Ever since the PRA published its near-final PS on Basel 3.1, the key unanswered question for industry was how the PRA would use the Pillar 2 framework to ensure that the removal of the SME and infrastructure supporting factors from the Pillar 1 framework do not cause an increase in overall capital requirements for SME and infrastructure exposures.

While that question now has an answer, it is far from a straightforward one. The Pillar 2A lending adjustment, calculated separately for SME exposures and infrastructure exposures, will be calculated as follows:

Pillar 2A lending adjustments = ΔRWA x Capital adjustment factor

While the formula itself is relatively simple, the complexity arises in its component parts, with the PRA seeking to avoid “double discounts” or “imprudent” reductions in capital requirements in its methodology for calculating ΔRWA. Firms will need to calculate the RWA for the exposure under the Basel 3.1 framework as if the supporting factor in question had been retained, and the RWA under the Basel 3.1 framework (without the supporting factor), and then determine the difference between the two to arrive at ΔRWA.

There is comparatively less detail on the methodology for determining the Capital Adjustment Factor (CAF), but our interpretation is that the CAF is essentially intended to translate ΔRWA into capital impacts (with the impact on different ratios and buffers varying due to the differences in the quality of capital to be held for different parts of the capital stack).

The PRA will base the calculation on the underlying approach used to calculate RWAs for SME and Infrastructure exposures, irrespective of whether the firm is bound by the output floor, and will not be recalculated as a result of a firm becoming bound by the output floor.

A challenge for firms arises from the fact that Pillar 2A is less dynamic than Pillar 1, with firms’ Pillar 2A set through the C-SREP – which could be as infrequent as every four years (as the PRA proposes in the CP) for some firms. It is not clear whether firms would be able to apply for an interim review.

This means that, after the PRA’s planned (but indefinitely postponed) off-cycle review to determine firms’ “day 1” P2 adjustments, the opportunity to take advantage of the discount will only come around relatively infrequently.  Consequently, the onus will be on firms to ensure that the internal process around their submissions is robust, with sufficient validation from Internal Audit and external assurance. An open question is whether the PRA will only consider a firm’s point in time exposure, or would be open to considering projections.

For supervisors, a benefit of implementing this approach is that it will create a greater level of transparency around the application of the supporting factors. At present, for both the SME and Infrastructure supporting factors, firms’ reporting only gives supervisors a view of RWAs pre- and post-application. The reporting instructions for firms under the new framework will be considerably more detailed. Firms seeking to take advantage of the potential discounts will need to weigh the increased reporting burden against the potential capital benefit, and bear in mind that the PRA will only apply the lending adjustments to firms that are able to produce submissions that are accurate and complete.        

The PRA is proposing to remove the IRB benchmarking methodology from its Pillar 2A framework. This is not particularly surprising, given the reduced need for the benchmarks (with the standardised approach (SA) becoming more risk sensitive under Basel 3.1) and the potential cost and complexity of updating them, not least given the implementation of the output floor under Basel 3.1. Moreover, the PRA’s plan to retire the “refined approach” for SA firms removes one of the benchmarks’ primary use cases.

Removing the IRB benchmarking approach means, however, that the PRA no longer has a consistent methodology to compare firms’ SA exposures against. As a result, the PRA is proposing to introduce systematic methodologies for two asset classes where it considers that standardised risk weights potentially underestimate actual risk: sovereign and certain quasi-sovereign exposures, and retail unconditionally cancellable commitments (UCCs).

Minimum effective risk weights for sovereign exposures

Sovereign risk weights have long been a point of contention, and an inherently political issue. As set out in Basel 3.1, the PRA is removing the possibility for firms to model sovereign exposures, meaning that all firms will need to use the SA.

Certain central government and central bank (CG/CB) exposures (i.e. exposures to a jurisdiction with equivalent supervisory and regulatory arrangements to the UK, denominated and funded in the domestic currency of the borrower) receive preferential treatment under the SA, often resulting in a 0% risk weight. Exposures to regional governments and local authorities in those countries are afforded the same treatment.

