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Prudential Regulation Update – Changes to Capital Framework for Stress Tests

Carl Ireland, Senior Consultant

The author

Carl Ireland

Senior Consultant

March 2019 saw the Prudential Regulation Authority (PRA) publish a new consultation paper (CP 5/19), proposing several updates to the current Pillar 2 capital framework. In this blog, Carl and Sonia (Head of Stress Testing) decode the regulation and how the changes will impact you.

The March proposal does not introduce substantial changes in direction, but rather clarifies and formalises certain elements of the Pillar 2 capital assessment processes, to reflect the significant developments in the Bank of England’s (BOE) Concurrent Stress Test (CST) approach in recent years, and their impact on the setting of the PRA buffer through ICAAP.

The consultation proposes changes to the method for both Pillar 2A and Pillar 2B capital calculation.

Clarification on Pillar 2A assessment
A refined approach is proposed for the calculation of Pillar 2A capital through a stress scenario. The current practice of calculating a fixed proportion of Risk Weighted Assets (RWA) is replaced with the application of different risk scalars for the individual risk components.

The proposal aims to achieve a more realistic Pillar 2A under stress conditions, as each risk's capital requirement scales with a specific risk driver.

Clarification on Pillar 2B assessment
Regarding Pillar 2B, the consultation offers clarification on the setting of the PRA buffer, both on its stress testing and Risk Management and Governance (RMG) components:

  • The definition of hurdle rate is updated, holding systematically important firms to a higher standard by increasing their stress testing buffers.
  • Clarification is given on the setting of the PRA buffer and its interactions with existing capital buffers, with the introduction of relevant changes regarding which specific buffers can be offset against the stress part of the PRA buffer…
  • … Smaller firms will most likely benefit from the addition of the Countercyclical Capital Buffer (CCyB) to this list, while larger organisations may be challenged by the exclusion of Systemic Risk Buffers (SRB) from the offsetting, if their CCyB buffer is lower than the SRB buffers.
  • Further clarifications are given on the rationale of capital buffers use over stress and the planning of their reconstitution after stress.
  • More details are provided on the process of calculating and imposing an additional capital requirement (the RMG scalar) in case of perceived risk management or governance weaknesses. For instance, adding the definition of ‘suspended scalar’, presenting firms an opportunity to correct issues before a capital penalty is applied.

 

The Hurdle Rate

The hurdle rate is the minimum level of capital that a financial institution is required to maintain under all conditions, including a severe but plausible stress scenario.

The hurdle rate varies across financial organisations. For most firms it is Pillar 1 and Pillar 2A capital requirements, defined as the Total Capital Requirement (TCR). The major change in this consultation relates to systemically important firms, given the severe systemic consequences of failure, and is in line with the approach initially adopted in CST 2018: the PRA is proposing to include the systemic buffers alongside the TCR in the determination of the hurdle rate to be maintained under stress. This would satisfy the expectation to hold systemically important firms to higher standards, without increasing these firm’s minimum capital requirements.

The hurdle rate is used solely to assess stress resilience, the systemic buffers would still be available to use during a period of stress.

Before CST 2018 systemically important firms were assessed against two capital benchmarks:

  1. The hurdle rate, constituted by the sum of Pillar 1 and Pillar 2A, alongside…
  2. A ‘systemic reference point’ including global systemic buffers.

The one benchmark approach adopted in CST 2018, and reiterated by the consultation paper, simplifies the calculation process and the presentation of stress testing outputs, while increasing the rigour of stress testing results assessment for systemic important banks. These are now expected to maintain consistently higher capital in a downturn.

 

Setting the PRA Buffer under Pillar 2B

How the stress test element of the PRA Buffer is calculated

Much more detail in the calculation of the stress testing element of the PRA buffer is provided, including a worked example of the gross buffer, and how to offset the CCoB (Capital Conservation Buffer) and CCyB (Countercyclical Capital Buffer).”

The pictorial ‘capital stack’ is also updated to reflect the changing approach to hurdle rate and offset:

Interaction between the buffers comprising Pillar 2B

Current wording describing the relationship between the PRA buffer and the Capital Requirements Directive IV (CRD IV) buffers is clarified in the consultation. As it stands, the PRA buffer can usually be offset by the Capital Conservation Buffer (CCoB) and any Systemic Risk Buffer (SRB).

It is assumed that these buffers are covering the same risks as the stress testing element of the PRA buffer. The current wording appears to exclude the Countercyclical Buffer (CCyB) from the offsetting.

