England (the Bank, which includes the Prudential Regulation Authority (PRA)). This may include your name, contact details (including, if provided, details of the organisation you work for), and opinions or details offered in the response itself.

The response will be assessed to inform our work as a regulator and central bank, both in the public interest and in the exercise of our official authority. We may use your details to contact you to clarify any aspects of your response.

The consultation paper will explain if responses will be shared with other organisations (for example, the Financial Conduct Authority). If this is the case, the other organisation will also review the responses and may also contact you to clarify aspects of your response. We will retain all responses for the period that is relevant to supporting ongoing regulatory policy developments and reviews. However, all personal data will be redacted from the responses within five years of receipt. To find out more about how we deal with your personal data, your rights, or to get in touch please visit Privacy and the Bank of England.

Information provided in response to this consultation, including personal information, may be subject to publication or disclosure to other parties in accordance with access to information regimes including under the Freedom of Information Act 2000 or data protection legislation, or as otherwise required by law or in discharge of the Bank’s functions.

Please indicate if you regard all, or some of, the information you provide as confidential. If the Bank receives a request for disclosure of this information, we will take your indication(s) into account but cannot give an assurance that confidentiality can be maintained in all circumstances. An automatic confidentiality disclaimer generated by your IT system on emails will not, of itself, be regarded as binding on the Bank.

Responses are requested by Friday 5 September 2025.

Consent to publication

In the policy statement for this consultation, the PRA will publish an account, in general terms, of the representations made as part of this consultation and its response to them. In the policy statement, the PRA is also required to publish a list of respondents to its consultations, where respondents have consented to such publication.

When you respond to this consultation paper, please tell us in your response if you agree to the publication of your name, or the name of the organisation you are responding on behalf of, in the PRA’s feedback response to this consultation.

Please make it clear if you are responding as an individual or on behalf of an organisation.

Where your name comprises ‘personal data’ within the meaning of data protection law, please see the Bank’s Privacy Notice above, about how your personal data will be processed.

Please note that you do not have to give your consent to the publication of your name. If you do not give consent to your name being published in the PRA’s feedback response to this consultation, please make this clear with your response.

If you do not give consent, the PRA may still collect, record and store it in accordance with the information provided above.

You have the right to withdraw, amend or revoke your consent at any time. If you would like to do this, please contact the PRA using the contact details set out below.

Responses can be sent by email to: CP12_25@bankofengland.co.uk.

Alternatively, please address any comments or enquiries to:
Prudential Regulation Authority
20 Moorgate
London
EC2R 6DA

1: Overview

1.1 This consultation paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposed updates to Pillar 2A methodologies and guidance. It is the first phase of a two-stage review. Pillar 2A capital requirements are set for firms to address risks not already, or not sufficiently, captured by Pillar 1.

1.2 The PRA previously committed to review and update Pillar 2A by first addressing the consequential impacts of Basel 3.1 Pillar 1 changes on Pillar 2 in an off-cycle review of firm-specific requirements. This would be followed by a review of the Pillar 2A methodologies after the PRA’s rules to implement the Basel 3.1 standards are finalised.^{footnote [1]}

1.3 This CP outlines the PRA’s proposals to address the consequential impacts of the near-final PRA rules that would implement the Basel 3.1 standards. Other proposals in the CP are intended to improve information, guidance and transparency for firms, including about the methodologies used by the PRA to inform the setting of Pillar 2A capital. The PRA also proposes certain changes to improve the proportionality of regulation, including proposals intended to reduce the reporting burden.

1.4 After this first phase has been completed, the PRA plans to conduct a more in-depth review of individual methodologies within Pillar 2A, on which it will publish a further CP setting out its proposals. This review will consider further clarifying expectations and proportionality, opportunities to reduce burden, as well as increasing the effectiveness of the PRA’s approaches where appropriate.

1.5 The CP proposals are structured into the following chapters:

• Chapter 2: Credit risk;
• Chapter 3: Operational risk;
• Chapter 4: Pension obligation risk; and
• Chapter 5: Market risk and counterparty credit risk.

1.6 This CP has been published alongside the near-final policy statement (PS) 7/25 – Update to PS9/24 on the SME and infrastructure lending adjustments, which sets out further details on the PRA’s near-final policy on the SME and infrastructure lending adjustments to Pillar 2A (Pillar 2A lending adjustments).^{footnote [2]}

1.7 Table 1 outlines the proposed changes to the PRA’s policy material (PRA rules, statements of policy, supervisory statements, reporting templates and reporting instructions).

1.8 The Pillar 2 SoP, SS31/15 and SS32/15 are currently subject to separate consultations, as part of a proposed simplified capital regime for Small Domestic Deposit Takers (SDDTs), and a proposed streamlined Pillar 2A capital framework and capital communications process. These consultations have not yet been finalised as at the publication date of this CP, and are separate to the proposals contained in this CP.^{footnote [3]} In Appendices 4 and 6 to this CP, draft amendments proposed under separate consultations that have yet to be finalised are indicated using grey highlighted text and are not within the scope of consultation for this CP.

1.9 The specific policy proposals included in this CP are:

• Credit risk:
  • removing the internal ratings-based (IRB) approach risk weight benchmarking approach for Pillar 2A credit risk;
  • introducing two systematic methodologies applicable to exposures to (i) central governments and central banks (CG/CB), regional governments and local authorities (RG/LA); and (ii) revolving retail exposures that are unconditionally cancellable commitments (retail UCCs); and
  • introducing expectations for firms on the use of credit scenarios.

Additionally, the chapter contains a voluntary data request related to non-retail unconditionally cancellable commitments (wholesale UCCs).

• Operational risk: Introducing clear expectations on the use of scenario analysis and further transparency on the PRA’s Pillar 2A operational risk methodology.
• Pension obligation risk: Removing the PRA-prescribed stress scenarios and, for those firms with fully bought-in or sufficiently well-funded schemes, reducing the burden of the Pillar 2A pension risk assessment and associated reporting.
• Market risk and counterparty credit risk: Updating information about the current methodologies that the PRA uses to inform the setting of firms’ Pillar 2A capital requirements for market risk and counterparty credit risk, including settlement risk.

1.10 The PRA has also taken the opportunity to propose minor updates to terms or references, such as those related to the Bank of England’s updated approach to stress testing the UK banking system, the frequency of the SREP cycle, and typographical errors. These proposals can be found in the relevant appendix.

1.11 The policy proposals are primarily intended to advance the PRA’s primary objective of promoting the safety and soundness of firms, such as through adequate, accurate and risk sensitive capital requirements, and improved transparency. The PRA has also assessed these proposals against its secondary objectives to facilitate effective competition and the international competitiveness and growth of the economy in the medium to long term, subject to alignment with international standards. In several areas, the proposals contribute to the PRA’s secondary competitiveness and growth objective, including by reducing the burden on firms and/or improving the transparency of the PRA’s approach to Pillar 2A. Some proposals are also intended to promote the PRA’s secondary competition objective, such as by improving Pillar 2A guidance for firms to encourage greater consistency and support a level playing field.

1.12 This CP is relevant to all PRA-regulated banks, building societies, designated investment firms, and all PRA-approved or PRA-designated holding companies (collectively ‘firms’). It is not relevant to credit unions. Since this CP is relevant to all PRA-regulated banks and building societies, it is relevant to Small Domestic Deposit Takers (SDDTs) and firms that meet the SDDT criteria and are considering becoming an SDDT. In 2024, the PRA issued a separate consultation, entitled CP7/24 – The Strong and Simple Framework: The simplified capital regime for SDDTs, covering proposals on capital-related measures under the Strong and Simple framework. These proposals include simplifications to the Pillar 2A framework for SDDTs. The PRA intends to publish a policy statement about the SDDT capital regime in Q4 2025; please refer to CP7/24 on specific proposals.

1.13 The PRA has a statutory duty to consult when introducing new rules and changing rules (Financial Services and Markets Act (FSMA) s138J), or new standards instruments (FSMA s138S). When not making rules, the PRA has a public law duty to consult where it would be fair to do so. 

1.14 The Practitioner’s Panel was consulted about the proposals in this CP. The Cost Benefit Analysis (CBA) Panel was not consulted because the expected impact of these proposals is below its materiality threshold.^{footnote [4]}

1.15 In carrying out its policymaking functions, the PRA is required to comply with several legal obligations. The analysis in this CP explains how the proposals have had regard to the most significant matters, including an explanation of the ways in which having regard to these matters has affected the proposals.

1.16 The ‘have regards’ that were most significant in the PRA’s analysis included the proposals’ positioning in relation to international standards. In particular, the PRA proposes updating Pillar 2A to recognise the PRA’s implementation of the Basel 3.1 standards, where the PRA seeks to maintain and enhance the UK’s position as a world-leading global finance hub. Across all proposals in this CP, the PRA has also had particular regard to the proportionality of its regulation, including through reducing the regulatory burden where appropriate. The PRA has also had regard to the transparent exercise of its functions, through improving and clarifying Pillar 2A guidance for firms in a number of areas. Individual chapters further address the ‘have regards’ most relevant to the PRA’s proposals in specific risk areas.

Impact on mutuals

1.17 The PRA considers that the impact of the proposed rule changes on mutuals is expected to be no different from the impact on other firms. Where a proposal might affect some firms more than others (eg smaller firms more than larger firms), there is not expected to be any differential impact for mutuals specifically. However, some of the proposals in Chapters 2 (credit risk) and 5 (market risk and counterparty credit risk) are likely to affect mutuals less than other firms.

Equality and diversity

1.18 In developing its proposals, the PRA has had due regard to the equality objectives under s.149 of the Equality Act 2010. The PRA considers that the proposals do not give rise to equality and diversity implications.

Aggregated cost benefit analysis (CBA)

1.19 This section sets out the PRA’s impact analysis of the expected aggregate costs and benefits of implementing the proposals outlined in this CP. This aggregated CBA brings together the expected costs and benefits discussed in the subsequent individual policy chapters. This section should, therefore, be read in conjunction with Chapters 2–4.

Case for action

1.20 The PRA proposes changes to prudential policies where appropriate to promote the safety and soundness of regulated firms.^{footnote [5]} When it determines that general policies advance its primary objectives, the PRA must also act in way that advances its secondary objectives, so far as is reasonably possible.^{footnote [6]}

1.21 In summary, the majority of the proposals in this CP are necessary to facilitate the effective implementation of the Basel 3.1 standards.^{footnote [7]} The PRA has also taken the opportunity to improve the transparency, clarity, and proportionality of the broader Pillar 2A capital framework.

Implementation of the Basel 3.1 standards

1.22 The PRA has previously set out its intention to review its Pillar 2A methodologies in response to the changes introduced through the PRA’s implementation of the Basel 3.1 standards.^{footnote [8]} The following changes proposed in this review are primarily driven by changes to the Pillar 1 credit risk framework, set out in PS9/24:

• Remove the IRB benchmarking approach. The implementation of the Basel 3.1 standards will improve the risk capture and sensitivity of the Standardised Approach (SA) to credit risk. Further, the implementation of the Basel 3.1 standards will introduce restrictions on the modelling of certain exposures under the IRB approach and will eliminate the data required to update some of the benchmarks (see further details in Chapter 2). Therefore, the PRA considers that the IRB benchmarking approach will no longer be a suitable approach to ensure that Pillar 2A credit risk capital requirements address risks not already, or not sufficiently, captured by Pillar 1.
• Introduce two systematic methodologies. Removing the IRB benchmarking methodology will mean the PRA no longer has a consistent methodology to assess if firms are adequately capitalised against credit risk across their SA exposures. Therefore, the PRA proposes to introduce two systematic methodologies to ensure adequate capitalisation of the exposure types for which it considers firms’ capital requirements may be under-estimated under Pillar 1, as explained in Chapter 2. These two areas are: (i) exposures to central governments and central banks (CG/CB), regional governments and local authorities (RG/LA); and (ii) revolving retail exposures that are unconditionally cancellable commitments (retail UCCs).
• Introduce expectations on the use of credit scenarios. Despite Basel 3.1 improving the risk sensitivity of the SA, the PRA considers that there will continue to be idiosyncratic risks that will not be captured by the SA for which firms should continue to maintain additional capital under Pillar 2A. Therefore, the PRA proposes to introduce expectations for firms on the use of credit scenarios in the Internal Capital Adequacy Assessment Process (ICAAP). This would achieve greater consistency and comparability across firms’ assessments. This would also improve the robustness of the assessments and thus enhance risk sensitivity and the accuracy of capital maintained.