The PRA feels that this treatment underestimates the actual default risk of sovereign exposures (with the exception of those exposures assigned to the highest Credit Quality Step (CQS) under the standardised credit risk framework (CQS1) – which, in practice, are the majority of most firms’ sovereign exposures). Consequently, it is introducing minimum effective risk weights for non-UK CG/CB and regional government and local authority (RG/LA) exposures to replace the outgoing IRB benchmarks. Where there is a difference between firms’ Pillar 1 risk weights and the P2A minima, the sum of positive differences across firms’ exposures would feed into their Pillar 2A add-on.

Non-UK central governments/central banks

• CQS1: No minimum effective risk weights
• CQS2-3: 5%
• CQS4-6 and unrated: 20%

Non-UK regional governments/local authorities

• CQS1: 5%
• CQS2-3: 20%
• CQS4-6 and unrated: 100%

The PRA exempts UK CG/CB exposures, and UK RG/LA debt, from the new treatment – as was the case under the previous benchmarking approach. While at present this will not make a practical difference for UK CB/CB exposures (which are currently CQS1), it does effectively create an immediate preferential treatment for UK RG/LA exposures. Taken together with the recent (albeit paused) changes to non-UK covered bond eligibility for recognition as High Quality Liquid Assets (HQLA), some may interpret this as an incentive for UK firms to favour UK government exposures over others (as acknowledged by the PRA). It should also be noted that in its recent Consultation Paper on the Large Exposures framework (CP14/24), the PRA has clarified that non-0% risk weighted sovereign exposures are not exempt from Large Exposure (LE) limits and would be subject to mandatory substitution requirements – meaning that firms with exposures to emerging markets could face a double penalty through both Pillar 2A and the LE regime.

The timing of the PRA’s proposals is also interesting in the context of current fiscal concerns in certain economies, and with the prospect of further fiscal strain in Europe and driven by increased defence spending. That said, the origins of the PRA’s proposals most likely pre-date current macroeconomic and geopolitical conditions.

UCCs

Similarly, the PRA believes that the Basel 3.1 approach for retail UCCs risks leaving firms undercapitalised – as in practice, while being theoretically cancellable, the exposures often remain uncancelled in practice (due, for example, to reputational concerns and difficulties in predicting obligor default).

While the PRA ultimately decided not to “gold-plate” the Pillar 1 framework (introducing a 10% conversion factor (CF) for UCCs (up from 0%) in the Basel 3.1 SA), it sees a need for an additional add-on in Pillar 2A. As a result, it is proposing a systematic methodology in which SA firms will need to calculate the difference between the 10% Pillar 1 CF and either:

• a prescribed CF reference point of 20%; or
• a firm-derived CF, substantiated by robust portfolio data demonstrating lower realised CFs over an extended period, including a downturn. This firm-derived CF cannot be lower than the 10% Pillar 1 CF.

The calibration of the Pillar 2A CF uplift is based on PRA analysis indicating that IRB capital requirements are on average 23% higher than SA capital requirements – with an uplift of approximately 20% required to equalise IRB and SA treatments when taking into account the proportion of UCCs that are on-balance sheet. It is unclear from the consultation whether the PRA will take that 23% figure as an implicit floor when considering the results of firms’ scenario analysis for the purposes of determining a firm-derived CF. The PRA has indicated that it is open to firms submitting data in their responses to the consultation, but that data will need to be robust in order to convince the PRA to change the calibration of the prescribed reference point.

Moreover, imposing an additional 10% CF (on top of the 10% CF under Pillar 1) could have a significant impact on some firms more exposed to UCCs  - PRA analysis is based on the assumption that only 30% of retail UCCs would be eligible for classification as “transactors”, thereby qualifying for the lower 45% risk weight, however the PRA notes that alternative datasets imply only 14% would qualify. Firms with exposures to UCCs that are not eligible for the transactor treatment will be doubly affected (i.e. by both the Pillar 1 and Pillar 2A treatments). The PRA seems to recognise this in its impact assessment, noting that “a small number of firms that are concentrated in undercapitalised exposures in Pillar 1 would have add-ons that are higher than average”. It is important that those firms undertake their own impact assessment as soon as possible.