The proposal to include the SRB within the hurdle rate ensures systemically important banks operate to a higher standard. It precludes netting this buffer from the PRA buffer. Additionally, the PRA elaborate on the buffer explanations to state that the CCyB can be offset against the PRA buffer, as the CCyB is a firm specific calculation, linked to the firm’s risk profile.

This however, is only possible through the formal setting of buffers during a stress testing process. Where a Financial Policy Committee (FPC) decision changes the rate of the CCyB, the buffer would not automatically update:

The impact for each organisation on the PRA buffer setting will depend on the relative size of the CCyB and the SRB buffers.

  • The impact on larger lenders - As a result of the consultation, systemically important banks could potentially see an increase of their (stress testing) PRA buffers, if the size of their SRB buffers is bigger than their CCyB buffer.
  • The impact on smaller lenders - Conversely, for smaller banks for which systemic buffers do not apply, the consultation will likely lead to lower (stress testing) PRA buffers, as netting the CCyB buffer will represent a capital benefit in all cases.

 

Changes to the RMG buffer

When the PRA perceives significant weaknesses in a firms’ risk management or governance it can apply an additional buffer (RMG), generally calculated as a scalar of the firms’ own CET1. Once the identified weaknesses are resolved the scalar should be removed. The determination is done on a case by case basis and subject to peer review. Otherwise penalties may be applied to newer entrants to the market whose experience would be limited compared to existing entities.

The PRAs approach is updated to include the option of presenting a ‘suspended scalar’ where by the PRA will identify a weakness and propose a future RMG scalar penalty if the weakness is not suitably addressed before a set date.

The proposed clarification in the way the PRA conducts the assessment of the RMG buffer and the suspended scalar approach should generally benefit firms in their capital planning, directing their actions to address the PRA’s concerns and prevent the impositions of financial penalties.

 

Refining Pillar 2A to reflect changes during a stress scenario

An additional refinement to the PRAs approach is the proposal to update how Pillar 2A is calculated throughout a stress period for all firms within their ICAAP submissions. This has to be in line with the requirements firstly introduced in CST 2018 for larger organisations.

Pillar 2A captures all the relevant risks for a firm that are not covered by Pillar 1. Currently, firms calculate the evolution of the Pillar 2A element over stress as a constant share of the total risk-weighted assets (RWAs). This simplistic approach assumes a firm’s risk profile stays the same as its balance sheet grows/contracts.

Under stress conditions, the interactions between the individual risk components contribute to changes of the overall risk profile, meaning this assumption is less likely to be appropriate.

To address this concern the PRA is proposing to introduce a system of different scalars depending on the risk category, to produce a more risk appropriate adjustment to the firm’s capital profile.

The new proposals could significantly change a firm’s Pillar 2A and thus their hurdle rate for a stress test. Given the number of permutations and interactions between balance sheet size, composition and risk weightings, determining a likely impact is difficult. Firms should run different assumptions through simulations and sensitivity analysis to understand the full impact of this change on their Pillar 2A capital requirement.

 

Update benchmarks to assess Pillar 2A credit risk

In the assessment of Pillar 2A capital requirements for standardised firms, the PRA uses benchmarks based on the risk weights of firms that calculate their capital requirements on an internal rating based (IRB) approach.

As part of the consultation, the PRA is proposing to regularly monitor changes in IRB RWAs to update the benchmarks when significant movements have occurred. To avoid excess volatility, the PRA is proposing to calculate the benchmarks as average changes over a long period of time.

Shifts in benchmarks can have a significant impact on firms’ Pillar 2A assessment and capital planning in either direction, but the benefit is to maintain the assessment in line with peers and prevailing market conditions. The determination of long run averages would contain the impact of temporary or short-term movements.

 

In summary

CP5/19 does not introduce substantial changes on Pillar 2 calculation, but some of its implications could have a significant effect on capital requirements under stress and stress capital planning.

The proposed changes in Pillar 2A assessment could lead to either higher or lower Pillar 2A capital requirements in a stress test. The impact on individual organisations will depend on their balance sheet composition and should be assessed through specific simulations.

The updated hurdle rate framework and capital buffers interactions can potentially lead to higher Pillar 2B capital requirements for larger organisations, who should be analysing the impact on their stress capital plan thoroughly.

Smaller organisations, that may benefit from netting the CCyB in their PRA buffer assessment, should still conduct an impact analysis to appreciate the changes introduced by the new proposal and provide adequate feedback ahead of the deadline of 13th June 2019.

For practical steps to help you meet these changes, do not hesitate to get in touch. Call 0333 370 6600 or email [email protected]