Improving transparency, clarity and proportionality

1.23 As part of the PRA’s implementation of the Basel 3.1 standards, the PRA will also implement a new standardised approach for Pillar 1 operational risk capital requirements (OR SA), which will replace all existing approaches for Pillar 1 operational risk requirements. While the existing Pillar 2A operational risk methodology will continue, the PRA proposes to update policy materials to ensure continued alignment between the Pillar 1 and Pillar 2A frameworks, to enhance the transparency of its methodology and to provide more guidance to firms.

1.24 Reviewing the Pillar 2A methodologies has also presented an opportunity to improve the transparency, clarity, and proportionality of other areas of the Pillar 2A framework, including credit risk, pension risk, operational risk, and market risk and counterparty credit risk.

Overall approach to the CBA

1.25 Where it is reasonable to do so, the PRA has produced quantitative estimates of costs and benefits associated with the proposals set out in this CP. As permitted under FSMA, costs and benefits have not been estimated (ie quantified) where they cannot reasonably be estimated or where it is not reasonably practicable to do so. In making these judgements, the PRA has considered factors including the reliability of any resulting estimates, proportionality (in relation to the costs of sourcing necessary data from firms) and the need to use its resources economically and efficiently. Where the PRA considers it would not be reasonable or practicable to quantify certain costs and benefits, the CP describes those costs and benefits qualitatively. In some cases, the CP presents quantitative facts to support the qualitative descriptions of costs and benefits.

1.26 For the purposes of this CBA, SDDT-eligible banks and building societies^{footnote [9]} are assumed to opt into the SDDT regime. They have, therefore, not been considered for the proposals in this CP that would not apply to SDDTs.

1.27 The PRA has not undertaken a CBA of the market risk and counterparty credit risk proposals as they do not meet the threshold for carrying out a CBA.^{footnote [10]} This is because there are no material changes proposed to the PRA’s approach to assessing market risk and counterparty credit risk in Pillar 2A. No costs are expected to arise including any additional regulatory burden for firms, as the proposals reflect existing supervisory and market practice.

Baseline

1.28 The costs and benefits are defined relative to a baseline or counterfactual. For the purposes of this CBA, we compare the proposed changes to the Pillar 2A framework against a baseline of the current Pillar 1 and Pillar 2A frameworks^{footnote [11]} (as set out in the Capital Requirements Regulations (CRR),^{footnote [12]} PRA Rulebook, Pillar 2 SoP, SS31/15 and SS32/15).

1.29 A typical baseline would also include any changes expected to come into force before the proposed implementation date for the proposals, such as the PRA’s Basel 3.1 Pillar 1 framework. This approach would not be a useful baseline for this CBA. The Pillar 1 and Pillar 2A frameworks are designed to operate alongside one another, as Pillar 2A ensures adequate capitalisation for risks that may not be fully captured by Pillar 1. This means that a Pillar 2A framework only relates to the Pillar 1 framework it operates alongside. The PRA will not implement the Basel 3.1 Pillar 1 framework without corresponding changes to Pillar 2A. Therefore, comparing the Pillar 2A proposals against a baseline of the Basel 3.1 Pillar 1 framework and current Pillar 2A framework would not provide an informative view of the costs and benefits.

Benefits of proposals in this CP

1.30 The proposals in this CP facilitate the implementation of the Basel 3.1 credit risk framework and the realisation of its benefits. This is because the Basel 3.1 standards and the proposals in this CP, if taken forward after consultation, will be implemented as a single package. Therefore, the costs and benefits of this CP should be considered alongside those of the Basel 3.1 standards, which were set out in CP16/22. These benefits primarily relate to more accurate risk measurement, which supports the PRA’s primary objective of maintaining the safety and soundness of firms. This should reduce the probability of financial crisis and support higher levels of economic output in the medium term.

1.31 However, the proposals set out in this CP would produce benefits beyond those of the PRA’s implementation of the Basel 3.1 standards. These benefits arise through three main channels: improved risk capture, increased transparency and clarity, and further proportionality. These channels are discussed in more detail in the CBAs contained within individual chapters, but in summary they operate in the following ways.

Risk capture

1.32 The proposed two new systematic methodologies in the Pillar 2A framework for CG/CB and RG/LA exposures and retail UCC exposures aim to address potential under-capitalisation that the PRA considers remains in the SA framework under the Basel 3.1 standards. The PRA considers that they more accurately reflect the underlying risk of the specific type of exposures. This improves risk capture and sensitivity in the capital framework, enhancing the safety and soundness of firms. The PRA also considers that the introduction of expectations for firms on the use of credit scenarios in ICAAPs would support firms’ understanding of the expectations. This would enhance the quality of the analysis and improve risk capture.

Transparency and clarity

1.33 The PRA is proposing to update sections of its Pillar 2 SoP, SS31/15 and instructions for reporting templates for credit risk and operational risk. The aim of these proposals is to improve the transparency and clarity of guidance to firms. The direct impact is to reduce the time and resources firms need to understand and comply with PRA requirements and expectations while improving the quality of firms’ ICAAP submissions.

Proportionality

1.34 In this CP, the PRA is proposing to reduce reporting requirements and simplify reporting templates for credit risk. Dependent on an individual firm’s circumstances and risk, the PRA proposes reducing certain Pillar 2A capital assessments for pension risk and associated reporting requirements.

1.35 These changes would mean that firms would report fewer data fields each quarter and when submitting their ICAAPs. An additional benefit of reduced reporting requirements is that firms may have more resource for the remaining regulatory reporting, which may increase the quality of that reporting. A smaller volume of better-quality reporting submissions would mean the PRA would have more available resources to review submissions, helping the PRA’s supervision of firms, which supports firms’ safety and soundness.

Costs of the proposals in this CP

1.36 Both the PRA and firms would incur some minor costs when implementing the proposals in this CP. Firms may incur costs in understanding and implementing the proposed methodologies. Firms could also incur one-off costs when implementing proposed amendments to reporting templates.

Summary table of aggregate CBA

1.37 Table 2 summarises the costs and benefits of the proposals in this CP.

Indirect impacts of the proposals

1.38 Increasing transparency and proportionality would reduce firms’ costs and improve firms’ certainty over the PRA’s requirements. This may help to provide confidence to smaller, newer, and foreign entities that they will be able to comply effectively along with facilitating competition and improving market outcomes.^{footnote [14]} Increased certainty would also support capital planning and lending growth.

1.39 The proposals that support the safety and soundness of firms may support confidence in PRA firms, which would also improve market outcomes, as well as financial stability. Improved market outcomes and financial stability should in turn support a higher level of economic output in the medium term. As the impact of the proposals on transparency and costs is limited, these indirect impacts are anticipated to be correspondingly small.

Implementation

1.40 The PRA proposes that the implementation date for the changes to pension obligation risk (set out in Chapter 4) and market risk and counterparty credit risk (Chapter 5) would be Monday 2 March 2026. Firms would be able to apply the proposals in ICAAP submissions from Monday 2 March 2026 onwards. For pension obligation risk, the updated FSA081 template would be used for submissions with reporting dates of Monday 2 March 2026 onwards. These parts of the CP have an earlier implementation date than the Basel 3.1 standards because they do not depend on simultaneous implementation of Basel 3.1.

1.41 The implementation date for the remaining proposals in this CP concerning credit risk (set out in Chapter 2) and operational risk (Chapter 3) would be aligned with the date of the PRA’s implementation of the Basel 3.1 standards.^{footnote [15]} The PRA proposes to apply the new methodologies when a firm’s Pillar 2 capital requirements are reset at the first full Capital Supervisory Review and Evaluation Process (C-SREP) after the PRA's implementation of the Basel 3.1 standards.

Responses and next steps

1.42 This consultation closes on Friday 5 September 2025. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP12_25@bankofengland.co.uk. Completed Wholesale UCC Data Collection forms can be sent by email to: WholesaleUCCDataCollection@bankofengland.co.uk.

1.43 When providing your response, please tell us whether or not you consent to the PRA publishing your name, and/or the name of your organisation, as a respondent to this CP.

1.44 Please also indicate in your response if you believe any of the proposals in this CP are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

1.45 References related to the UK’s membership of the EU in the Pillar 2 SoP, SS31/15 and FSA templates and instructions covered by this CP have been updated as part of these proposals to reflect the UK’s withdrawal from the EU. Unless otherwise stated, any remaining references to EU or assimilated legislation refer to the version of that legislation that forms part of assimilated law.^{footnote [16]}

2: Credit risk

2.1 Credit risk is the risk of losses arising from a borrower or counterparty failing to meet its obligations as they fall due. Pillar 1 capital requirements for credit risk are set out in the CRR and PRA rules. However, the PRA considers that the Pillar 1 SA for credit risk may underestimate the risk for certain asset classes and may not fully capture idiosyncratic risk. The PRA therefore assesses credit risk as part of its Pillar 2 review of firms’ capital adequacy.

2.2 Currently, SS31/15 – The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), does not contain specific expectations on how firms should conduct their assessments of credit risk in their ICAAP. The PRA has observed that firms generally refer to the PRA’s Pillar 2A credit risk methodology (as set out in the Pillar 2 SoP) in their own assessments. This methodology (often known as the benchmarking methodology), is applied to exposures on the SA, and is based on a comparison of firms’ SA risk weights at a portfolio level to an IRB approach risk weight benchmark (the IRB benchmark). The PRA uses this methodology as an input to inform the setting of a firm’s Pillar 2A capital requirement for credit risk for all portfolios to which the SA is applied (ie including portfolios subject to partial use of the SA where the firm has an IRB permission). The determination of a firm’s overall credit risk add-on is not a mechanical calculation but is also based on supervisory judgment, taking into account considerations such as the firm’s own assessments.

2.3 The PRA has observed that some firms also make use of credit scenarios to stress their credit portfolios, assessing whether additional capital might be required, particularly to cover idiosyncratic credit risks (for example, by considering the performance of sub-prime real estate lending under a significant reduction in property prices). Several firms create their own proxy IRB models to estimate what the equivalent risk weight might be based on the historical performance of their own credit portfolios, and then compare it with their Pillar 1 requirements to assess whether additional capital might be required.

Review of the benchmarking methodology

2.4 The PRA has reviewed the application of the current benchmarking methodology, which was developed to inform judgement as to whether a firm should maintain additional capital for credit risk under Pillar 2A. The implementation of the Basel 3.1 standards will improve risk capture and sensitivity of the SA. As a result, the Risk Weighted Assets (RWAs) of firms using the SA will, in general, better reflect the relative riskiness of their portfolios. The PRA also considers the portfolios of IRB firms are often different to those of SA firms and, therefore, IRB risk weights are not always directly comparable with SA risk weights. The introduction of the output floor, which aims to address shortcomings in the use of internal models, also reinforces the PRA’s view that IRB risk weights may not always be an appropriate comparator. At the same time, the PRA considers that there will continue to be idiosyncratic risks that will not be captured by the SA for which firms should continue to maintain additional capital under Pillar 2A. This is inevitable given that even the improved and more risk sensitive SA continues to be a broad approximation in some cases. The PRA considers that these idiosyncratic risks will not be effectively captured under the current benchmarking methodology. Therefore, post-Basel 3.1, the PRA considers the IRB benchmarks and the benchmarking methodology will no longer be an appropriate approach to assess potential credit risk under-estimation under the SA.

2.5 Furthermore, the PRA considers that the implementation of Basel 3.1 standards will make it unviable for the PRA to maintain risk-sensitive IRB benchmarks to inform risk assessments. First, the removal of IRB modelling for certain asset classes will eliminate the data required to update some of the IRB benchmarks. Second, the greater use of the foundation IRB (FIRB) approach and restrictions on exposure at default (EAD) modelling under the advanced IRB (AIRB) approach means more IRB parameters would be based on inputs prescribed by regulators, reducing the additional informational value from use of the IRB benchmarks.

