PRA proposes Pillar 2A capital methodology changes

What does this mean?

The PRA’s Phase 1 consultation changes are intended to improve information, guidance and transparency for firms, including about the methodologies used by the PRA to inform the setting of Pillar 2A capital. For Phase 2, the PRA plans to conduct a more in-depth review of individual methodologies within Pillar 2A, on which it will publish a further consultation at a later date.

The proposed changes in Phase 1 are structured according to: credit risk, operational risk, pension obligation risk, and market risk and counterparty credit risk. 

Credit risk

The PRA proposes to remove the benchmarking methodology (including the internal ratings-based (IRB) benchmarks) for Pillar 2A credit risk. The PRA notes that implementation of Basel 3.1 standards will improve risk capture and sensitivity of the Standardised Approach (SA) and therefore it considers the IRB benchmarks and the benchmarking methodology will no longer be appropriate to assess potential credit risk underestimation under the SA. 

The PRA also highlights that it expects some undercapitalisation will remain in the SA framework for exposures to central governments or central banks (CG/CB) and exposures to regional government and local authorities (RG/LA).  This is because certain CG/CB and RG/LA exposures are eligible for a lower risk weight through CRR Art. 114(7) and Art. 115(4), respectively, where they are to a jurisdiction with equivalent supervisory and regulatory arrangements to the UK and are denominated and funded in the domestic currency of the borrower. The PRA states this can often lead to a 0% risk weight, which may not adequately capture the risk implied by the credit rating.

To address this, the consultation proposes the introduction of two systematic methodologies to ensure adequate capitalisation to these exposure types, including introducing a number of minimum effective risk weights for these exposure types in Pillar 2A as a replacement for the relevant IRB benchmarks. 

The PRA also proposes to introduce a specific Pillar 2A methodology to ensure adequate capitalisation for retail unconditionally cancellable commitments (UCCs). For wholesale UCCs, the PRA is initiating a voluntary data request to gather evidence from firms with material wholesale UCC portfolios to understand the adequacy of SA conversion factors. 

The consultation also proposes to introduce expectations for firms on the use of credit scenarios in the Internal Capital Adequacy Assessment Process (ICAAP) in order to achieve greater consistency and comparability across firms’ assessments. These expectations include clarifying that firms should design their own scenarios through exploring high-severity tail events over a 12-month horizon, with particular focus on how these events may result in credit losses that are not captured under Pillar 1 or the systematic methodologies. 

The PRA is also proposing to reduce reporting requirements by streamlining FSA076 and decommissioning FSA077 and FSA082, which cover wholesale portfolio and retail portfolio of exposures for which capital requirements are calculated using the SA. This will have the effect of reducing reporting requirements for firms using the SA from 326 to 78 data points. 

The PRA notes that overall it expects these changes to mean more firms may have credit risk add-ons in Pillar 2A in the future due to the removal of the benchmarking methodology and introduction of the two systemic methodologies. However it does not expect firms’ total capital requirements across Pillar 1 and Pillar 2A to change substantially, as the add-ons derived from the two systemic methodologies are not expected to be material.

Operational risk

Implementation of Basel 3.1 standards will introduce a new SA for Pillar 1 operational risk capital requirements (OR SA) and remove the advanced measurement approach (AMA). The PRA is therefore seeking to enhance the transparency of its Pillar 2A methodology and provide more guidance to firms to ensure this remains consistent with OR SA and retain industry best practices that were codified in AMA requirements and guidelines. 

The PRA proposes to introduce expectations on scenario analysis for all firms to improve the quality and consistency of their ICAAP operational risk scenario analysis, in line with industry best practice. This includes specifying a minimum set of information it expects firms to provide in an ICAAP and clarifying the expectation for firms to capture potentially severe operational risk exposures, including low-frequency high severity events, achieving a soundness standard comparable to a 99.9 % confidence interval over one year.

In addition, the PRA is proposing updates to its Pillar 2 Statement of Policy (SoP) to clarify what factors it considers when setting Pillar 2A capital requirements for operational risk. It also proposes to introduce a set of good practices for significant firms in maintaining a robust operational risk measurement framework. 

Pension obligation risk

The PRA recognises the declining relevance of Pillar 2A pension risk due to recent market trends - for example, the de-risking of schemes’ investment strategies and falling pension scheme deficits. The PRA is seeking to reduce the regulatory burden on firms by removing the PRA prescribed stress scenarios. This is in response to the observed increase in firms’ modelling capabilities and the subsequent reduction in usefulness of the PRA’s two published stress scenarios. 

