Unpicking the ECB's new methodology for setting Pillar 2 Requirements

At a glance:

• The ECB’s new approach to setting Pillar 2 Requirements (P2R) reinforces the link between the SREP and banks’ capital requirements. Remediation of supervisory findings, increasingly important as a determinant of SREP scores, will have a direct influence on banks’ capital requirements.
• It remains to be seen whether the new methodology will result in a change in the level at which P2R are set, although the ECB has said that it does not expect any abrupt change. It will be important for banks to engage with their supervisors to understand how their P2R will be articulated to them in the future, and to adapt capital planning and stress testing processes accordingly.
• A notable feature of the new framework is the different role for the ICAAP – which will inform SREP scores, but will not be a direct input into P2R. However, in our view banks should continue to treat the ICAAP as an important part of capital management, and banks should not assume that supervisory expectations around the robustness and comprehensiveness of ICAAPs will decrease.
• There is more to come on Pillar 2 in the coming months, given continued uncertainty over how P2R/P2A will be adjusted in both the EU and UK to offset the impact of Basel 3.1/CRR3.

The ECB has announced its new approach to setting Pillar 2 Requirements (P2R). This is the latest of a number of steps taken by the ECB in the past year to reform its supervisory approach following a 2023 Expert Group report assessing the ECB’s supervisory framework.

You can read our previous article on the reforms to the Supervisory Review and Evaluation Process (SREP) here: Snakes and (escalation) ladders: the ECB’s new SREP is coming.

What is changing?

• The process for determining banks’ P2R will be streamlined – from four steps to three (see diagram below).
• Under the new approach, capital requirements will be driven more directly by “relevant areas of risk”. Although the ECB has not set out exactly what this means, taken together with the reforms to the SREP announced last year (which granted supervisors more flexibility to prioritise and focus on key risks over a multi-year period for individual banks), our working assumption is that P2R will be calibrated with a focus on risks identified as supervisory priorities.
• SREP scores will remain a key input into the ECB’s Pillar 2 methodology. However, the ICAAP will no longer be a direct input into the determination of banks’ P2R. Whereas in the previous process, a bank’s ICAAP was used to determine the risk-by-risk breakdown of its overall P2R, under the new approach ICAAPs will become more ancillary information that informs the Pillar 2 assessment at the risk level. Step 2 in the previous process leaned heavily on banks’ ICAAP submissions, with supervisors then challenging banks’ risk-by-risk breakdown under Step 3. Under the new process, supervisors will determine the risk-by-risk breakdown of banks’ P2R themselves, eliminating the need for the challenge step from the previous process.
• The new approach leaves significant room for supervisors to apply judgement across the various steps of the process, albeit with review by the ECB’s own second line of defence to ensure consistency: in the determination of SREP scores (step 1); as they set risk-by-risk capital requirements (step 2); and in their assessment of banks’ overall risk profile (step 3) where they consider banks’ risk profiles to be “more complex than the sum of its individual parts”. The ECB has hinted that these types of adjustments may be used in relation to “rapidly evolving risks” that are not well captured by models relying on historical data – reflecting the ECB’s recent focus on management of “novel risks” related to geopolitics, climate and digitisation.

How does this affect banks supervised by the ECB?

A key question for banks is whether the level at which P2R are set will change, having been relatively stable over recent years. This is not yet clear, although the ECB has signalled that it does not expect any “abrupt change” to banks’ P2R upon implementation.

Either way, banks will need to reach a view quickly on how they expect their P2R to evolve over their planning horizon, and in stress scenarios. The reduced linkage with banks’ ICAAPs may make this more challenging, although their supervisors may alleviate this if they articulate banks’ final P2R with sufficient risk-by-risk granularity.

The continued relevance of SREP scores as a determinant of Pillar 2 Requirements is notable. One of the options that would have been considered by the ECB (following the Expert Group report) was moving to the UK-style approach to setting Pillar 2R that estimates capital needs on a risk-by-risk basis, based on supervisory methodologies (with the results of the SREP a less direct input into P2R). Ultimately, the ECB has decided not to pursue this option. In practice, the increased flexibility and judgement envisaged in the proposed approach may be more analogous to the PRA’s approach to setting Risk Management and Governance (RMG) scalars for banks.