2.6 The PRA also considers that updating the IRB benchmarks would create a cost to firms using the IRB approach, adding to the burden on firms during a time of significant regulatory change.

Overview of the proposals

2.7 As stated in CP16/22 – Implementation of the Basel 3.1 standards, the PRA considers that some undercapitalisation will remain in the SA framework under the Basel 3.1 standards for exposures to central governments or central banks (CG/CB) and exposures to regional governments or local authorities (RG/LA). Furthermore, the PRA also considers a specific Pillar 2A methodology for retail UCCs is required to ensure firms are adequately capitalised for these exposures. Therefore, the PRA is proposing a tailored approach for these exposures to better capture these two risks. The PRA also considers that there will be idiosyncratic risks faced by specific firms for which they should continue to maintain additional capital.

2.8 Therefore, the PRA proposes to update its Pillar 2A methodology for credit risk as follows:

• remove the benchmarking methodology (including the IRB benchmarks) currently set out in the existing Pillar 2 SoP – The PRA’s methodologies for setting Pillar 2 capital; 
• introduce two systematic methodologies to assess the two areas where the PRA considers firms’ capital requirements will often be under-estimated under Pillar 1. These two areas are: (i) exposures to CG/CB and RG/LA; and (ii) retail UCCs; and
• introduce expectations for firms on the use of credit scenarios in ICAAPs, which would inform the PRA’s assessment of whether firms are adequately capitalised against credit risk exposures on the SA, reflecting the idiosyncratic risks they face.

2.9 The PRA proposes to apply the proposed methodologies to all portfolios on the SA, including off-balance sheet exposures and exposures risk-weighted under SA by firms with IRB permissions.^{footnote [17]} For portfolios risk-weighted under the IRB approach, the PRA would seek to address insufficient Pillar 1 requirements through requiring the firm to remediate the shortcomings of the IRB models (for known deficiencies), as well as through the backstop of the output floor (for unknown deficiencies), rather than setting Pillar 2A capital requirements. Firms may be required to hold a post-model adjustment (PMA) in their Pillar 1 capital requirements while they are remediating their model.

2.10 Consistent with the above changes to the methodology, the PRA proposes to reduce reporting requirements for firms by streamlining FSA076 and decommissioning FSA077 and FSA082. To reflect these changes, the PRA proposes to update the Reporting Pillar 2 Part of the PRA Rulebook (please see further details in paragraph 2.63).

2.11 With the forthcoming implementation of Basel 3.1 standards, the PRA also proposes to update references and obsolete terms across the policy materials. These include consequential updates to SS31/15 (Appendix 4) and the draft SS – ICAAP and SREP for SDDTs^{footnote [18]} (Appendix 5) regarding the eligibility of guarantees and credit derivatives as credit risk mitigation in Pillar 1 of a firm’s capital requirements. This is to reflect the changes made to SS17/13 – Credit risk mitigation as set out in PS9/24 – Implementation of the Basel 3.1 standards near-final part 2.

2.12 The proposals in this chapter would not apply to SDDTs, except for the consequential update to the draft SS mentioned in paragraph 2.11 regarding the eligibility of guarantees and credit derivatives as credit risk mitigation. Please refer to CP7/24 – The Strong and Simple Framework: The simplified capital regime for SDDTs for the proposed Pillar 2A credit risk methodologies for SDDTs.

2.13 Key proposed changes are set out in Table 3 below.

Proposal 1: Proposed systematic methodology for exposures to central governments and central banks (CG/CB), regional governments and local authorities (RG/LA)

2.14 Currently, the IRB benchmarking methodology (as set out in the Pillar 2 SoP) covers sovereign exposures (ie exposures to CGs and CBs), and the benchmarks are broadly structured based on credit quality steps. The methodology does not cover RG and LA exposures.

2.15 The PRA set out, in CP16/22, its intention to remove the ability to model CG/CB exposures, but to later consult on a Pillar 2 methodology to help promote the adequate capitalisation of exposures to CG/CBs and RG/LAs. Proposal 1 delivers the consultation of that Pillar 2 methodology. The PRA considers this is necessary because there are certain CG/CB and RG/LA exposures where the Pillar 1 SA risk weight may not adequately reflect the riskiness of the exposures. These comprise certain CG/CB exposures, which are eligible for a lower risk weight as a result of CRR Article 114(7) because they are to a jurisdiction with equivalent supervisory and regulatory arrangements to the UK and are denominated and funded in the domestic currency of the borrower. They also include certain RG/LA exposures, which benefit from the treatment set out in CRR Article 115(4). These preferential treatments, which often lead to a 0% risk weight, may result in capital requirements that do not adequately capture the risk implied by the credit rating.

CG and CB exposures

2.16 The PRA recognises that a CG/CB exposure being denominated and funded in the domestic currency of the borrower provides some risk mitigation. However, the PRA considers that this is not always sufficient to justify a reduction in the Pillar 1 risk weight to zero relative to the risk weight that would be assigned based on the credit assessment of the borrower by an external credit assessment institution (ECAI). For example, the risk weight for a credit quality step (CQS) 6 exposure can be reduced from 150% to 0% if that risk weight is applied by the regulator of the equivalent jurisdiction in question.

2.17 While recognising that sovereigns are more likely to be solvent in domestic currency than foreign currency, defaults in domestic currency are still possible and defaults, particularly of higher risk sovereigns, have been observed in recent history. The PRA also considers that the equivalence of supervisory and regulatory arrangements may not be a good indicator of the creditworthiness of the CG/CB and therefore may not be a reliable risk mitigant. The PRA considers that these features are not sufficient to justify zero capitalisation in all cases.

2.18 To ensure adequate capitalisation, the PRA therefore proposes to introduce a number of minimum effective risk weights for exposures to non-UK CG/CBs in Pillar 2A, as a replacement for the relevant IRB benchmarks. The minimum effective risk weights were calibrated based on PRA judgement and historical default rate analysis. Where the Pillar 1 risk weight for an exposure is below the proposed relevant minimum effective risk weight, the PRA proposes to introduce an expectation that firms should calculate the difference between the Pillar 2A minimum effective risk weight and the Pillar 1 risk weight. The sum of these positive differences across exposures (ie credit risk under-estimation) would contribute to the setting of the Pillar 2A add-on.

2.19 The PRA conducted analysis on defaults on sovereign debt denominated in domestic currency using ECAIs’ historical default rate data. For example, data on all sovereigns from S&P Global shows that zero sovereign defaults were observed over a 1-year outcome window for CQS1 over the period that data was available and an 11-year outcome window is required in order for a non-zero default rate to be observed for these.^{footnote [19]} The PRA therefore considers that the risk associated with CQS1 exposures (equivalent to minimum export insurance premiums (MEIP) 0 and 1 where the exposure is rated by an Export Credit Agency) is sufficiently close to zero to justify a zero minimum effective risk weight. The PRA notes that a significant majority of firms' exposures to CG/CBs measured by exposure value are CQS1 exposures and would still attract a 0% risk weight, and no additional Pillar 2A charge.

2.20 While the data from S&P Global also shows that zero sovereign defaults were observed for CQS2 and CQS3 exposures over a 1-year outcome window, a positive default rate was observed over 3-year and 2-year outcome windows for CQS2 and CQS3 exposures respectively. The PRA considers that this indicates that it would be imprudent to treat CQS2 and below exposures as having zero risk. The PRA thus considers that under-capitalisation in Pillar 1 is more likely to occur for exposures to CG/CBs rated CQS2 to CQS6, which are risk weighted in accordance with CRR Article 114(7).

2.21 The PRA is proposing a minimum effective risk weight of 20% for CQS4 to 6 (and MEIP4 to 7) and unrated exposures. This reflects the higher historical default rates of these exposures relative to CQS2 and CQS3 exposures and ensures the capitalisation of these exposures is not lower than that for the highest quality corporate exposures (which have significantly lower historical default rates).^{footnote [21]} The PRA considers that the proposed minimum effective risk weight of 5% for CQS2 and CQS3 (and MEIP2 and 3) appropriately reflects the lower but non-zero risk associated with these exposures.

2.22 The PRA notes that the proposed minimum effective risk weights are significantly lower than the equivalent existing IRB benchmarks, which range from 7.0% for CQS1 exposures to 143.1% for CQS5 exposures.^{footnote [22]} The PRA considers that this difference gives appropriate credit for the exposure being funded and denominated in domestic currency, and appropriately recognises both: (i) the removal of IRB modelling for these exposures; and (ii) the broader differences between the current and proposed Pillar 2A methodology for credit risk.

2.23 The PRA proposes to exclude exposures to the UK Government and the Bank of England from its methodology and therefore the proposed minimum effective risk weights would not be applied to these exposures. The PRA notes that exposures to both the UK Government and the Bank of England are currently CQS1 so would not be subject to the proposed minimum effective risk weights even in the absence of this exclusion. However, the PRA considers that being explicit about this exclusion would provide certainty that its proposed policy does not provide a barrier to the effective implementation of UK monetary policy.

RG and LA exposures

2.24 The PRA also proposes to apply minimum effective risk weights to RG/LA exposures. The proposed minimum effective risk weights would primarily affect exposures where:

• the exposure is risk-weighted in accordance with CRR Article 115(4), which allows RG/LA exposures to be risk-weighted as if they were direct exposures to the central government where certain conditions are met; and
• the exposure is denominated and funded in local currency and exposures to the central government denominated and funded in local currency are eligible for a lower risk weight as a result of CRR Article 114(7), which often leads to such RG/LA exposures receiving a 0% risk weight.

2.25 The PRA considers that RG/LAs generally have lower fiscal and monetary capacity than central governments given they cannot print their own currency and, therefore, their risk does not justify zero capitalisation. Even where local regulators assess there to be no difference in risk between the regional government or local authority and the central government, the PRA has seen variance in how this assessment is made across jurisdictions. The PRA observes that there are examples where a jurisdiction assesses there to be no difference in risk but ECAI’s credit ratings are lower for the RG/LA than for the relevant central government. The PRA considers it would not be an efficient use of its resources to make and regularly update a worldwide assessment of the credit quality of RG/LAs, particularly given its view that, generally speaking, they are less credit worthy than central governments.

2.26 For RG/LA exposures in scope, the PRA proposes a minimum effective risk weight of 5% for RG/LA exposures assigned a CQS1 rating (this will only impact exposures benefiting from a lower risk weight as a result of CRR Article 115(4)). These exposures represent a non-zero risk and the PRA’s proposal reflects the marginal additional risk relative to a sovereign exposure due the absence of monetary and fiscal autonomy. The PRA proposes a 20% minimum effective risk weight for RG/LA exposures assigned a CQS2 or CQS3 rating, mirroring the lowest Pillar 1 SA risk weight for the highest credit quality exposures outside of this exposure class, and a 100% minimum effective risk weight for RG/LA exposures assigned a CQS4 to 6 (or MEIP 4–7) rating which is equal to the risk weight assigned to a CQS4 CG/CB exposure that is not risk weighted in accordance with CRR Article 114(7).

2.27 The PRA does not propose to include exposures to UK RG/LAs within the scope of this treatment in line with the proposed approach for exposures to the UK central Government and the Bank of England. Therefore, the proposed minimum effective risk weights would not be applied to these exposures.

Credit risk mitigation (CRM)

2.28 As set out in PS9/24, firms may use the risk weight substitution method and financial collateral simple method to reflect the effect of credit protection provided by central governments, central banks, regional governments and local authorities. When these methods are applied, the covered part of an exposure receives the RW of the protection provider as calculated under the SA. The PRA proposes to apply the Pillar 2A minimum effective risk weight to the covered part of an exposure when credit protection provided by a central government or central bank that is within the scope of the systemic add-ons is recognised for Pillar 1 purposes. The PRA considers that this proposal would advance its safety and soundness objective as it would mitigate the risk of excessively low SA RWs being used for CRM purposes.