Although the approach only covers retail UCCs, the PRA’s view is that wholesale UCCs may also be undercapitalised in Pillar 1. It has initiated a voluntary data request, and indicated that it could consult on a specific capital treatment for wholesale UCCs in the medium term.

Emphasis on scenario analysis

The CP sends a clear message that scenario analysis is a key capability for all firms. All firms are expected to use credit scenarios in the ICAAP. Firms would be expected to design their own scenarios, which would need to be more severe than those used to set Pillar 2B – capturing “high severity events over a 12-month horizon” (as opposed to “severe but plausible” scenarios under Pillar 2B). The PRA sets out an expectation that firms ensure their own credit scenarios are more severe than the historical average peak-to-trough changes in key macroeconomic scenario variables in  its bank capital stress tests. While the PRA will continue to consider alternative approaches (e.g. proxy IRB approaches), it is clear that firms using such approaches would be subject to significant supervisory scrutiny.   

The sum of removing IRB benchmarks and introducing new scenario analysis expectations is a framework that is less prescriptive and potentially more risk sensitive. But it is also an approach that requires firms to exercise more judgement and develop their own assumptions – which in turn will require additional governance, validation, involvement from the second and third lines of defence, and potentially external assurance and benchmarking.

It should also be noted that, while credit scenario outputs can lead to an uplift in a firm’s credit risk P2A add-on they will never lead to an offset in requirements (for example, if a firm’s credit scenarios show that the sum of Pillar 1 and the systematic components of Pillar 2A overestimate the firm’s risk). So in effect, the sum of Pillar 1 RWAs and the systematic components of Pillar 2A becomes a floor for a firm’s Pillar 2A credit risk add-on (see diagram below).

On operational risk, the PRA is clarifying the key factors it considers when setting firms’ operational risk Pillar 2A add-ons: namely the firm’s business model, ICAAP analysis, Pillar 2A assessment, supervisory engagement and peer group comparison. Clarification on the latter of these will be particularly welcome to firms, given its centrality to the PRA’s approach and the previous lack of transparency. While the PRA is not proposing any changes to its methodology, and does not expect that firms’ overall operational risk charges will change significantly, it does suggest that, as a consequence of the changes in Basel 3.1, the distribution of firms’ operational risk capital requirements across Pillar 1 and Pillar 2A may change. We would note that, if a greater proportion is allocated to Pillar 1 under the new framework, this could have an impact on firms’ overall capital requirements (given that Pillar 2A and capital buffers are scaled to Pillar 1 RWAs).

Similarly, the PRA sets out clarifications and additional guidance for firms on market and CCR. For market risk, this includes clearer expectations on reconciliation of illiquid risks and on the adequate involvement of senior representatives in product control, how prudent assumed liquidity horizons are and whether firms’ models capture material non-linearity. Additionally, greater transparency is provided on the PRA’s internal approach to assessing syndicated loan underwriting risk. On CCR, the PRA will request additional information from firms to inform capital add-ons; this could in turn lead to increased requirements under P2A, as some risks (e.g., residual risks arising from credit risk mitigation, wrong way risk, exposures to CCPs and settlement risk) may not be adequately captured under Pillar 1.

The PRA is also proposing simplification of the pension obligation risk framework. Firms’ stress testing capabilities have developed significantly over recent years, and firms predominantly rely on internal scenarios rather than the two supervisor-prescribed scenarios – consequently, the PRA is retiring its prescribed scenarios. The PRA is also proposing to exempt from pension risk assessments firms with fully bought-in or sufficiently well-funded schemes (i.e., with a funding ratio of at least 130%) – although it would continue to expect assessment in the ICAAP of the residual risks following a buy-in, such as credit risk relating to the insurer counterparty.