Pillar 2 capital requirements bite harder

Pillar 2 capital requirements bite harder

PRA has issued a consultation paper on changes to the Pillar 2 regime, which gives a clear view of their methodology.

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Pillar 2 as suddenly become centre stage. The European Central Bank (ECB), has been writing to banks on Pillar 2, however it is not 100% clear how they are approaching the topic. The UK Prudential Regulation Authority (PRA) has issued a consultation paper on changes to the Pillar 2 regime, which gives a clear view of their methodology. While it is not safe to assume the ECB will follow the same process we would be surprised if there is not considerable alignment between Frankfurt and London.

Main proposals

The main proposals are:

  • New approaches for determining Pillar 2A capital for credit, credit concentration, operational and pension obligation risks;
  • Publishing the Pillar 2A capital methodologies for all the risks for the first time;
  • Explaining how the capital planning buffer will be replaced with a 'PRA buffer' based on the impact of stress tests;
  • Specifying a range for capital add-ons in response to weaknesses in governance and risk management; and
  • A more liberal approach to banks disclosing some information on their Pillar 2 capital requirements.   

The consultation period for the UK runs to 17 April and the new framework will be implemented from 1 January 2016.

Although, as noted above, these proposed changes are UK – specific, they are consistent with the European Banking Authority’s guidelines (December 2014) on the Supervisory Review and Evaluation Process (SREP), and therefore also likely to be relevant to the ECB’s moves to introduce a harmonised SREP approach for the European Banking Union.

ECB supervised banks have already received quantitative supervisory capital requirements from the ECB, derived from the findings of the Comprehensive Assessment CA and of the (national) SREP process for 2014. By the end of 2015 the ECB will have in place a single SREP approach, judging the soundness of banks according to business model sustainability, robustness of governance and controls, risks for capital, and risks for liquidity and funding. This process will cumulate in a new SREP-letter, defining supervisory requirements – including Pillar 2 capital – for the next 12 months.

Implications

The main implications of the PRA revised approach (and indeed of the ECB’s likely approach) are that:

  • Some banks will face higher Pillar 2 capital requirements. In the UK this will reflect the sensitivity of individual banks to the revised methodologies. In the Banking Union the harmonised ECB approach will alter the calibration of Pillar 2 requirements for some banks, and impose new requirements (and potentially much higher requirements, as is already becoming evident from the end-2014 SREP outcomes) on  banks from countries which previously had under-developed Pillar 2 regimes.
  • Banks will be required to put in place the systems and data necessary to support the new and revised methodologies, and in some areas to perform new calculations to input to these methodologies.
  • Although not a formal requirement, banks will no doubt be expected to reflect the new methodologies in their ICAAP submissions, not least in order to demonstrate that a bank has considered why its own assessment of its capital requirements differs from the starting point of its supervisor. This may lead to a 'herding' of banks’ own risk assessments and an over-reliance on the PRA’s methodologies. 

Setting out the details of the supervisory methodologies may constrain the discretion of a supervisor to reflect a bank’s own internal assessment of its capital requirements (as set out in the bank’s ICAAP submission) in the Pillar 2 capital requirement as determined by the bank’s supervisor.   

In the details

For further KPMG analysis on this, please click here

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