As a result, with SREP scores set to be driven increasingly by banks’ ability to remediate longstanding deficiencies, there is a more direct link between capital requirements and the effectiveness of implementation programmes. Banks will need to ensure that they are fully aware of the criteria set out in the ECB’s revised SREP methodologies, published in December 2024 – noting in particular the increased emphasis on risk culture and the functioning of the management body in the internal governance and risk management methodology, and the focus on third-party risk in the operational risk and ICT risk methodology.

Another key question that will become clearer as the ECB rolls out its new methodology is how P2R interact with supervisory enforcement measures such as periodic penalty payments. For banks with longstanding deficiencies (in risk data aggregation, for example) there appears to be a risk of being doubly penalised – directly (through periodic penalty payments) and indirectly (through worsening SREP scores that lead to higher capital requirements).

The ICAAP: evolving role, enduring importance

In our experience, there are differing levels of maturity to the ICAAP across the industry: some banks have fully embedded the ICAAP as an integral part of capital management, while others have treated it as a regulatory exercise or obligation. For the latter cohort of banks, the direct link to P2R created a sense of “skin in the game” that incentivised investment in the ICAAP, and a less direct link between the ICAAP and Pillar 2 could call that into question. Some banks may be tempted to scale back their ambition and deliver an ICAAP that is just “good enough” to avoid an adverse impact on their SREP scores.

However, in our view the ICAAP should remain an important part of the capital planning process, and banks should not assume that supervisory expectations around the robustness and comprehensiveness of ICAAPs will decrease. Recent statements by supervisors underscore its continued relevance, particularly in capturing emerging risks (such as geopolitical and climate-related risks). As recently as February 2025, the ECB published a document reminding banks of its expectations surrounding the governance and content of their ICAAP submissions. Moreover, many banks have outstanding measures from the 2025 SREP cycle related to the ICAAP and the quality of their capital planning – this scrutiny will continue, and (as described above) will feed indirectly into capital requirements through SREP scores.

How does this compare to what is happening elsewhere?

In the broader EU context, a key milestone to watch for over the course of 2025 (particularly for banks falling below the threshold for direct supervision by the ECB) will be the EBA’s consultation on revisions to its guidelines on the SREP (due in Q3 2025) and how closely they reflect the ECB’s new approach.

In the UK, the PRA has made some changes to its own Pillar 2 framework in recent months, but these have been more limited - streamlining bank-specific capital communications, and proposing to retire the “refined approach” whereby standardised banks’ RWAs are compared against an IRB benchmark.

The BoE has recently revamped its stress testing framework, the exercise used to set bank-specific capital requirements. However, the Bank Capital Stress Test (previously known as the Annual Cyclical Scenario) will remain consistent in its objectives, scenario design and process to its predecessor, albeit it will be run on a biennial basis rather than annually. In contrast to the ECB, in its updated approach to stress testing the BoE has signalled its intention to increase its focus on (and use of) banks’ ICAAPs.

More to come on Pillar 2?

A question that remains at least partially unanswered in both the EU and UK is how Pillar 2 will be adjusted to offset the impact of Basel 3.1/CRR3. The EBA has set out its view that competent authorities (including the ECB) should offset Output Floor driven increases in capital requirements through reduced add-ons for model deficiencies. The ECB has yet to provide detail on how it will take this into account in its new framework.

The PRA, meanwhile, is due to explain how adjustments to Pillar 2 to offset the removal of the SME and infrastructure supporting factors in the Pillar 1 framework will operate. In both cases, the respective decisions of the ECB and PRA may ultimately have a greater bearing on the size of banks’ Pillar 2 capital add-ons than the framework changes described above.

Next steps

The ECB’s new methodology will be tested internally in 2025, and then eventually rolled out for the 2026 SREP cycle. This means that P2R based on the new methodology will take effect from 1 January 2027. Banks supervised by the ECB will need to engage with their supervisors to deepen their understanding of how the new approach will operate, and adapt their capital planning processes accordingly.