2nd June 2017

A step in the right direction

Written by Simon Hills, Executive Director, Prudential Regulation and Risk

Earlier in the week I submitted the BBA’s response on behalf of its members to the PRA’s consultation paper CP 3/17 Refining the PRA’s Pillar 2A capital framework.

Pillar 2A capital is the extra capital the PRA expects a bank to hold over and above the Pillar 1 minimum requirements for credit, market and operational risk. This extra capital addresses non-Pillar 1 risks such as concentration risk, counter party credit risk, interest rate risk or pension obligation risk. It is set on a bank-by-bank basis as Individual Capital Guidance.

The refinements to the Pillar 2A framework proposed in CP 3/17 are designed to smooth out the perceived unlevel playing field between banks using the Internal Ratings Based (IRB) approach to calculating credit risk weighted assets (RWAs) and those, typically smaller  specialist and challenger banks, that use the Standardised Approach (SA). The SA produces higher capital requirements for some types of lending, such as low loan to value residential mortgages. This makes it harder for SA banks to match the pricing (which is partly determined by capital requirements) offered by larger banks using the IRB approach, reducing choice for consumers. Addressing this competition aspect of the capital regime is the key driver behind the PRA’s proposals, all of which are in line with the requirements of CRD and CRR.

The BBA’s response very much welcomed the PRA’s initiative to address the current overly conservative Pillar 1 SA requirements through offsetting some of the excess by adjusting Pillar 2A.  Correcting this over-prudence should free up excess capital, allowing it to be redeployed in, for instance, lending to first time house buyers. The PRA’s proposals will allow SA banks to refer to the range of risk weightings that IRB banks use in calculating their capital requirements.

Whilst it appears that the amount of capital from SA banks will decrease as a result of these proposals, it is not clear that the reduction will be significant enough to fully redress the balance. The BBA has proposed a number of improvements that could level the playing field further, including allowing banks to take as their starting point the average of the risk weights employed by IRB banks, rather than the top end of the range, decomposing the risk weights into Probability of Default (PD) and Loss Given Default (LGD) and clarification of whether the published IRB risk weight ranges are on a Point in Time (PiT) or Through the Cycle (TtC) basis.

We also observed that for some banks the PRA’s minimum requirement for own funds and eligible liabilities (MREL) are more likely to act as the binding constraint than Pillar 2A capital requirements.

Our response also asked the PRA to clarify its preferred approach to residential property development and commercial property development, which have different risk profiles, and observed that for IRB banks there could be an element of double counting between IFRS 9 Expected Credit Loss calculations and IRB outputs.

The PRA’s proposals in CP3/17 are a very welcome workaround in correcting over-conservatism in Pillar 1. An even better way of achieving this would be to address the Pillar 1 risk weightings in their own right. This is part of the Basel Committee on Banking Supervision’s work programme to finalise Basel III. I am hopeful that this will be completed in the near future.

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