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In March 2019, the Prudential Regulation Authority (PRA) published consultation paper (CP 5/19) to update the Pillar 2 capital framework and to reflect on-going enhancements in setting the PRA buffer (Pillar 2B).

As the CP states, its key objective is to “...bring greater clarity, consistency and transparency to the PRA’s capital setting approach. In promoting a greater level of transparency, the PRA seeks to promote financial stability, the safety and soundness of PRA-authorised firms, and facilitate more informed and effective capital planning for banks.”

This CP is relevant to PRA-authorised banks, building societies and PRA-designated investment firms (‘firms’). This CP is not relevant to credit unions, insurance and reinsurance firms. It is open for review, question or comment by 13 June 2019 and the PRA proposes to implement it from 1 October 2019.

 

Key Proposals

The CP presents 5 key proposals:

  1. Clarification around the hurdle rate to be used under stress;
  2. Scaling of P2A computations into the future;
  3. Interactions of various buffer types and their usability;
  4. Considerations around the risk management and governance assessment;
  5. Updating benchmarks for assessing P2A credit risk.

The CP also incorporates a number of minor drafting corrections.

Looking at the 5 key proposals, we present below some key considerations and potential impact areas for firms.

Table 1: A Summary of the Proposals

Proposal

Summary Description

Potential Impacts

#1: Hurdle Rates

The hurdle rate is the minimum level of capital that a firm is expected to meet or exceed in a severe but plausible stress. To ensure systemically important firms are held to a higher standard, systemic buffers are proposed to be included in the hurdle rate in the stress.

 

The PRA states that this inclusion should not lead to any changes in the firms’ overall regulatory buffers as PRA buffers are already additive to systemic buffers. This change would impact global or domestic systemically important firms, including ring-fenced banks.

 

Its important to note that prior to the 2018 exercise, only the G-SIB buffer (and not D-SIB buffer) was included as a component of the hurdle rate.

 

· Inclusion of systemic buffers (over and above Pillar 1 plus Pillar 2A) in the hurdle rate could mean that in a severe stress, minimum capital requirements are breached at an earlier stage, potentially raising a challenge to firms meeting the minimum level of capital required during the course of the stress, considering the bar would be higher.

·Management actions required to recover from a stress may then need to mobilize sooner, so as to avoid breaching minimum capital requirements during the course of a stress.

·Through the course of the stress, if the proposed Pillar 2A scalability factor causes capital requirements to rise, the above mentioned impacts may amplify further.

·The component of the PRA buffer that relates to the impact of the stress is calculated as the maximum reduction in CET 1 capital above the hurdle rate throughout the economic cycle relative to the starting point of the stress. If the hurdle rate is higher than before, the maximum reduction in surplus could be higher than before, leading to a potential for a higher (than before) PRA buffer.

· Given Table 2, essentially, if systemically important firms are applying the ACS hurdle rate framework within their internal stress tests, then this CP may have no impact on current practices.

·However, to clarify, the systemic risk buffer applies to ring-fenced banks and large building societies (those with deposits in excess of £25bn). Firms building up to that threshold, would need to consider the impact of growing (either via acquisition or organic growth) into a £25billion organisation, one of which is the higher hurdle rate i.e. threshold conditions.

#2: P2A Scaling

For simplicity, the aggregate P2A element of the capital stack has typically been set as a constant share of Total Risk Weight Assets (TRWAs) over the planning horizon, both from a supervisory and industry perspective. This practice was inherently simplistic since many P2A risk types do not bear a direct relation to TRWAs (e.g. IRRBB or Operational Risk).

 

In this CP, The PRA has identified “scaling bases” to reflect the evolution of individual P2A risk types. (See Table 2 below)

The PRA clarifies that the scaling bases are not intended to provide guidance on how it sets P2A requirements, but rather provide a simple way to ensure P2A requirements under stress reflect more closely the probable impact of the stress on P2A.

 

·Firms’ capital adequacy projections are expected to become more effective as more relevant scaling bases (e.g. total assets for operational risk) may be used in forward-looking analysis.

·Nonetheless, there is still room for variability in application – for example, the option to use ‘total assets’ or the ‘leverage exposure measure’ (per CRR A.429) as a scalar for operational risk.

·For some risk types, the capital requirements may go up or down based on the scaling base considered and the rate of change of that base over the planning horizon, both under base and stress scenarios.

·Firms may need to internally determine appropriate scaling bases for various risk types. The proposal may also require minor additional computations to be performed for scaling P2A requirements. These details should be provided in the ICAAP.

·Firms may also need to consider any potential considerations when completing the PRA111 templates since they require a single P1+P2A as % of Total RWAs figure.

#3: Interactions of capital buffers

As established from previous guidance, to avoid double counting, the component of the PRA buffer that relates to the impact of stress is calculated as the excess amount of capital requirement over and above the Capital Conservation Buffer (CCoB).

The Countercylical Capital Buffer (CCyB) is set to capture system-wide cyclical risk and hence the PRA buffer, in general, will be over and above the CCyB (so no set-off against CCyB).   

The PRA buffer and the combined buffer (CCoB+CCyB+Systemic Buffers) can be used to absorb losses in stress.