Proposal 2: Proposed systematic methodology for UCCs

2.29 This section sets out the PRA’s proposals regarding the treatment of UCCs under Pillar 2A. UCCs are off-balance sheet contractual arrangements to, among other things, extend credit and purchase assets, which can be unconditionally cancelled by the lender at any time.^{footnote [24]}

2.30 As set out in PS9/24, the PRA considers that despite a commitment being unconditionally cancellable, firms sometimes do not cancel a commitment and instead allow obligors to continue to draw down on existing facilities for a variety of reasons. These include reputational or business reasons and firms’ inability to perfectly predict the likelihood of obligor default.

2.31 The capitalisation of these exposures reflects the likelihood of a commitment coming onto the balance sheet via a conversion factor (CF), which is applied to the exposure value before it is risk weighted. Under the PRA’s implementation of the Basel 3.1 standards, a CF of 10% will be applied under the SA.

2.32 Due to differences in data availability and in treatment under the IRB approach, the PRA has considered retail UCCs and wholesale UCCs separately.

Retail UCCs

2.33 Firms using the SA are currently required to assess the adequacy of their Pillar 1 capital requirements for personal loans and credit cards via the IRB benchmark methodology, which the PRA is proposing to retire as set out above. The existing benchmark is higher than the equivalent SA RWs. The PRA considers that this indicates that SA Pillar 1 capital requirements for these exposures are too low.

2.34 The PRA considers that the increase in CFs for retail UCCs from 0% to 10% under the Basel 3.1 standards will partially address some of the existing Pillar 1 under-capitalisation of retail UCCs that is currently captured in Pillar 2A. However, the PRA’s evaluation of existing research and new analysis undertaken by the PRA indicates that under-capitalisation of retail UCCs could still be a significant issue for some firms. The PRA considers that a new capital treatment in Pillar 2A is the most appropriate way to address this deficiency (rather than increasing the Pillar 1 CF across the board) because of the flexibility it affords to reflect firms’ individual circumstances. This enables firms to continue to use the Pillar 1 CF treatment where they have robust evidence that this is adequate.

2.35 The PRA proposes that the contribution to the Pillar 2A credit risk add-on for firms using the SA for their retail UCC exposures would be equal to the difference between applying the Pillar 1 CF of 10% and:

• a prescribed CF reference point of 20%; or
• a CF derived by the firm based on their portfolio, where the firm chooses to submit data to the PRA and assesses that the prescribed 20% is too high for their portfolio. The firm would need to robustly substantiate this based on the portfolio’s realised CFs. This CF would be no less than the 10% CF in Pillar 1.

2.36 The proposed approach would enable firms to adopt a lower CF than the proposed reference point where they can robustly substantiate that their realised CFs are lower over a long run period including a downturn. For example, using data drawn from the global financial crisis for UK exposures. Where firms do not have data covering a downturn period, benign year CFs would need to be suitably increased, reflecting an estimation of their behaviour in a downturn event. This is to ensure an appropriate realised CF.

2.37 The calibration of the proposed CF reference point has been informed by analysis of the relative capitalisation of these exposures under the SA and the IRB approach, evidenced by regulatory reporting data (the PRA used qualifying revolving exposures as a proxy for UCCs when utilising IRB approach data throughout this analysis).

2.38 The PRA initially compared CFs assigned to retail UCCs under the SA and the IRB approach. This showed that the 10% CF under SA is substantially below the IRB average of 57%. This indicates that the SA CF may materially under-estimate the risk of draw-down associated with these exposures in a default event.

2.39 The PRA considered proposing a reference point based on this direct comparison of SA and IRB approach CFs. However, the PRA considered that such an approach would result in disproportionate outcomes for firms using the SA, as it would not reflect the overall Pillar 1 capital treatment of these exposures.

2.40 The PRA therefore proceeded to consider the risk weights applied to retail UCCs and any associated on-balance sheet exposures under the SA and the IRB approach. The average SA risk weight under the Basel 3.1 standards will range from 45% to 75% depending on the proportion of exposures that qualify for the 45% transactor treatment and assuming that the currency mismatch multiplier does not apply. The average IRB risk weight stands at 30%. The PRA notes however that the IRB risk weight was measured during a period of relatively low default rates and the average risk weight over an economic cycle is expected to be higher.

2.41 The PRA then estimated the relative capital requirements differential between the SA and the IRB approach for retail UCCs and any associated on-balance sheet exposures. To do this, the PRA made several simplifying assumptions, including:

• the proportion of retail UCCs that qualify for the transactor treatment – the PRA assumed this to be 30% based on Basel QIS returns, however the PRA also considered data that indicated this proportion may be as low as 14%; and
• the uplift required to the IRB risk weights such that they appropriately reflect the average of an economic cycle – the PRA estimated this to be approximately 9.5% based on analysis of stress testing data and assumptions relating to the length and severity of the economic cycle and assumed this figure in its analysis.

2.42 The PRA’s analysis indicated adjusted IRB capital requirements were on average approximately 23% higher than SA capital requirements based on the above assumptions. The PRA then estimated the uplift in CFs that would be required to align SA capital requirements with those applicable under the IRB approach. To do this, the PRA made a following further assumption.

• The proportion of retail UCCs and associated on-balance sheet exposures that are on-balance sheet (measured by notional value of the exposure) – the PRA assumed a value of 25%. This reflected regulatory return data indicating that 18% of such exposures are on-balance sheet plus an uplift to reflect the risk of this proportion increasing during an economic cycle.

2.43 The PRA estimated from this analysis that a CF uplift to approximately 20% was required to equalise the IRB and SA overall treatments; and it used this estimate to determine the proposed CF reference point. The PRA recognises, however, that the estimate is sensitive to the assumptions made. It would therefore welcome submissions of industry data relating to these assumptions in response to this consultation, to enable it to refine the calibration of the proposed reference point.

Wholesale UCCs

2.44 The PRA considers that UCCs in other categories of exposures (eg revolving credit facilities to corporate counterparties) may also be undercapitalised in Pillar 1. In the PRA’s implementation of the Basel 3.1 standards, these exposures will receive a 10% Pillar 1 CF under the SA. Firms using the Foundation IRB (FIRB) approach will also apply this CF, alongside modelled probabilities of default, and firms using the Advanced IRB (AIRB) approach will apply this CF for UCCs except those that are revolving loan commitments, alongside modelled probability of default and loss given default. The PRA considers that where an inappropriately low SA CF is combined with a modelled risk weight, the risk of undercapitalisation may be greatest.

2.45 In order to assess the adequacy of SA CFs for wholesale UCCs, the PRA is therefore initiating a voluntary data request, to gather evidence from firms that assess that they have material wholesale UCC portfolios, on the likelihood of certain wholesale UCCs coming onto the balance sheet in the 12 months prior to a default event, as evidenced from their portfolio. This request will segment data by product type and certain other breakdowns, as the PRA recognises that the risk characteristics can vary significantly between different types of wholesale UCC exposures.

2.46 This data will inform the PRA’s policy (including the potential for a specific Pillar 2A capital treatment) in the medium term. The PRA recognises that wholesale lending is more international in nature than retail lending, and so will carefully consider this in line with its secondary competitiveness and growth objective. Any such proposals would be subject to further consultation.

2.47 The PRA is also seeking to understand how firms using the AIRB approach are modelling this risk, to enable a comparison of capitalisation of these exposures with SA and FIRB approaches.

2.48 Firms should submit data to WholesaleUCCDataCollection@bankofengland.co.uk by 31 March 2026. The PRA invites firms to complete and return the form titled ‘Wholesale UCC Data Collection’ in Appendix 8. This appendix is not formally part of the consultation. However, it has been included in this publication due to the close interlinkages with the proposed Pillar 2A treatment for retail UCCs, which informed the PRA’s decision to seek wholesale UCC data from firms. The PRA is not seeking feedback on the contents of this voluntary data request.

Proposal 3: Expectations for firms on the use of credit scenarios

2.49 The PRA expects firms using the SA, in the first instance, to take responsibility for ensuring that the capital they have is adequate, with the ICAAP being an integral part of meeting this expectation. The PRA proposes that firms would undertake credit scenario analysis alongside the two systematic methodologies.

2.50 The PRA considers credit scenarios and the two systematic methodologies are complementary, where the former focuses on firms’ idiosyncratic risks and the latter focuses on addressing more systematic areas of under-estimation of risk identified in the Pillar 1 SA. The PRA has observed that credit scenarios are currently commonly adopted by some firms in their Pillar 2A assessments. The PRA considers that these have been effective in capturing idiosyncratic risks in firms’ ICAAPs, while providing the flexibility required to suitably address these risks.

2.51 In order to ensure that scenarios are designed consistently across firms, the PRA proposes to introduce clear expectations for firms on the use of credit scenarios in ICAAPs. This would inform the PRA’s assessment of whether firms are adequately capitalised against credit risk across exposures on the SA, reflecting the idiosyncratic risks they face. This proposal is also in line with the credit risk Pillar 2A methodology proposed for SDDTs in CP7/24.

2.52 The PRA proposes to set out clear expectations for firms that they should design their own scenarios through exploring high-severity tail events over a 12-month horizon, with particular focus on how these events may result in credit losses that are not captured under Pillar 1 or the systematic methodologies. Such analysis should aim to assess whether the firm is adequately capitalised for credit risk across its exposures.

2.53 The PRA proposes that this assessment should be used to ensure that minimum requirements across Pillar 1 and Pillar 2A provide sufficient capacity to absorb losses incurred in high-severity tail events over a 12-month horizon. This is more severe than – and different from – the assessment in Pillar 2B, which is intended to ensure that firms maintain sufficient capital to withstand a severe but plausible stress over a longer time horizon.

2.54 Firms should ensure their own credit scenarios are more severe than the historical average peak-to-trough change in key macroeconomic scenario variables in Bank Capital Stress Tests or equivalent benchmark scenarios published by the PRA. More information on how firms should calibrate and tailor their scenarios to the risks in their portfolios is set out in the proposed changes to SS31/15.

2.55 The PRA also proposes that it would continue to consider firms’ alternative assessments in their ICAAPs (in place of credit scenarios) to inform its assessments of whether firms are adequately capitalised against credit risk across exposures on the SA. These would include assessments based on firms’ own proxy IRB approaches except where: 

• the proxy IRB approach is used for exposures where the IRB approach is not available under Pillar 1;
• the proxy IRB approach is used for exposures for which a firm with an IRB permission has been granted permission to permanently use the SA on the grounds that the firm cannot reasonably model the exposures; and
• the proxy IRB approach is used for a set of exposures in respect of which the proxied approach is not available under Pillar 1. This includes in particular:
  • proxy IRB approaches using firm estimates of LGD, where the AIRB approach is not available under Pillar 1;
  • proxy IRB approaches using firm estimates of conversion factor or EAD, where either:
    • the AIRB approach is not available under Pillar 1, or
    • modelling conversion factors or EAD is not permitted under the AIRB approach;
  • proxy IRB approaches that do not proxy the Slotting Approach, where the Slotting Approach is the only IRB approach available under Pillar 1; or
  • proxy IRB approaches that proxy the Slotting Approach, where the Slotting Approach is not available under Pillar 1.

2.56 The PRA proposes that if a firm is to use an IRB proxy model instead of a credit scenario, it should provide sufficient details in the ICAAP document to enable the PRA to understand the modelling and assumptions. 

Interaction between credit scenarios and systematic methodologies

2.57 The PRA proposes that a firm’s credit risk Pillar 2A add-on would be informed by the difference between Pillar 1 requirements and the higher of:

(a) Pillar 1 capital requirements for credit risk plus the additional capital deemed necessary according to the two systematic methodologies (ie the systematic components); and

(b) the capital needed for credit risk as identified through the credit scenarios analysis (and/or other methodologies used to assess the sufficiency of overall capital, accounting for idiosyncratic risks where appropriate).

Chart 1: Illustrations of Pillar 2A credit risk add-on calculation

Footnotes

• In scenario 1, a firm’s (a) Pillar 1 capital requirements for credit risk plus the systematic components are lower than (b) the capital needed for credit risk as identified through the credit scenarios analysis (and/or other methodologies). Therefore, a firm’s credit risk add-on would be equal to (b) minus Pillar 1.
• In scenario 2, a firm’s (a) Pillar 1 capital requirements for credit risk plus the systematic components are higher than (b) the capital needed for credit risk as identified through the credit scenarios analysis (and/or other methodologies). Therefore, a firm’s credit risk add-on would be equal to the systematic components.