It is also proposing to exempt firms with fully bought-in or sufficiently well-funded schemes from the Pillar 2A pension risk assessment, as well as reduce the number of data entries required in the FSA081 pension risk template for these firms. 

Market risk and counterparty credit risk

Although no changes are expected to the way market risk and counterparty credit risk are assessed in Pillar 2A, the consultation’s proposals aim to provide more clarity and transparency on the existing methodologies used for setting Pillar 2A capital requirements for these risks. 

The PRA notes the proposed updates reflect established supervisory and market practice. For market risk, this includes explaining how the PRA assesses firms’ processes and practices for identifying illiquid risks and the suitability of firms’ proposed capital mitigants and reserves. For counterparty credit risk, this includes outlining the types of risks against which the PRA may require firms to maintain additional capital under Pillar 2A and expanding on the PRA’s expectations around firms’ identification, risk assessment and capitalisation of residual risks that may arise from the use of credit risk mitigation strategies. 

PS7/25

The near-final policy statement confirms the planned introduction of the Pillar 2A lending adjustment. This aims to to minimise any potential disruption to SME and infrastructure lending following the removal of the respective support factors under Pillar 1 by providing an ‘offset’ in Pillar 2.

The PRA confirms the approach to calculating the Pillar 2A lending adjustment, the scope of eligible exposures, and the interaction with the output floor. The PRA states that it will implement the lending adjustment for firms that submit the necessary data for eligible SME and/or infrastructure exposures with the appropriate RWA breakdown.

What do firms need to do?

The PRA’s consultation represents the first of a two-stage review of Pillar 2A capital requirements aimed at ensuring these - particularly for operational risk and credit risk - remain aligned with the planned changes brought about by Basel 3.1 implementation. 

The PRA’s proposed changes also indicate a desire for the Pillar 2A capital framework to be proportionate and relevant to the risks firms are facing - for example, through the pension risk proposed changes.  Firms should therefore undertake a thorough evaluation of their current capital frameworks to identify areas where the PRA’s proposed changes may result in adjustments, lead to simplifications and/or further benefits.

As part of this, firms should leverage their existing ICAAP and Pillar 2B stress testing frameworks to develop targeted Pillar 2A credit scenarios that capture idiosyncratic risks not fully addressed under Pillar 1 or firm-wide stress tests. As a proportionate first step, firms should assess current credit risk coverage in their ICAAP, identify reusable elements from Pillar 2B infrastructure, and pilot credit-focused scenarios to strengthen governance and evaluate resource needs. 

Firms transitioning from AMA or making major changes to operational risk frameworks should engage with the PRA early. Firms should ensure all aspects of the operational risk framework are well-documented,up-to-date, and aligned to supervisory expectations.

Firms with material wholesale UCCs should also consider responding to the PRA’s data request to inform the regulator’s future policy development in relation to these exposures to ensure this remains proportionate and effective. 

The PRA also recognises the opportunity to reduce the regulatory burden on firms, for example in streamlining certain Pillar 2 reporting requirements, which firms should make the necessary preparations to apply. In response to PS7/25, firms should consider the associated costs of data collection and submission required to qualify for the Pillar 2A lending adjustment, alongside the benefit this adjustment would bring to their firm. Firms seeking to benefit from the Pillar 2A lending adjustment should ensure they can identify and report eligible SME and infrastructure exposures with the required RWA breakdown. For day 1, firms will need to submit completed data templates as part of the PRA’s Basel 3.1 data collection exercise for off-cycle review of firm-specific Pillar 2 capital requirements. Following this, firms will need to return the data templates alongside their ICAAP submission, following the same frequency as their C-SREP. 

Through the proposed changes, the PRA is also aiming to provide firms with a greater degree of transparency to its own assessment and methodology - for example, in its proposals relating to market risk. Firms should remain alert to the PRA’s Phase 2 consultation which will provide a more in-depth review of individual methodologies within Pillar 2A.

Next steps

The consultation closes on 5 September 2025. Changes to pension obligation risk and market risk and counterparty credit risk would apply from 2 March 2026 and firms would be able to apply the proposals in ICAAP submission from this date onwards. 

Implementation of remaining proposals on credit risk and operational risk, and the near-final policy in PS7/25 will be aligned to date of PRA's implementation of Basel 3.1 standards.