Prudential Regulation Authority Rulebook

3.1

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

3.2

Market risk is the risk of losses resulting from adverse changes in the value of positions arising from movements in market prices across commodity, credit, equity, FX and interest rates risk factors.

3.3

The Pillar 2A approach to market risk applies to all firms and covers all positions in the trading and fair value through other comprehensive income (FVOCI) books, including securitisation instruments/positions and covered bonds booked in the trading and FVOCI books.

3.4

The PRA’s review of a firm’s risks and risk management standards applies equally to positions covered by approved models or standardised approaches and, as such, is relevant to firms both with and without advanced model approval. In practice, however, the PRA expects the Pillar 2A regime for market risk to affect mainly firms with material trading books, which are typically those firms with advanced market risk model permission.

3.5

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

3.6

CRR Part Three, Title IV sets out the methodologies that firms must apply when calculating capital requirements for market risk under Pillar 1. The PRA may require firms to hold additional capital under Pillar 2A to cover risks likely to be underestimated or not covered under Pillar 1. The majority of such risks relate to illiquid, one-way and concentrated positions (referred to collectively as illiquid risks), which may not be capitalised appropriately.

3.7

To inform the setting of Pillar 2A capital, the PRA relies on a firm’s own methodologies for assessing illiquid and concentrated positions. This is because market risk is specific to firms’ individual positions. The PRA’s focus is on the quality of firms’ methodologies, including the magnitude of market shocks applied to assess illiquidity risks. The PRA also assesses the firm’s abilities to manage the risk.

3.8

When assessing firms’ own calculations, the PRA will:

• review the completeness of illiquidity risk identification by the firm;
• assess whether the stresses designed and calibrated by the firm are appropriate to measure the risk given a 1-in-1,000 year confidence level over one year (and, if not, request the firm to apply alternative stresses);
• assess the suitability of any existing capital mitigants or reserves which are proposed to offset the calculated stressed losses and discount these where not relevant; and
• set a Pillar 2A capital add-on such that the sum of the Pillar 1 (and Pillar 1 adjustments for model risks) and the Pillar 2A capital requirement is sufficient to cover losses at a 1-in-1,000 year confidence level.

3.9

In addition to the Pillar 2A add-ons for illiquid, concentrated and one-way positions, the PRA may also request a firm to hold additional capital under Pillar 2A where the PRA identifies deficiencies in a firm’s market risk systems and controls.

3.10

The PRA already collects information on illiquid, concentrated and one-way positions from firms participating in the Stress Testing Data Framework (STDF) programme. This information is used for assessing the adequacy of a firm’s capital under Pillar 2A.

3.11

Firms with significant illiquidity risk in their trading books are required by Reporting Pillar 2, 2.4 to submit data on market risk, unless those data have already been submitted as part of the STDF programme. Firms that are in scope are required to submit the data with their ICAAP submissions.