2.58 The PRA observes that, currently, when firms run credit scenarios on their lending portfolios, a whole balance sheet level view is taken on whether the firm requires additional Pillar 2A capital. The PRA notes some firms may net off excess conservatism inherent in some aspects of the credit risk SA risk weight with under-capitalisation identified in their credit scenarios. The PRA proposes to continue to allow firms to take a whole balance sheet level assessment (including assessing the idiosyncratic risk of exposures subject to the systematic components) that allows netting across different credit portfolios when assessing whether the credit risk exposures are adequately capitalised.^{footnote [25]} The PRA would only consider it appropriate if firms can robustly substantiate the idiosyncratic factors in their portfolios that give rise to excess conservatism.

2.59 The PRA would continue to exercise supervisory judgement when setting a firm’s Pillar 2A capital requirements to ensure that the required amount of total capital supports sound risk management and the effective coverage of risks, promoting the safety and soundness of firms.

Proposal 4: Reporting

2.60 In light of the proposed changes to Pillar 2A methodologies, the PRA proposes to streamline FSA076 and decommission FSA077, as set out in Appendix 7. This proposal would reduce reporting requirements for firms using the SA from 326 data points to 78 data points.

2.61 Currently, firms are required to complete FSA076 and 077 for any wholesale portfolio and retail portfolio of exposures for which capital requirements are calculated using the SA. To reflect the proposed new methodologies, the PRA proposes to decommission FSA077, and firms would be required to submit the FSA076 for any of the following exposures:

• exposures to central governments or central banks that are assigned a risk weight in accordance with CRR Article 114(7);
• exposures to regional governments or local authorities that are assigned a risk weight in accordance with CRR Article 115(4);
• off-balance sheet items assigned to the exposure class in Article 112(1)(h) of the near-final Credit Risk: Standardised Approach (CRR) Part of the PRA Rulebook and subject to a conversion factor of 10% in accordance with Table A1 in Article 111 of the near-final Credit Risk: Standardised Approach (CRR) Part; and/or
• exposures to other counterparties are also included within the first two bullet points of this list where these result in a risk-weight being assigned in accordance with CRR article 114(7) or 115(4).^{footnote [26]}

2.62 In line with the proposal to remove the benchmarking methodology, the PRA also proposes to remove requirements from firms that have permission to use the IRB approach to submit FSA082, which has 210 data points.

2.63 To reflect these changes, the PRA proposes to update the Reporting Pillar 2 Part of the PRA Rulebook as follows:

• update rule 1.6 to reflect the deletion of certain defined terms;
• delete rules 2.8 and 4.12 due to the proposal to decommission FSA077;
• amend rules 2.7 and 4.11, and introduce rule 2.7A to reflect changes of scope and template of FSA076; and
• delete rules 2.5 and 4.10 due to the proposal to decommission FSA082.

2.64 The proposed changes of these templates are based on the PRA implementing its proposal in relation to retiring the refined methodology, which is subject to the outcome of CP9/24 – Streamlining the Pillar 2A capital framework and the capital communications process.

PRA objectives analysis

2.65 The PRA considers that:

• its proposals for Pillar 2A credit risk would advance its primary safety and soundness objective by ensuring that firms are adequately capitalised for the risks that they face, in a manner that is risk-sensitive and responsive to firms’ individual circumstances;
• its proposal to assess credit risk in Pillar 2A using credit scenarios would advance safety and soundness by maintaining firms’ own responsibility for assessing their own capital adequacy, including by promoting senior level engagement with the analysis as part of the ICAAP document submission process; and
• the proposed systematic methodologies for CG/CBs and RG/LAs and retail UCCs would ensure a minimum level of prudence in total capital requirements for these exposures.

2.66 The PRA considers that the proposals would advance its secondary competition objective. For example, its proposal to offer more detailed expectations on credit scenarios would promote a more consistent approach among firms, fostering a level playing field. At the same time, the proposals would allow flexibility, enabling firms to tailor approaches to their unique circumstances. The PRA’s proposals for UCCs would advance competition between firms using the SA and the IRB approach by bringing about greater parity in capital requirements across the approaches.

2.67 Overall, the PRA considers that its proposals would advance its secondary competitiveness and growth objective. The PRA considers that its proposed systematic methodologies for CG/CBs and RG/LAs would facilitate UK growth by lowering distortionary incentives to invest in certain non-UK exposures due to their relative undercapitalisation in Pillar 1. In particular, the PRA recognises the benefits to UK growth of ensuring that firms are not unduly incentivised to lend to non-UK sovereigns instead of, for example, lending to UK corporates. The PRA considers that its proposals would support growth in the medium to long term by ensuring firms are adequately capitalised for the risk of their exposures, supporting their ability to withstand economic shocks, and in turn, continue lending throughout the economic cycle. The simplification of reporting requirements would also reduce regulatory burden on firms.

2.68 The PRA notes that Pillar 2 approaches vary across jurisdictions and these approaches are often high-level to allow for supervisory judgment and tailoring to firm-specific circumstances. Therefore, assessing the implications of the PRA’s proposals for UK competitiveness via direct comparison with other jurisdictions is challenging. However, the PRA does not consider its proposal in relation to retail UCCs would significantly impact competitiveness as retail lending is primarily a domestic market. Furthermore, the PRA has considered the international nature of wholesale lending and plans further work (including a voluntary data collection) before deciding whether to propose further Pillar 2A policy in respect of wholesale UCCs.

Cost Benefit Analysis – Credit risk

2.69 The PRA has considered the costs and benefits of the proposed changes to the Pillar 2A credit risk methodology. More details on the overall CBA approaches can be found in Chapter 1.

1. Proposal to remove the benchmarking methodology

2.70 As mentioned in paragraph 2.4, the PRA considers that the forthcoming implementation of the Basel 3.1 standards would improve risk capture and sensitivity of the SA, and some of the existing risk under-estimation (which the benchmarking methodology was designed to assess) would be addressed directly in Pillar 1. At the same time, the benchmarking methodology does not capture idiosyncratic risks faced by specific firms for which firms should continue to maintain additional capital under Pillar 2A. Therefore, the benchmarking methodology would no longer be the best approach to assess if there is any potential credit risk under-estimation under the SA.

2.71 Removing the benchmarking methodology, combined with the proposal under CP9/24 to remove the refined methodology, would allow the PRA to simplify firms’ reporting requirements (ie FSA076, FSA077) from 326 data points to 78 data points. It would also remove IRB firms’ ongoing costs in submitting the FSA082, which has 210 data points, and the PRA’s costs of updating the benchmark.

2. Proposed systematic methodology for CG/CB and RG/LA exposures

2.72 Currently, the IRB benchmarking methodology (as set out in the Pillar 2 SoP) covers sovereign exposures and the benchmarks are broadly structured based on credit quality steps. The methodology does not cover RG and LA exposures.

2.73 The PRA considers the proposed methodology better targets the exposures (including both CG/CB and RG/LA exposures) that are risk-weighted 0% under preferential treatment due to risk weight overrides, which is a source of potential under-capitalisation. This would enhance risk sensitivity, ensure that these exposures are adequately capitalised according to their risk, and would enhance the safety and soundness of firms.

2.74 Together with the restrictions on the modelling of these exposures introduced by the forthcoming Basel 3.1 standards, this would mean that firms using the SA and the IRB approach would have the same capital requirements for these exposures. This enhances comparability and consistency, which facilitates competition. The PRA also notes that most of the relevant exposures held by firms are to the UK or other CQS1 countries, which would not be subject to the systematic components under these proposals. Therefore, the impact on firms’ capital from the proposals is relatively limited (and will be explained further below).

2.75 Furthermore, as mentioned above, firms with IRB permissions will no longer be able to apply the IRB approach to these exposures following the PRA’s implementation of the Basel 3.1 standards. Therefore, some exposures that are currently modelled under the IRB approach will be assigned lower RWs in the future under SA. For instance, based on relevant firms’ regulatory returns (see Table 6), these firms would currently apply a positive risk weight for CQS1 sovereign exposures (on count-weighted average of 9.7% according to 2023 Q4 data, exposure-weighted average of 4.8%) but their migration to SA means they would instead apply a 0% RW for these exposures. The same will happen for exposures to non-CQS1 rated sovereigns getting a preferential treatment set out in Article 114(7) of the CRR, where exposures risk weighted under the IRB approach will move from a positive risk weight, on average, to a 0% risk weight. Therefore, firms currently risk-weighting sovereign exposures under the IRB approach with exposures moving to the SA that would be subject to the systematic components are likely to see an overall decrease in capital requirements.

2.76 In terms of implementation and ongoing compliance costs, the PRA expects firms to have the required data already available (which are fed into the current Pillar 1 reporting). The PRA understands firms may need to implement minor system changes to report relevant exposures using a specific breakdown in the revised FSA076. This will increase reporting by 40 data points.

3. Proposed systematic methodology for retail UCCs

2.77 Firms using the SA are currently required to assess the adequacy of their Pillar 1 capital requirements for personal loans and credit cards via the IRB benchmark methodology, which the PRA is proposing to retire. The PRA considers the proposed systematic methodology in respect of retail UCCs would advance safety and soundness, as it would capture both on and off-balance sheet retail UCC exposures. The average IRB CFs modelled by firms are materially higher than the 10% CF prescribed under the SA, and overall capital requirements are 23% higher for firms using the IRB approach. The capitalisation of these exposures in Pillar 1 under SA is thus often likely to be inadequate. The PRA considers that addressing this in Pillar 2 to be more proportionate and risk sensitive as the proposed treatment can be sensitive to the various characteristics of firms’ portfolios.

2.78 In terms of implementation and ongoing compliance costs, the PRA expects that firms should have the data available (which are fed into the current Pillar 1 reporting). The PRA understands firms may need to implement minor system changes to report relevant exposures using a specific breakdown in the revised FSA076. This will involve reporting 36 data points.

2.79 The proposed methodology is mechanical and straightforward so that firms’ relevant exposures could be assessed in a consistent way. In addition to this, the PRA proposes an optional approach that allows firms to challenge the prescribed reference point and apply their own realised CFs in the Pillar 2A assessment, if available.

2.80 The mechanical approach ensures simplicity and ease of use, while the tailored approach offers enhanced risk sensitivity. While the tailored approach may have higher implementation and operational costs in maintaining and updating the data, by offering this flexibility, firms may choose the option that best suits their circumstances (eg whether they already have the relevant data and systems in place).

4. Proposed expectations for firms on the use of credit scenarios in ICAAP

2.81 The PRA considers the proposal to introduce expectations for firms on the use of credit scenarios would provide greater consistency across firms’ ICAAP assessment, given that SS31/15 does not currently provide specific expectations on how firms may conduct Pillar 2A credit assessments in their ICAAP. This should support firms to understand the PRA’s expectations concerning Pillar 2A capital requirements in a consistent way, which would enhance the quality of the analysis and improve risk capture.

2.82 The PRA notes that firms may incur one-off costs to understand the PRA’s expectations on credit scenarios, as well as in designing scenarios that align with the PRA’s expectations. There may also be ongoing implementation cost to regularly review and enhance the credit scenarios.

2.83 The PRA notes that some firms are already using credit scenarios in their credit Pillar 2A assessment in the ICAAP, so the PRA considers the costs would differ between firms. Further, while the Pillar 2A credit scenarios would be used for a different purpose to the Pillar 2B stress testing, firms could leverage their experiences and capabilities in running Pillar 2B stress testing to design and run Pillar 2A credit scenarios where they have not done so already. Therefore, the PRA does not consider the costs for firms of aligning with our proposed expectations to be significant.

2.84 On the other hand, clearer expectations in SS31/15 should be less costly to firms and the PRA. Additionally, minimising back-and-forth interactions during the C-SREPs and reducing ambiguity would result in more uniform submissions, thereby facilitating peer assessment conducted by the PRA.