·The PRA has re-emphasized the potential set-off between the PRA buffer and the combined buffers. A portion of the capital firms need to meet their Total Capital Requirement (TCR) under stress is considered to be already captured in the CCoB and CCYB. Therefore, “to avoid double counting, the component of the PRA buffer that relates to the impact of the stress is calculated as the excess amount of capital required over and above the CCoB and CCyB”. (emphasis added)

·Equally, any changes in buffers applied for macro-prudential purposes outside of stress will always be additive to the existing PRA buffer. (emphasis added)

#4: Risk Management and Governance Assessment

 

The PRA has used the Risk Management and Governance (RMG) scalar as a tool to drive better internal practices and governance processes at firms. The RMG scalar is part of the PRA buffer and is always additive to other buffers.

 

It is worth noting that in response to CP 1/15 (‘Assessing capital adequacy under Pillar 2’ – 2015), the British Bankers’ Association (BBA) raised specific comments on the RMG scalar, seeking assurance from the PRA that “where concerns exist, the firm’s supervisor will have already raised them with the firm” and furthermore that “once the RM&G failing has been addressed the scalar would be removed immediately, without waiting for the next SREP”.  The formalisation of a ‘suspended scalar’ in CP 5/19 seems to address this concern.

 

·In a bid towards formalising an “early warning” approach, the PRA may apply a “suspended scalar” before the imposition of the RMG scalar. This means that the PRA may give firms time to address identified weaknesses before applying a scalar and will give firms an indicative figure for the size of the scalar.

·The “suspended scalar” will be applied based on the severity of weaknesses identified.

·This may provide firms with early sight of their potential capital requirements if issues raised by the PRA are not addressed in a timely and satisfactory manner.

·Where firms receive the suspended scalar it will be critical to ensure that an appropriate remediation action plan is designed and put into effect. The quality of this plan may be a key factor in determining whether the suspended scalar actually translates into a capital add-on.

·The PRA has also updated the range of scalar from “10-40% of CET1 TCR” to “upto 40% of CET1 TCR” potentially providing relief to firms with less significant RMG issues.

·It may also be relevant at this point to consider the guidance on Model Risk Management Principles for Stress Testing (SS3/18) issued by the PRA (applicable from 1 Jan 2019). The SS states that for firms participating in the ACS, the assessment of MRM practices will be part of the ACS qualitative review, while for firms not participating in the ACS, the PRA will review their MRM practices as part of the SREP. This may potentially be one of the areas that may by tackled through the RM&G (suspended) scalar.

#5: Updating Credit Risk Benchmarks

The PRA has committed to monitoring changes in IRB risk weights on a regular basis, especially if significant movements in risk weights are observed. The PRA has chosen to not update the published IRB benchmarks in full in this consultation. However, the PRA has proposed a slight change to the commercial real estate IRB benchmarks whereby they state that risk weights can vary between 50% and 250% which represent the full range of risk weights outlined by CRR articles.

·Increasingly standardised firms have been encouraged to undertake slotting approach to assess their Pillar 2A commercial real estate risks.

·It is possible that the slotting approach methodology would lead to lower Pillar 2A risk weights than the previous commercial real estate IRB benchmarks range (60% -250%) , therefore the new proposed wider range of IRB benchmarks may lead to fewer firms receiving incremental add-ons for commercial real estate.

·However, given that under PRA proposed a RW% of 100% (under Pillar 1) for CRE exposures (through CP5/13), this update might not lead to any changes in P2 capital updates.

 

As another point of clarification, the PRA has replaced the word “should” with “could” in relation to reverse stress testing scenarios where firms were expected to consider the failure of one of more of their major counterparties or significant market disruptions. This means that firms may not be obligated to run those scenarios as part of their reverse stress test and may look at more relevant and bespoke scenarios based on their business model and the size, nature and complexity of their business.

Conclusion

The CP presents some areas of further transparency (e.g. the use of RMG scalar), clarification (use of capital buffers) and updates (hurdle rates or P2A scaling). Altogether, it represents an important next step in the PRA’s on-going enhancement of the P2 framework in the UK.

For more details on this please reach out to the authors of this blog.

Mike

Michael W Williams - Partner, Audit & Assurance, Banking Regulation

Mike leads the Banking Regulation team in the London Banking & Capital Markets Group. Having founded the Deloitte regulatory practice in 1992, Mike has a wide ranging knowledge of UK Prudential Regulation Authority and Financial Conduct Authority regulation, as well as increasing knowledge of European Central Bank/European Banking Authority regulation. His remit includes capital and liquidity, governance, conduct, and specific reporting requested by the regulators and clients. He leads the regulatory response on key audit clients and is involved in Brexit work from a governance and processes as well as capital, liquidity and conduct perspectives.

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Vishwas Khanna

Vishwas Khanna - Director, Risk Advisory

Vishwas supports start-up and non-bank financial institutions through their regulatory authorization process in the UK. Vishwas specialises in prudential regulation, ICAAPs, stress testing and risk management, with over 11 years’ experience working in the financial industry. Vishwas also leads the Deloitte EMEA Supervisory Review and Evaluation Process (SREP) initiative, working closely with UK and EMEA banks and investment firms on large, complex programmes.

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Fioza

Faiza Farooq - Senior Manager, Audit & Assurance

Faiza is a Senior Manager within the Prudential Regulation team in Deloitte’s Financial Services (Banking and Capital Markets) practice. Prior to joining Deloitte in November 2017, Faiza spent over six years with the UK financial regulator (firstly the FSA, then the PRA) as a firm supervisor and latterly as a technical specialist on capital and credit team, specializing particularly in the challenger banks and new banks space. As part of her role she reviewed ICAAPs, assessed the appropriateness of Pillar 2a methodology and set capital requirements of retail banks operating in the UK.

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Ssss

Peter  Galea - Assistant Manager, Audit and Risk Advisory

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