This consultation paper (CP) sets out proposed adjustments to the Prudential Regulation Authority’s (PRA) Pillar 2A capital framework which came into force on 1 January 2016. It is relevant to banks, building societies and PRA-designated investment firms.
The PRA is proposing to refine its Pillar 2A approach for firms using the standardised approach (SA) for credit risk. In particular, the PRA may exercise its supervisory judgement to adjust a firm’s Pillar 2A add-ons, as assessed by applying the PRA’s methodologies, to ensure that the total amount of capital required to be held does not exceed the amount necessary to ensure a sound management and coverage of its risks.
International Financial Reporting Standard (IFRS) 9 will apply for accounting periods beginning on or after 1 January 2018. The PRA is also proposing to consider, as part of the supervisory review and evaluation process (SREP), the extent to which expected credit losses (ECL) in IFRS 9 may already be covered by the SA Pillar 1 capital charge.
Finally, the PRA is consulting on an update to its credit risk benchmark (the ‘IRB benchmark’) which is part of the Pillar 2A credit risk methodology, and on amendments to the Pillar 2 reporting rules.
The PRA sets Pillar 2A capital for risks which are either not captured, or not fully captured, under the Capital Requirements Regulation (575/2013) (CRR). It assesses those risks as part of the SREP, in light of both the calculations included in a firm’s Internal Capital Adequacy Assessment Process (ICAAP) document and the PRA’s Pillar 2A methodologies set out in its ‘Statement of Policy – The PRA’s methodologies for setting Pillar 2 capital’.
The PRA’s Pillar 2A credit risk methodology is based on a comparison of firms’ SA risk weights to risk weights derived from internal-rating based (IRB) models (the ‘IRB benchmark’). The IRB benchmark suggests that, for certain asset classes (eg credit cards), the SA for credit risk may underestimate the risk, in which case supervisors may want to apply a Pillar 2A capital add-on. For others (eg residential mortgages with a low loan-to-value (LTV) ratio), the level of capital required under the SA is significantly higher than the Pillar 1 capital charge implied from average IRB risk weights.
The PRA has expressed some concerns about the potentially conservative nature of the SA compared to IRB risk weights, especially for asset classes that are considered lower risk. These concerns have been shared by the Competition and Markets Authority in its retail banking market investigation concluded in August 2016.
The purpose of the proposals in this CP is to make the PRA’s Pillar 2A capital assessment both more robust and proportionate by addressing some of the concerns over the differences between SA and IRB risk weights and by strengthening and updating the calibration of the IRB benchmark. They are aimed at promoting the safety and soundness of PRA-regulated firms, as well as facilitating more effective competition in the banking sector.
Firms may find it useful to see the supporting Pillar 2 policy documents, available under Related Links.
The proposed implementation date for the updated Pillar 2A capital framework is 1 January 2018.
The PRA will assess whether ongoing adjustments to the Pillar 2A approach may be required in light of developments on the proposed revisions by the Basel Commission on Banking Supervision (BCBS) to the standardised and IRB approaches for credit risk.
In parallel, the BCBS and the European Commission are considering transitional measures to smooth the impact of IFRS 9 on capital. The European Commission is notably proposing to phase in the capital impact of the IFRS 9 ECL requirements over a five year period. The PRA will take transitional measures as well as further BCBS proposals into consideration when setting Pillar 2A capital for SA firms using IFRS 9 as their accounting framework.
This policy has been designed in the context of the current UK and EU regulatory framework. The PRA will keep the policy under review to assess whether any changes would be required due to changes in the UK regulatory framework, including those arising once any new arrangements with the European Union take effect.
This consultation closes on Wednesday 31 May 2017. The PRA invites feedback on the proposals. Please address any comments or enquiries to CP3_17@bankofengland.co.uk.
Refining the PRA’s Pillar 2A capital framework – CP3/17