2.85 There would be a small cost to the PRA associated with updating internal processes for evaluating firms’ ICAAPs. The PRA also considers that this cost should be one-off and minimal as credit scenarios are already used by some firms. Therefore, the PRA is already equipped with the required resources and capabilities to assess them. The recommended policies do not place additional resource requirements on the PRA’s supervisory functions relative to the resource requirements associated with the current process for setting firms’ Pillar 2A capital requirements via the C-SREP.

5. Impact on firms’ overall capital requirements

2.86 The PRA notes that there may be additional costs or benefits to firms that are related to the change in capital requirements.

2.87 The current benchmarking methodology involves a comparison of firms’ SA RWs at a portfolio level to IRB benchmarks developed by the PRA. This methodology looks at total credit risk. If the IRB benchmark implies that the SA for calculating the Pillar 1 risk weight overestimates the overall level of capital required for a given portfolio when compared to IRB data, the calculated excess can be offset against shortfalls in those portfolios for which the benchmark implies that the SA Pillar 1 risk weight is lower than the IRB risk weight. Currently, relatively few firms are subject to a credit risk add-on, as the current SA risk-weights are often higher than the applicable IRB benchmark.

2.88 However, the PRA considers such potential excess conservatism in Pillar 1 will be much less likely in the future. The implementation of the Basel 3.1 standards will improve risk sensitivity of the SA, including reducing SA risk weights for certain low-risk lending activities (eg real estate exposures). Therefore, the PRA expects firms that currently see excess conservatism in Pillar 1 to see a direct reduction in their Pillar 1 capital requirements. The PRA notes that the capital impact on firms would vary, depending on their specific portfolios. However, the stylised example in Box A sets out further details of the interaction between the changes to the SA resulting from the Basel 3.1 standards and the proposals set out in this chapter.

2.89 The PRA does not have the data to perform a quantitative assessment on how firms’ Pillar 2A requirements will change on an aggregate basis. This is because capital impacts would be largely dependent on firms’ specific portfolios, in particular regarding firms’ use of credit scenarios. However, some firms are already using credit scenarios in the credit risk Pillar 2A assessment in their ICAAPs and some firms currently have add-ons based on credit scenarios. Therefore, the PRA does not expect assessment of idiosyncratic risks would change significantly due to the introduction of expectations on the use of credit scenarios.

2.90 The PRA has further examined how firms’ Pillar 2A requirements would change due to the removal of the benchmarking methodology and the introduction of the two systematic methodologies. Given the objective of the PRA’s credit risk Pillar 2A methodology is to capture credit risks that are not fully captured under Pillar 1, the PRA considers it crucial to examine the Pillar 1 credit risk approach. This approach will be introduced by the PRA’s implementation of the Basel 3.1 standards,^{footnote [27]} and its interaction with the Pillar 2A methodology. Absent the implementation of the Basel 3.1 standards, the PRA would retain the current credit risk Pillar 2A methodology. This is particularly important when looking into factors that drive changes in firms’ total capital requirements.

2.91 Overall, the PRA expects more firms may have credit risk add-ons in Pillar 2A in the future due to the removal of the benchmarking methodology and the introduction of the two systematic methodologies. However, the PRA does not expect firms’ total capital requirements across Pillar 1 and Pillar 2A to change substantially. The PRA’s analysis suggested that the add-ons derived from the two systematic methodologies will not be sizeable. The PRA expects 45% of CRR firms (excluding SDDT-eligible firms) would likely be subject to these systematic add-ons, with an average add-on of 0.08% and a median of 0.02% (both in % of firms’ total RWAs). Please see Table 7 for further details. A small number of firms that are concentrated in undercapitalised exposures in Pillar 1 would have add-ons that are higher than average.

'Have regards’ analysis

2.92 In developing these proposals, the PRA has had regard to the FSMA regulatory principles and aspects of the Government’s economic policy as set out in the HMT recommendation letter of November 2024. In addition to have regards relating to competitiveness and growth (covered above under objectives), the following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Proportionality and different business models:

• The PRA considers that these proposals represent a proportionate approach to addressing a range of clearly identified risks (idiosyncratic risks and exposures where Pillar 1 capital will often be inadequate). The PRA’s credit scenarios proposal would provide flexibility for firms of different sizes, nature and business models to assess the risk and capitalisation of their exposures in a way that is appropriate to them. The PRA considers that the level of firm resource required to undertake this analysis should be consistent with the resource currently required to undertake credit scenarios or other approaches to assessing idiosyncratic risk now. The PRA’s proposed systematic methodologies are simple to calculate and would require the submission of less data than is required for the IRB benchmark analysis at present. In respect of UCCs, the PRA proposes that firms can choose a simple approach or can undertake their own analysis to apply a CF in Pillar 2A that reflects their individual circumstances where this is appropriately justified.

2. Efficient use of resources:

• The PRA considers that the proposed policies are consistent with efficient use of the PRA’s resources. This is because the proposed policies would not place additional resource requirements on the PRA’s supervisory functions relative to the resource requirements associated with the current process for setting firms’ Pillar 2A capital requirements through the C-SREP.

3. Transparency and LRRA principles of good regulation:

• The PRA considers that these proposals would improve transparency by setting clearer expectations on how firms are expected to assess idiosyncratic credit risks in their ICAAPs. The PRA expects that this would help firms to comply with their obligations in an efficient way.

3: Operational risk

3.1 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.

3.2 As set out in PS17/23 – Implementation of the Basel 3.1 standards near-final part 1, the PRA will implement a new SA for Pillar 1 operational risk capital requirements (OR SA), which would replace all existing approaches for Pillar 1 operational risk requirements.

3.3 As set out in CP16/22 – Implementation of the Basel 3.1 standards, the PRA does not intend to make significant changes to the Pillar 2A methodology because of the changes to the Pillar 1 framework brought by the forthcoming implementation of Basel 3.1 standards. However, the PRA considers there are some areas that could benefit from clarification to ensure the methodology remains consistent with the OR SA. Therefore, the PRA does not propose changes to its Pillar 2A operational risk methodology. Instead, the PRA proposes to update its policy materials to enhance the transparency of its methodology and provide more guidance to firms. The PRA proposes to:

• introduce expectations on scenario analysis in SS31/15 to all firms to improve the quality and consistency of their ICAAP scenario analysis;
• provide more transparency in the Pillar 2 SoP, The PRA’s methodologies for setting Pillar 2 capital, clarifying what factors the PRA considers when setting Pillar 2A capital requirement for operational risk for all firms, as well as additional factors considered for significant firms.^{footnote [28]}
• introduce a set of good practices for significant firms in maintaining a robust operational risk measurement framework in SS31/15 for firms to consider;
• make minor clarification changes to the instructions of FSA072–075 templates; and
• update references and obsolete terms across the policy documents (including Reporting Pillar 2 rules, SS31/15 and Pillar 2 SoP), including removing specific requirements on firms with advanced measurement approach (AMA) permissions, given AMA would be removed with the implementation of the Basel 3.1 standards.

3.4 All else being equal, the PRA expects most firms’ total operational risk capital requirements would remain unchanged due to the implementation of the Basel 3.1 standards and/or the proposals set out in this chapter, although the distribution of firms’ operational risk capital requirements across Pillar 1 and Pillar 2A may change.^{footnote [29]}

3.5 For SDDTs, the proposed Pillar 2A operational risk methodology was set out in CP7/24 – The Strong and Simple Framework: The simplified capital regime for SDDTs. These proposals do not change the proposals in CP7/24. The PRA intends to publish a policy statement about the SDDT capital regime in Q4 2025.

Proposal 1: Expectations on scenario analysis for all firms

3.6 The PRA proposes to introduce clearer and proportionate expectations for firms on the operational risk scenario analysis in the ICAAP, in line with current observed best practice among firms. This includes clarifying the expectations for firms to capture potentially severe operational risk exposures, including low-frequency high severity events, achieving a soundness standard comparable to a 99.9 % confidence interval over a one year. (Please see Appendix 4 for further details.)

3.7 The PRA also proposes to specify a minimum set of information it expects firms to provide in ICAAP. This includes brief information on their management of operational risk, information on the operational risk scenarios they have considered in their ICAAP, and any available data the firm has on historical loss events, expected losses and/or forecast losses.

3.8 The PRA also proposes to maintain a proportionate approach when reviewing a firm’s operational risk assessment and expects a firm to tailor its analysis based on the risks to which it is most exposed.

Proposal 2: More transparency on the PRA’s Pillar 2A operational risk methodology

3.9 The current published methodology for operational risk in the Pillar 2 SoP focuses on Category 1 firms. The PRA proposes to update the naming convention from ‘Category 1 firms’ to ‘significant firms’ in the Pillar 2 SoP, in order to align with the naming convention in the Reporting Pillar 2 rules and other supervisory statements. The PRA notes these two terms are often used interchangeably and does not affect the scope of application of the methodology.

3.10 With the aim of enhancing clarity and transparency to all firms (including significant and non-significant firms), the PRA proposes to set out the factors that the PRA considers when setting Pillar 2A. As set out in Appendix 2, this will include:

• the firm’s business model and its exposure to operational risk;
• the firm’s analysis in its ICAAP, with a focus on scenario analysis;
• the quality of the firm’s own Pillar 2A assessment, including appropriateness and robustness;
• any insights gathered through engagement with the firm; and
• peer group comparison.

3.11 This is to improve clarity and address some questions commonly raised by firms during the supervisory review process. The PRA has also added additional clarifications to the Pillar 2 SoP on the methodology applied to significant firms.

Proposal 3: Good practices in maintaining a robust operational risk measurement framework

3.12 As set out in paragraph 4.11 of the current Pillar 2 SoP, if a firm’s operational risk measurement framework is of the AMA standard, the firm’s ICAAP is the main input into the setting of Pillar 2A capital for operational risk. However, once the Basel 3.1 standards are implemented, AMA will be retired. Therefore, the current requirements and guidelines will no longer be applicable. These include Articles 321 to 324 of the UK CRR and the EBA’s Regulatory Technical Standards on assessment methodologies for the use of AMAs for operational risk. The PRA considers some of the relevant AMA requirements and guidelines are useful for promoting good practices.

3.13 With the aim of retaining the current practice (set out in paragraph 4.11 of the current Pillar 2 SoP) and onboarding the relevant AMA requirements and guidelines, the PRA proposes to introduce a set of good practices for significant firms in maintaining a robust operational risk measurement framework in SS31/15. The PRA proposes that where a significant firm’s operational risk measurement framework aligns with the good practices, the PRA would place greater emphasis on the firm's ICAAP when determining Pillar 2A capital for operational risk. Otherwise, the PRA would rely more on the methodology outlined below.

Proposal 4: Clarification of changes to the instructions of FSA072–075 templates

3.14 Currently, all significant firms and firms with AMA permission must report the FSA072–075 returns (unless the data required has already been reported to the PRA by other means). The PRA may request that other firms submit these returns in advance of their ICAAP document. The PRA proposes to retain this submission requirement, except to remove specific AMA-related requirements on firms with an AMA permission, given the AMA would be removed under Pillar 1 with the implementation of the Basel 3.1 standards.

3.15 In PS9/24 – Implementation of the Basel 3.1 standards near-final part 2, the PRA stated its intention to review the Pillar 2 reporting templates to address any potential interaction between the Basel 3.1 Pillar 1 operational risk reporting and the Pillar 2 reporting requirements. The PRA has completed this review and has concluded that these templates are complementary to each other and there is no duplication. Under Basel 3.1 Pillar 1 reporting, firms with Business Indicators greater than £0.88 billion report aggregate operational losses based on an accounting view. This information is used to monitor the capital impact of a variable internal loss multiplier (ILM) as part of policy evaluation of setting the ILM to 1. On the other hand, Pillar 2 reporting is required of significant firms and requires operational losses to be reported on an event basis. This information is used to inform the PRA’s setting of Pillar 2A add-ons.

3.16 Nevertheless, the PRA considers that there is scope to make minor clarifications to the instructions to improve clarity and consistency and address some questions commonly raised by firms during the supervisory review process.

