Temporary change to Pillar 2A may offer capital insulation

The latest PRA response to the Covid-19 pandemic could provide some insulation against the likely capital impact. But not everyone will benefit automatically so it’s worth understanding the detail behind the changes and starting to prepare an application if you need to.

The PRA has implemented a number of measures in response to the Covid-19 pandemic. Earlier this month, the authority issued a statement on the setting of Pillar 2A capital requirements for firms subject to the fourth Capital Requirements Directive, or CRD IV. The PRA announced that to “alleviate unwarranted pressure” they would set all Pillar 2A requirements as a nominal amount, instead of a percentage of total Risk Weighted Assets.

Calculating Pillar 2A capital requirements

Firms subject to CRD IV calculate their Pillar 1 minimum capital requirements according to a complex set of rules defined in the Capital Requirements Regulation (CRR). Under these rules, firms risk-weight their exposures, resulting in Risk Weighted Assets (RWAs) and hold a percentage of their RWAs as their Pillar 1 capital.

Firms are also required to hold Pillar 2A capital, which is intended to cover additional risks specific to the firm over and above those already covered by the rules-based Pillar 1 calculations. These risks are assessed as part of the Supervisory Review and Evaluation Process (SREP). The PRA apply a detailed methodology to determine the firm’s Pillar 2A capital requirement and typically reflect an element of this as a percentage of the Pillar 1 RWAs, which is advised to firms following the SREP. Thus, as the firm’s Pillar 1 RWAs increase, for example due to an increase in the size of its loan book, so does the Pillar 2A requirement.

Changing Pillar 2A risk under Covid-19

The PRA recognise that some of the risks being captured by the Pillar 2A methodology are different in nature from those addressed by the Pillar 1 calculations and therefore manifest or evolve differently under stressed conditions. Under extreme stress, such as that is presented by the Covid-19 pandemic, these differences can become profound and may even exacerbate the impact of the stress on the firm.

To alleviate the extraordinary pressure firms are already being subjected to, the Pillar 2A requirement will be converted into a nominal amount rather than a percentage of RWAs. This can significantly lessen the firm’s total capital requirement and removes a variable from strategic planning exercises.

The process for implementation of this conversion varies according to the date of the firm’s next SREP:

  • Firms with a SREP due in 2020 will have a nominal Pillar 2A amount set as part of the process and need take no further action at this stage
  • Firms who do not have a SREP due in 2020 need to apply to have their Pillar 2A requirement converted into a nominal amount and should be aware that application success is by no means guaranteed.

Firms who wish to apply for the conversion will need to complete the Voluntary Requirement (VREQ) form setting-out a proposed Pillar 2A requirement. The PRA will assess each application and determine on a case by case basis whether to grant the conversation. Successful firms will receive written notification confirming the effective date for the conversion.

How we can help

Bovill can help firms with all aspects of the VREQ application process and the SREP as a whole. We have a broad range of regulatory expertise and have helped a number of firms with matters ranging from new bank applications to ICAAPs, ILAAPs, Recovery and Resolution Plans and Pillar 3 reporting. Please get in touch if you would like to know more about how we can help or the services we offer.