Prudential Regulation Authority Rulebook

2.1

This chapter sets out the methodology the PRA uses to inform the setting of a firm’s Pillar 2A capital requirement for credit risk.

2.2

Credit risk is the risk of losses arising from a borrower or counterparty failing to meet its obligations as they fall due.

2.3

A firm’s capital requirements for credit risk are determined in accordance with Pillar 1 of the Capital Requirements Regulation (CRR). However, the PRA believes that there are asset classes for which the standardised approach (SA) underestimates the risk (eg zero risk-weighted sovereigns). The PRA therefore assesses credit risk as part of its Pillar 2 review of firms’ capital adequacy.

2.4

The methodology detailed below is applied to all firms using the SA. It will also be applied to those portfolios capitalised using the SA by firms employing internal ratings--based (IRB) models (the methodology is therefore applied to exposures subject to a partial use exemption). Application of the methodology may be expected to be significant where a firm has higher-risk exposures on the SA and lower-risk exposures on the IRB approach, or where the SA treatment is especially favourable (eg sovereigns).

2.5

Where the underestimation of Pillar 1 capital is due to deficiencies in IRB models, the PRA addresses the capital shortfall by requiring the firm to remediate the shortcomings of the Pillar 1 models rather than setting Pillar 2A capital requirements.

2.6

The methodology used to inform the setting of firms’ Pillar 2A capital requirement for credit risk is based on a comparison of firms’ SA risk weights at a portfolio level to an IRB risk-weight benchmark. The PRA has created two sets of benchmarks. One is calculated based on both unexpected and expected losses (see Table A1). The other is based on unexpected losses only (see Table A2). The latter applies to firms using International Financial Reporting Standards and for which 12 months’ expected credit losses may already be covered by the SA Pillar 1 capital charge. Benchmarks have been calculated for mortgages (distinguished by loan to value (LTV) bands into fourteen categories), credit cards (both domestic and international), corporates, sovereigns and institutions (the latter two mapped to credit quality steps).

2.7

The PRA’s use of this methodology does not imply that estimated IRB risk weights are a better reflection of underlying risk than the SA. For that reason the methodology includes scope for the exercise of supervisory judgement where there are acknowledged problems with IRB models (eg inadequate historical data).

2.8

The PRA has not calculated benchmarks for the portfolios:

• for which, whilst material for SA firms, the PRA does not have sufficient data to produce a reliable benchmark;
• that are immaterial for SA firms; and
• where the difference between the IRB and SA risk weight is small.

2.9

The PRA is going to collect data, as they become available, on a wider range of credit risk portfolios than in Table A1 and Table A2. When the PRA has sufficient data, the PRA may develop more formal benchmarks for those portfolios.

2.10

The PRA uses data collected via regulatory returns, stress testing, hypothetical portfolio exercises, data on retail exposures under the IRB approach as required by Reporting Pillar 2, 2.5 and firm-specific data requests. Each portfolio average risk weight is weighted by exposure amount. While average risk weighting gives a greater degree of importance to larger portfolios, this also reflects the fact that the associated models have been subject to a greater degree of scrutiny by the PRA.

2.11

The method used to inform judgement as to whether a firm should hold additional capital for credit risk under Pillar 2A involves a calculation on an aggregate basis. If the IRB benchmark implies that the SA for calculating the Pillar 1 capital charge overestimates the overall level of capital required for a given portfolio when compared to IRB data, the calculated excess can be offset against shortfalls in those portfolios for which the benchmark implies that the SA Pillar 1 capital charge is lower than the IRB capital charge.

2.12

Supervisory judgement is then used to determine the credit risk add-on, taking into account considerations such as firms’ own assessments, the IRB benchmark range, the PRA’s confidence in the benchmarks and supervisory knowledge of the credit risk portfolios acquired via continuous assessment.

2.12A

Evidence indicates that IRB firms’ commercial real estate (CRE) portfolios are not always comparable to SA firms’ portfolios. In addition, there is significant heterogeneity between SA firms, in terms of the nature and riskiness of their CRE activities.

2.12B

For the purpose of calculating a benchmark that reflects an appropriate level of risk sensitivity, the PRA encourages firms with material CRE exposures and which use the SA in relation to these exposures to assign, as part of their ICAAP, risk weights to these exposures in accordance with Table 1 of CRR Article 153(5) and the draft EBA technical standards for specialised lending. The PRA’s assessment of risk weights for CRE exposures will be informed by the outcome of the firm’s assignation of risk weights and the quality of its assessment. The PRA will take a proportionate approach where firms’ CRE portfolios are not material.

2.13

Initial analysis of the data indicates that relatively few firms would be subject to an add-on using the PRA’s Pillar 2A credit risk methodology. Therefore, the PRA applies it on an exceptions only basis. Firms that are likely to be subject to it include, but are not limited to, those with significant exposures to sovereigns, high LTV mortgages, credit cards and CRE.

2.13A

The PRA will monitor changes in IRB risk weights at least annually. Where significant changes are observed, the PRA will consider updating the IRB benchmark. This may include a partial update if this is only relevant for selected asset classes. In considering updates to the benchmark, the PRA will look to: minimise the lag between the data used to calculate the benchmark and its application to firms; and limit excessive volatility by smoothing out changes (for example, through the use of multi-year averages).

2.14

Firms using the SA for credit risk for wholesale and retail credit exposures are required by Reporting Pillar 2 2.7 and 2.8 to complete the data items for wholesale and retail credit exposures under the SA (FSA076 and FSA077).

2.15

The SA data cover a larger array of data than set out in Table A1 and Table A2 in order to inform the assessment of the credit portfolios reported under the SA.

2.16

To calibrate the Pillar 2 credit risk methodology the PRA collects data. Firms with permission to use the IRB approach for retail exposures are required by Reporting Pillar 2, 2.5 to submit data on retail exposures. Firms that are in scope are required to submit the data with their Internal Capital Adequacy Assessment Process (ICAAP) submissions.