PRA objectives analysis

3.17 The PRA considers that the proposals in this chapter would advance the PRA’s primary objective of safety and soundness of firms. The clarifications and enhancements to the transparency of the PRA’s methodologies and expectations should make meeting regulatory expectations more straight forward and create a more level playing field for firms, particularly for non-significant firms where there is less guidance in the Pillar 2 SoP. The proposed changes in the Pillar 2 SoP and SS31/15 would allow firms to better understand the PRA’s expectations and assess their operational risk Pillar 2A add-ons in a more consistent way. The PRA also considers that the proposed expectations on scenario analysis would improve firms’ assessment and risk management, promoting safety and soundness.

3.18 The PRA considers that the proposals would facilitate the PRA’s secondary competition objective. The current published methodology focuses on Category 1 firms (significant firms) with limited detail on the PRA’s methodology for non-significant firms. The proposal to introduce expectations on scenario analysis in SS31/15 and improve transparency in the Pillar 2 SoP would provide greater clarity on areas of expectations that firms find challenging and reduce firm burden. More transparency and clarity about the PRA’s methodologies may also support the PRA in facilitating its secondary competition objective by assisting firms in preparing consistent submissions and thus improving the data the PRA uses when setting firms’ Pillar 2A add-ons.

Cost Benefit Analysis – Operational risk

3.19 The PRA has considered the expected costs and benefits of implementing the operational risk proposals set out in this CP as part of the Pillar 2A review. More details on the overall CBA approaches can be found in Chapter 1.

3.20 The CBA assumes that all SDDT-eligible firms opt into the SDDT regime and, therefore, the proposals set out in that chapter will not apply to them.

Benefits

3.21 The proposal to introduce expectations on scenario analysis in SS31/15 and improve transparency in the Pillar 2 SoP will provide greater clarity on areas of expectations that firms find challenging. This would reduce the time and resources firms need to understand the PRA’s methodologies. As a result, this may also mean firms have more resources available to improve the quality and consistency of their ICAAP scenario analysis and better meet the PRA’s expectations.

3.22 Further, the current published methodology focuses on Category 1 firms (significant firms) with limited detail on the PRA’s methodology for non-significant firms. The PRA considered the improved transparency, and clarity would benefit non-significant firms even more. This would, in turn, allow the PRA to spend less time and effort explaining methodologies during the supervisory review process. This would enable the PRA to focus its supervisory resources on the riskiest firms, and help ensure they are capitalised in a prudent manner.

3.23 The PRA also proposes to introduce the good practices in maintaining a robust operational risk measurement framework. As set out currently in the Pillar 2 SoP, when a firm’s operational risk management and measurement framework are of AMA standard, the firm’s ICAAP is the main input into the setting of Pillar 2A capital requirements for operational risk. However, with the retirement of the AMA under Pillar 1 with the implementation of Basel 3.1 standards, the current requirements and guidelines will no longer be applicable. Therefore, the PRA’s proposal to incorporate some relevant good practices in SS31/15 would continue to promote equivalent practices for firms whose operational risk management and measurement frameworks currently meet the AMA standard.

3.24 Finally, the minor proposed clarifications to the FSA reporting instructions would improve clarity for firms. This aims to address questions identified during the submission and supervisory review process, such as improving definitions of certain data items and setting out clear examples of how firms should submit data. The proposals would not impose additional legal requirements on firms as the PRA proposes to retain the current submission requirements.

Costs

3.25 The PRA does not expect that the proposed changes to the Pillar 2A operational risk policy materials would result in material costs to firms because the PRA is not proposing policy changes. Instead, the PRA is making updates to the policy materials to enhance overall clarity and increase transparency to the benefit of firms. The PRA expects that firms may incur one-off costs when seeking to understand and to align their Pillar 2A assessments to the more comprehensive expectations set out in the SS31/15.

3.26 The other proposals in this chapter have no material bearing on costs as the review is limited to enhancing clarity and transparency for firms without any policy changes, therefore the cost impacts are minimal.

3.27 Specifically, the proposed good practices in maintaining a robust operational risk management and measurement framework are not mandatory for all significant firms. Rather, the intention of the proposed good practices is to promote existing strong risk management approaches. If a significant firm’s operational risk measurement framework does not meet the standard of good practices as a minimum, the PRA would rely on its own methodologies to inform the setting of a firm’s Pillar 2A operational risk capital, instead of placing greater emphasis on the firm's ICAAP. Therefore, the PRA does not expect these changes to add to firms’ costs.

3.28 Finally, the PRA expects most firms’ total operational risk capital requirements would remain unchanged as a result of the proposals set out in this chapter, all else being equal. This is because the PRA is not proposing to change the methodology it uses to set firms’ capital add-ons, but rather, to provide more transparency of its methodology and provide further guidance to firms.

‘Have regards’ analysis

3.29 In developing these proposals, the PRA has had regard to the FSMA regulatory principles and aspects of the Government’s economic policy as set out in the HMT recommendation letter from November 2024. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposal:

1. Proportionality:

• The PRA adopts regulatory proportionality to ensure that the regulatory framework is appropriate for the size, complexity, and risk profile of different types of firms. The proposal to include more detail on scenario analysis in SS31/15 and improve transparency in the Pillar 2 SoP will provide greater clarity on areas of expectations that firms find challenging. Further, the PRA proposes to maintain a proportionate approach when reviewing a firm’s operational risk assessment and expects a firm to tailor its analysis based on the risks to which it is most exposed. This approach reduces the regulatory burden on smaller firms and encourages competition and innovation. The proposals aim to improve consistency and ensure proportional prudential requirements are applied to all firms.

2. Different business models:

• The proposals in this chapter recognise the differences between types of firms. Under the proposal to clearly set out the PRA’s expectations on the operational risk scenario analysis, the PRA considered the consistency and relevance of rules for different business models. This is to ensure that the PRA can continue to capture different types of risks that may vary across firms. Overall, the proposed framework would continue to be proportionate to the size, business model, and risk profile of firms.

3. Transparency:

• The PRA considers that proposals in this chapter would enhance the transparency of its Pillar 2A methodology by setting out clearly the areas that the PRA’s assessment considers in the Pillar 2 SoP and providing more clarity on the PRA’s expectations related to scenario analysis. This would allow firms to better understand the PRA’s requirements and expectations and consider their risks more consistently.

4. Efficient use of PRA resources:

• The PRA considers that the proposals in this chapter would enhance the efficiency with which the PRA uses its resources to assess the Pillar 2A capital requirements for all firms but particularly it will bring enhanced clarity for firms. The proposed updates to the Pillar 2 SoP and SS31/15 would support firms to conduct more consistent analysis and therefore facilitate more effective peer review. This would enable the PRA to allocate its supervisory resources more efficiently.

3.30 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for this set of proposals, it is because the PRA considers that ‘have regard’ to not be a significant factor for this set of proposals.

4: Pension obligation risk

Overview

4.1 Pension obligation risk (pension risk) relates to defined benefit pension schemes and defined contribution schemes offering guaranteed returns that are not fully matched by underlying investments. Hybrid schemes are considered to be defined benefit pension schemes. Risks arising from overseas pension schemes are included.

4.2 Pension risk has fallen markedly for most firms in recent years due to the de-risking of schemes’ investment strategies and falling pension scheme deficits. This has been driven by multiple factors, including rising interest rates and cash contributions from sponsoring firms. Due to these developments, Pillar 2A pension risk for some of these firms is now close to zero.

4.3 Responding to this and other changes to the market context, the PRA outlines two main proposals in this chapter:

• Proposal 1: Removing the PRA-prescribed stress scenarios; and
• Proposal 2: Exempting those firms with fully bought-in or sufficiently well-funded schemes from the Pillar 2A pension risk assessment and reducing the associated reporting requirements.

4.4 Therefore, both proposals in this chapter aim to reduce the regulatory burden on firms. They do not change the PRA’s overall approach to assessing firms’ pension risk.

4.5 These updates would require an amendment to rule 4.9 of the Reporting Pillar 2 Part of the PRA Rulebook. The PRA also proposes some minor updates to the FSA081 template, FSA081 instructions, Pillar 2 SoP, Pillar 2 SoP for SDDTs, and SS31/15 to correct outdated terminology and improve readability.

4.6 This chapter is relevant to banks, building societies, and PRA-designated investment firms, including those which are SDDTs.

Proposal 1: Remove the PRA’s two published stress scenarios for pension risk

4.7 Currently, the PRA assesses firms’ Pillar 2A pension risk add-on through several approaches, including by comparing four stress scenarios: two prescribed by the PRA, one developed and submitted by firms, and the PRA’s assessment. Each firm reports the results of the first three scenarios in its data submission to the PRA.

4.8 The PRA has observed that firms have increased their modelling capabilities and no longer use the PRA’s two published scenarios as in previous years. The reliance placed by the PRA on the PRA-prescribed scenarios has diminished since they were introduced. Given this reduction in usefulness, the PRA proposes removing the two stress scenarios. By removing them, the PRA seeks to reduce the burden of disclosure on firms, without materially impacting the PRA’s ability to undertake an assessment of Pillar 2A pension risk capital.

4.9 The PRA therefore proposes to remove ‘Stress scenario 1’ and ‘Stress scenario 2’ from Section II of the FSA081 template.

Proposal 2: Reduce firms’ Pillar 2A pension risk assessments and lighten reporting requirements where schemes are fully bought-in or sufficiently well-funded

4.10 The PRA proposes to reduce the number of data entries required in the FSA081 template for schemes that have either fully bought-in or sufficiently well-funded schemes.

4.11 The PRA considers that pension schemes subject to a full-scheme buy-in are unlikely to present a material risk for firms, and in such cases, it is also unlikely that the Pillar 2A pension risk framework will result in a material add-on. Therefore, the PRA proposes that firms with pension schemes that meet this criterion do not need to provide a full submission of the FSA081 template for that scheme. Nonetheless, the PRA would continue to expect an assessment of the residual risks remaining following a buy-in, such as credit risk relating to the insurer counterparty. The ICAAP should document firms’ assessments of these risks.

4.12 The PRA also considers that pension schemes with large accounting surpluses, and which are likely to remain in surplus post-stress, also carry minimal prudential risk for firms. Firms with pension schemes with large accounting surpluses are therefore unlikely to receive a material add-on under the Pillar 2A pension risk framework. In line with this, the PRA proposes that pension schemes with a funding ratio of at least 130%, on the firm’s accounting basis, need not provide a full submission of the FSA081 template.

4.13 The PRA proposes setting the funding ratio for a reduced FSA081 template submission at 130% because PRA data shows that firms with schemes at or above this ratio have not received pension risk add-ons for a number of years. PRA data also shows that some firms with schemes that have funding ratios below 130% continue to receive pension risk add-ons. The PRA considers that setting the funding ratio for lower pension risk assessment and reporting requirements below 130% would potentially carry higher prudential risk for firms because future stresses are more likely to lead to funding deficits if starting from a lower funding ratio. The proposed method for calculating the pension scheme’s funding ratio can be found in the FSA081 instructions in Appendix 8.

4.14 The PRA proposes to reduce firms’ risk assessments and lighten reporting requirements where firms meet one of these two criteria, which it considers important determinants of a firm’s pension risk. However, for the avoidance of doubt, trustees of pension schemes should decide if meeting either criterion is a suitable outcome for the scheme in question.

4.15 If a firm has multiple schemes, the PRA proposes that these conditions would be applied on an individual scheme-by-scheme basis. For example, for a firm which has one scheme fully bought-in, one scheme with a funding ratio at 130% and one scheme meeting neither condition, only the third scheme would still require a full disclosure in the FSA081 alongside the limited disclosures for the other two schemes.

PRA objectives analysis

4.16 The two proposals set out in this chapter advance the PRA’s objective of promoting the safety and soundness of firms. Proposal 1 reduces the reporting burden for firms while maintaining the PRA’s ability to undertake assessments of Pillar 2A pension risk capital requirements. The PRA considers that pension schemes that fulfil one of the criteria set out in Proposal 2 carry far less pension risk for firms than pension schemes that do not. On this basis, the PRA assesses that reducing the regulatory and reporting burden for such firms will not affect the PRA’s ability to promote firms’ safety and soundness. Meanwhile, the PRA will continue to request the same data for firms whose pension schemes are not fully bought-in or that have a funding ratio below 130%. The PRA’s overall risk appetite toward firms’ defined benefit pension schemes remains unchanged.

