Prudential Regulation Authority Rulebook

5.1

This chapter sets out the methodology the PRA uses to inform the setting of a firm’s Pillar 2A capital requirement for counterparty credit risk (CCR), including settlement risk.

5.2

The PRA’s review of a firm’s CCR and risk management standards applies equally to positions covered by advanced 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 CCR to affect mainly those firms with material derivatives, margin lending, securities lending, repurchase and reverse repurchase or long settlement transaction businesses.

5.3

CCR is the risk of losses arising from the default of the counterparty to derivatives, margin lending, securities lending, repurchase and reverse repurchase or long settlement transactions before final settlement of the transaction’s cash flows and where the exposure at default is crucially dependent on market factors.

5.4

For firms with advanced model permission,¹¹ deficiencies or issues in the quantification of the capital needed to mitigate CCR adequately, or other shortcomings in the management of such risk, are addressed as part of the model approval and review process, with any additional capital requirements reflected via model multipliers or add-ons under Pillar 1 in line with Article 101 of the Capital Requirements Directive (CRD).¹²

5.5

For firms with advanced model permission, the PRA will focus on areas of risk that are not covered by internal modelling. Examples include concentration risk and settlement risk.

5.6

For firms without advanced model permission, or for products and counterparties not included in a CCR advanced model permission, the focus of the Pillar 2A review will be broader and cover key areas that would otherwise be assessed as part of model permission. In particular: qualitative requirements for CCR; credit concentration risk; IT sufficiency and data quality; settlement risk; collateral management; wrong-way risk; stress testing of CCR; model validation; and the limitations of non-advanced methods.

5.7

CRR Articles 286–294 set out a number of qualitative requirements that firms must meet in order to use the advanced model for CCR. The PRA’s view is that these qualitative standards should be the basis for assessing CCR risk management by all firms. The PRA assesses firms’ management standards for CCR against these qualitative standards and may require firms to hold additional capital under Pillar 2 to address material deficiencies. The PRA focuses on the following areas: collateral disputes, collateral concentration and stress testing.

5.8

The PRA captures CCR exposures in the firm’s assessment of concentration risk, as set out in Chapter 5. The PRA addresses concentration risk by looking at single name, sectoral and geographical credit concentration across all exposures, including exposures and facilities across the trading and banking book.

5.9

IT and data issues can compromise the effectiveness of risk management and the calculation of capital requirements. For firms with advanced model permission, IT sufficiency and data quality are reviewed as part of an internal model application. For firms using standardised approaches, and for products not included within the scope of internal models, the Pillar 2A review focuses on IT sufficiency and data quality related to trade capture, exposure information for risk management and capital calculation. The PRA may require a firm to hold additional capital under Pillar 2A to address identified deficiencies.

5.10

Settlement risk for transactions where the settlement or delivery date is no later than the market standard or five business days after the transaction date is not capitalised under Pillar 1.

5.11

For firms with advanced model permission, the risk management framework for settlement risk is reviewed as part of the advanced model application and its ongoing review.

5.12

Where firms do not adequately manage settlement risk arising from products outside the scope of an advanced CCR model¹³ (eg through pre-deal checking, defined limit frameworks, appropriate reporting), the PRA may challenge the appropriateness of a zero capital requirement for such risk and require firms to hold additional capital under Pillar 2.

5.13

The review of settlement risk management will also include those products that do not attract CCR capital but give rise to settlement risk (eg cash securities transactions that are not conducted on a delivery versus payment basis).

5.14

The risk mitigation effects of collateral on derivative and repo-style transactions are incorporated into exposure calculations. However, the way in which collateral is used can give rise to additional risks. One particular area of concern is the re-use of collateral, for example when securities posted by a counterparty are re-used to collateralise an exposure with a riskier counterparty which does not segregate them. In such cases a firm may face liquidity constraints and losses if the counterparty defaults.

5.15

Collateral management is reviewed as part of the advanced model application and its ongoing review. For firms without advanced model permission, the PRA reviews firms’ management of risks arising from collateral and may ask such firms to hold additional capital under Pillar 2 to address risks not sufficiently covered under Pillar 1.

5.16

Other than for specific wrong-way risk,¹⁴ the CCR capital framework assumes independence between the creditworthiness of a firm’s counterparty and the level of exposure to that counterparty. Wrong-way risk, where there is an adverse relationship between the exposure to the counterparty and the creditworthiness of that counterparty, arises in circumstances in which this assumption does not hold.

5.17

Wrong-way risk frameworks of firms with advanced model permission are reviewed as part of their Internal Model Method application process. The PRA expects firms without advanced model permission to identify, monitor, manage, mitigate and capitalise their wrong-way risk appropriately. Misidentification of wrong-way risk leads to underestimation of risks and undercapitalisation. The PRA reviews the firm’s management and capitalisation of wrong-way risk in its Pillar 2 assessment and may ask firms to hold additional capital under Pillar 2A to address identified deficiencies.

5.18

The PRA considers stress testing to be an important complement to business-as-usual measures of CCR exposure used for risk management. Firms with advanced model permission are required to carry out comprehensive stress testing analysis for both risk management and capital adequacy assessments. The PRA expects a firm without advanced model permission, or with material proportions of business outside the scope of advanced model permission, to carry out stress testing that is commensurate with the complexity of its business. The PRA focuses on CCR stress testing capabilities in its Pillar 2 assessment and may ask firms to hold additional capital under Pillar 2A to address identified deficiencies.

5.19

Models are used extensively in the measurement of CCR, for the modelling of risk factors, the pricing of instruments and the quantification of risk. Firms with CCR advanced model permission have their model validation functions reviewed as part of the application and review processes. The PRA expects firms without CCR advanced model permission (but still using models in their CCR management) to have a model validation function that meets the PRA’s expectations. The PRA focuses on the model validation function in its Pillar 2 assessment and may ask firms to hold additional capital under Pillar 2A to address identified deficiencies.

5.20

[Deleted]

5.21

The PRA reviews the risks that are not adequately captured by standardised approaches in its Pillar 2 assessment and may ask firms to hold additional capital under Pillar 2A to address identified deficiencies.

5.22

Inputs to the standardised approaches may come from a model or rely on prudent valuation. Where such inputs are inaccurate firms may fail to manage their exposures properly and may be under-capitalised. The PRA reviews the accuracy of those inputs to calculate Pillar 1 CCR charges and may ask firms to hold additional capital under Pillar 2A to address identified deficiencies.