4.17 The PRA further assesses that the proposals in this chapter also advance its secondary objective of facilitating the international competitiveness and growth of the economy in the medium to long term. Specifically, the proposals lighten the regulatory burden on firms where there is a sound prudential justification for doing so. This will save firms time in calculating and reporting requirements. The proposals may also reduce the fees paid to external actuarial advisers. The PRA assesses that the proposals meanwhile have limited bearing on its secondary competition objective.

Cost Benefit Analysis – Pension risk

4.18 The PRA has considered the costs and benefits of the proposed changes to the Pillar 2A pension risk methodology. More details on the overall CBA approaches can be found in Chapter 1.

4.19 The PRA considers that the proposals in this chapter would benefit firms by reducing the regulatory burden and the costs associated with submitting information to the PRA. The PRA does not expect any negative impact on firms’ resilience or financial stability in relation to these proposals. The PRA does not consider there to be any significant marginal cost involved with making these changes.

4.20 The proposals do not require any new information to be disclosed. For some firms, the proposals will reduce the regulatory disclosure requirements in relation to pension risk and therefore provide some savings in the amount of work required.

4.21 The PRA has estimated the cost savings that might be expected across the industry. To do this, some assumptions have been made. The savings are expected to come from two areas: (i) time saved by the firm itself in preparing regulatory returns; and (ii) cost savings to some firms in the form of lower spend on pension or actuarial consultancy advice in relation to undertaking stress calculations and preparing regulatory returns.

4.22 The PRA estimates that these proposals would affect around 75 banks and building societies with defined benefit pension schemes, including all the largest systemically important banks. These firms are required to maintain Pillar 2A capital in relation to pension risk if appropriate. Savings are expected to be modest across all applicable firms, reflecting spend on external advisers and/or time spent by the firm’s in-house pensions team.

4.23 An estimate has been made regarding the proportion of firms with defined benefit schemes that satisfy either of the two qualifying criteria. This proportion will change over time as scheme funding ratios fluctuate and more schemes enter full-scheme buy-ins. However, based on historical data, the PRA has assumed 10% of firms with defined benefit schemes meet at least one of these criteria.

4.24 The PRA estimates annualised savings of less than £1 million across the banking industry. Costs to the PRA of implementing and monitoring the policy under these proposals are expected to be small.

4.25 Implementing these proposals would prevent firms from carrying out unnecessary work that does not support the PRA’s objectives. Therefore, the PRA does not see any scope for these proposals to negatively impact firms’ resilience, market outcomes or financial stability.

‘Have regards’ analysis

4.26 In developing these proposals, the PRA has had regard to the FSMA regulatory principles and aspects of the Government’s economic policy as set out in the HMT recommendation letter of November 2024. In addition to have regards relating to competitiveness and growth (covered above under ‘PRA objectives analysis’), the following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Proportionality:

• In reducing the reporting requirements and capital assessments for qualifying firms, the proposals reduce the regulatory burden for firms meeting the criteria and therefore improve the proportionality of the PRA’s regulation.

2. Different business models:

• In developing these proposals, the PRA recognises the different approaches firms take to setting pensions risk. A minority of firms may still rely on the two prescribed scenarios in deriving stress scenarios. The removal of these, as outlined in Proposal 1, may mean that some firms have to develop their own scenario(s) regarding an appropriate stress. However, the PRA assesses that these firms may simply decide to adopt one of the published scenarios as their own stress, nullifying this potential additional burden.

3. Economic growth:

• The proposals in this chapter are aimed at reducing the regulatory burden where prudentially justified. This allows qualifying firms to reallocate resources to more productive use.

4. Transparency:

• Proposal 1 removes the two lesser-used prescribed stress scenarios, while continuing to require firms to develop their own stress scenario. This improves the transparency surrounding the stress scenarios that will inform the PRA’s assessment of pension risk.

5. Efficient and economic use of PRA resources and LRRA principles of good regulation:

• Costs to the PRA of implementing and monitoring the policy under these proposals are expected to be small. These proposals would reduce the time and resource the PRA spends on pension risk regulatory reporting and calculation of stress impacts. This would enable the PRA to focus its resources more efficiently.
• For similar reasons, the PRA assesses that the proposals are aligned with the LRRA principles of good regulation.

4.27 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for these proposals, it is because the PRA considers that ‘have regard’ to not be a significant factor for these proposals.

5: Market risk and counterparty credit risk

Overview

5.1 Market risk is the risk of losses resulting from adverse changes in the value of positions, which arises from movements in market prices across commodity, credit, equity, foreign exchange and interest rate risk factors. Counterparty credit risk is the risk of losses arising from the default of a counterparty to derivatives, margin lending, securities lending, repurchase and reverse repurchase or long settlement transactions before final settlement of the transaction’s cash flows, and where the EAD is crucially dependent on market factors. Under the existing Pillar 2A methodology for market risk and counterparty credit 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.

5.2 This chapter sets out the PRA’s proposals to provide more information on the existing methodologies used for setting Pillar 2A capital requirements for market risk and counterparty credit risk.

5.3 As well as providing more information on the existing methodologies that the PRA uses to inform the setting of Pillar 2A capital requirements, the PRA also proposes to update supervisory statement 31/15 – The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) to reflect the current reporting it expects firms to provide as part of their ICAAP submission.

5.4 This chapter is relevant to banks, building societies, and PRA-designated investment firms, including those which are SDDTs. As set out in the draft Pillar 2A SoP for SDDTs, which was consulted on as part of CP7/24, market risk is of limited relevance to SDDTs. As such, the proposed updated information set out in Proposal 1 will not be included in the Pillar 2A SoP for SDDTs. To the extent that an SDDT is exposed to market risk, the PRA may apply Pillar 2A add-ons using other methodologies, including those set out in the Pillar 2A SoP. The proposed updated information for counterparty credit risk set out in Proposal 2 will similarly not be included in the Pillar 2A SoP for SDDTs. However, where an SDDT does not manage its counterparty credit risk prudently, the PRA may apply a Pillar 2A add-on in line with the counterparty credit risk section of the Pillar 2A SoP.

5.5 Overall, the proposals in this chapter would not change the way that market risk and counterparty credit risk are assessed in Pillar 2A. Instead, the proposed updated information, which is in line with current established supervisory and market practice, would provide more transparency and clarity on the PRA’s approach and expectations. The PRA does not expect that the proposals would change firms’ total market risk and counterparty credit risk capital requirements.

Proposal 1: Update information about the PRA’s Market Risk Pillar 2A assessment methodology

5.6 The PRA proposes to provide more information on its own Pillar 2A methodology used to inform the setting of Pillar 2A capital requirements for market risk, including illiquid risks, that the PRA assesses are not sufficiently captured in Pillar 1. The PRA’s proposed updates to the SoP reflect established supervisory and market practice. The additional information is intended to offer greater transparency and detail, improve consistency in firms’ submissions, and reduce the burden on firms. The proposed additional information would not change how the PRA assesses market risk.

5.7 Illiquid, one-way and concentrated positions are collectively referred to as illiquid risks. The proposed updated information in the SoP explains how the PRA assesses firms’ processes and practices for identifying illiquid risks. The PRA seeks assurances that firms’ assumed liquidity horizons are sufficiently prudent including, where relevant, that their models capture material non-linearity. Where possible, the PRA also benchmarks firms’ methodologies for assessing illiquid risk against realised shocks from relevant stress periods (eg the global financial crisis). The proposed updated information also details how the PRA assesses the suitability of firms’ proposed capital mitigants and reserves, and sets out the benchmarking method used to calculate the incremental Pillar 2A add-on required.

5.8 The proposed updated information also covers other market risks. Other market risks that the PRA considers include, but are not limited to, gap risk, intraday risks, non-interest rate market risks on fair-valued positions in available-for-sale books, and syndicated loan underwriting.^{footnote [30]} The proposed updated information also explains the stress-testing approach adopted by the PRA when it assesses a firm’s syndicated loan underwriting risk for Pillar 2A, and the factors that are incorporated into the calculation of its gross stress loss.

5.9 The proposed updated information also sets out the current reporting requirements for market risk, including the minimum information that firms are expected to submit to the PRA alongside their ICAAP submission.

Proposal 2: Update information about the PRA’s Counterparty Credit Risk Pillar 2A assessment methodology

5.10 The PRA proposes to provide more information on the Pillar 2A SoP methodology used to inform the setting of Pillar 2A capital requirements for counterparty credit risk, including settlement risk, where they are not sufficiently captured through Pillar 1 capital. The PRA’s proposed updates to the SoP are in line with established supervisory and market practice. The updates are intended to offer greater transparency and detail and would not change how the PRA assesses counterparty credit risk.

5.11 The proposed updated information about the PRA’s methodology sets out the types of counterparty credit risk against which the PRA may require firms to maintain additional capital under Pillar 2A. These risks are likely to be underestimated or not well captured under Pillar 1. In particular, they relate to residual risks arising from credit risk mitigation, wrong way risk, exposures to CCPs and settlement risk, as well as other tail risks including weaknesses in firms’ stress testing or model validation and governance processes, the adequacy of Pillar 1 capital requirements for credit valuation adjustment (CVA) volatility risk, and the accuracy of exposures under non-advanced methods.

5.12 The proposed updated information on settlement risk also explains the PRA’s treatment of non-payment versus payment (PvP) settlement protocols.

5.13 The proposed updated information also expands on the PRA’s expectations around firms’ identification, risk assessment and capitalisation of residual risks that may arise from the use of credit risk mitigation strategies. These include over-collateralised portfolios, where collateral received is concentrated in a single security or issuer, and large individual trades where the recognition of credit risk mitigation leads to comparatively low Pillar 1 requirements. The proposed updated information clarifies that the PRA considers both a firm’s assessment of residual risks against individual positions as well as at the overall portfolio level.

5.14 The proposed updated information also sets out the reporting requirements for counterparty credit risk, including the minimum information that firms are expected to submit to the PRA alongside their ICAAP submission.

PRA objectives analysis

5.15 The PRA assesses that the proposed updated information would improve the transparency of the PRA’s policies. The updated information would encourage more consistent submissions by firms on their identification, assessment and capitalisation of market risk and counterparty credit risk exposures. Consistent data would help to support the PRA in fulfilling its primary objective of promoting the safety and soundness of firms.

5.16 The PRA has also assessed whether the proposals in this chapter would support the PRA in its secondary objectives to facilitate effective competition, the international competitiveness of the economy and the growth of the economy in the medium to long term. Providing updated information and being more transparent about the PRA’s methodologies concerning market risk and counterparty credit risk may reduce firm burden and thus support the PRA’s secondary competitiveness objective. More transparency and clarity about the PRA’s methodologies may also support the PRA in facilitating its secondary competition objective by assisting firms in preparing consistent submissions and thus improving the data the PRA uses when setting firms’ Pillar 2A add-ons.

Cost Benefit Analysis – Market risk and counterparty credit risk

5.17 The PRA has not considered the expected costs and benefits of the market risk and counterparty credit risk proposals set out in this chapter because they would entail updates reflecting current supervisory and market practice and not changes to policy. Therefore, the PRA does not expect these changes to create costs.

‘Have regards’ analysis

5.18 In developing these proposals, the PRA has had regard to the FSMA regulatory principles and aspects of the Government’s economic policy as set out in the HMT recommendation letter of November 2024. In addition to have regards relating to competitiveness and growth (covered above under objectives), the following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Transparency:

• The primary aim of publishing updated information about the PRA’s methodologies for assessing market risk and counterparty credit risk is to increase transparency about how the PRA sets capital as part of the Pillar 2A framework. The proposed updated information is in line with established supervisory and market practice, so the PRA assesses that these updates would enhance both the publication and transparency of available information on the PRA’s approach to market risk and counterparty credit risk.

5.19 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for these proposals, it is because the PRA considers that ‘have regard’ to not be a significant factor for these proposals.