Prudential Regulation Authority Rulebook

2.1

A firm must carry out an ICAAP in accordance with the PRA’s ICAA rules. These include requirements on the firm to assess on an ongoing basis the amounts, types and distribution of capital that it considers adequate to cover the level and nature of the risks to which it is or might be exposed. This assessment should cover the major sources of risks to the firm’s ability to meet its liabilities as they fall due, and should incorporate stress testing and scenario analysis. If a firm is merely attempting to replicate the PRA’s own methodologies, it will not be carrying out its own assessment in accordance with the ICAA rules. The ICAAP should be documented and updated annually by the firm, or more frequently if changes in the business, strategy, nature or scale of its activities or operational environment suggest that the current level of financial resources is no longer adequate.

2.2

The PRA expects firms, in the first instance, to take responsibility for ensuring that the capital they have is adequate, with the ICAAP being an integral part of meeting this expectation. The PRA expects an ICAAP to be the responsibility of a firm’s management body, that it is approved by the management body, and that it is used as an integral part of the firm’s management process and decision making. The processes and systems used to produce the ICAAP should ensure that the assessment of the adequacy of a firm’s financial resources is reported to its management body as often as is necessary.

2.3

The ICAAP, and internal processes and systems supporting it, should be proportionate to the nature, scale and complexity of the activities of a firm, as set out in Internal Capital Adequacy Assessment 3.3 in the PRA’s Rulebook. Where a firm has identified risks as not being material, it should be able to provide evidence of the assessment process that determined this and discuss why that conclusion has been reached.

2.4

Liquidity risk should also be assessed, including in relation to potential losses arising from the liquidation of assets and increases in the cost of funding during periods of stress. The requirements in relation to liquidity risk may be found in PS11/15.^[8]

2.5

As set out in further detail below, the PRA also expects firms to develop a framework for stress testing, scenario analysis and capital management that captures the full range of risks to which they are exposed and enables these risks to be assessed against a range of plausible yet severe scenarios. The ICAAP document should outline how stress testing supports capital planning for the firm.

2.6

Where a firm uses a model to aid its assessment of the level of capital adequacy, it should be appropriately conservative and should contribute to prudent risk management and measurement. The firm should expect the PRA to investigate the structure, parameterisation and governance of the model, and the PRA will seek reassurance that the firm understands the attributes, outputs and limitations of the model, and that it has the appropriate skills and expertise to operate, maintain and develop the model.

2.6A

For firms using the Standardised Approach for credit risk, CRR Article 235(1) allows firms to recognise guarantees qualifying as unfunded credit protection under Part Three, Title II, Chapter 4 (Credit risk mitigation) of the CRR by substituting the risk weight of an obligor with the risk weight of a guarantor, for the protected amount of the exposure. Firms are expected to assess whether a full substitution of the risk weight of the guarantor is warranted or not. As part of this assessment, firms should consider the risk that, notwithstanding fulfilment of eligibility criteria under Pillar 1 for qualifying guarantees, the credit protection could in practice become ineffective due to any reason other than the default of the guarantor and evidence this assessment within its ICAAP document. As part of this consideration, the PRA expects firms to consider in particular the:

• risk, if any, that in practice the guarantor would seek to reduce or be released from liability under the guarantee, for example through lengthy settlement or disputes processes; and
• operational risk that the firm may breach its obligations under the terms of the guarantee in a manner that might entitle the guarantor not to pay out.

2.6B

Where firms assess that a full substitution is not prudent, the PRA expects firms to consider whether a Pillar 2A add-on is appropriate.

2.7

All firms must have appropriate systems and processes, proportionate to the nature, scale and complexity of their business, to identify, evaluate and manage IRRBB.

2.7A

The PRA expects a firm to include small trading book business (as identified under Article 94 of the UK-CRR) as part of its identification, evaluation and management of IRRBB unless its interest rate risk is captured in another risk measure.

2.7B

A firm that, under Internal Capital Adequacy Assessment 9.4A, must immediately notify the PRA if its economic value of equity (EVE) would decline by more than 15% of its Tier 1 capital as a result of the application of the interest rate scenarios in Internal Capital Adequacy Assessment Rule 9.7, shall be considered an outlier firm. The PRA will review each outlier firm to determine whether the PRA considers that the firm has excessive IRRBB or inadequate management of IRRBB. The PRA may also conduct such a review for firms that are not outlier firms.

2.7C

Where the review in 2.7B leads the PRA to consider that a firm's risk management of IRRBB is inadequate for the purposes of its obligations in the PRA Rulebook, or that the risk is excessive relative to the firm's capital or earnings, the PRA is likely to expect the firm to take one or more of the following actions:

1. (i) take steps to reduce its IRRBB exposures;
2. (ii) hold additional capital for its IRRBB;
3. (iii) implement constraints to internal risk parameters; or
4. (iv) make other corrective actions to address deficiencies in its models or risk management framework.

2.8

[deleted]

2.8A

A firm’s management body should oversee and approve the firm’s risk appetite and framework for managing IRRBB. This framework should be consistent across consolidated and sub-consolidated entities. The risk appetite should be expressed in terms of the risk to economic value and the risk to earnings.

2.8B

The systems and processes should allow the firm to:

1. (i) identify and quantify the major sources of IRRBB exposures;
2. (ii) retrieve accurate information in a timely manner;
3. (iii) compute economic value and earnings measures of IRRBB for different scenarios;
4. (iv) incorporate constraints specified by the PRA on the firm's internal risk parameter estimates;
5. (v) compare risk figures over different periods (eg by monitoring the impact of changes to the cash-flow slotting criteria);
6. (vi) assess all material cash flows from relevant interest rate sensitive instruments, including non-performing exposures (net of provisions), interest rate derivatives and off-balance sheet items such as interest rate sensitive loan commitments;
7. (vii) measure the exposure and sensitivity of its activities, if material, to gap risk, yield curve risk, basis risk and risks arising from embedded optionality (eg pipeline risk and prepayment risk) as well as changes in assumptions (eg those relating to customer behaviour);
8. (viii) consider whether a purely static analysis of the impact on its current portfolio of a given shock or shocks should be supplemented by a more dynamic simulation approach;
9. (ix) model scenarios in which different interest rate paths are computed and in which some of the assumptions (eg about behaviour, contribution to risk and balance sheet size and composition) are themselves functions of interest rate levels; and
10. (x) measure the exposure and sensitivity of its fair value exposures to changes in value resulting from yield curve and basis risk.

2.8C

The PRA expects a firm to set and apply policy limits for IRRBB that are consistent with the firm’s risk appetite. When setting policy limits, a firm should ensure that:

1. (i) policy limits are appropriate to the nature, size, complexity and capital adequacy of the firm;
2. (ii) policy limits are reviewed at least annually; and
3. (iii) gap risk, basis risk and positions with explicit and embedded options are considered in the setting of policy limits where the firm has significant exposures to these risks and positions.

2.8D

The PRA expects a firm’s management body to have the appropriate expertise to understand:

1. (i) the nature and the level of IRRBB;
2. (ii) the implications of a firm's strategies for managing IRRBB, including the potential linkages with and impact on market, liquidity, credit and operational risk; and
3. (iii) the most significant behavioural and modelling assumptions and their implications, including for hedging strategies.

2.8E

A firm’s management body may delegate the management and monitoring of IRRBB to senior management, the firm’s Asset and Liability Committee or to one or more individuals with sufficient expertise. The relevant delegate(s) should include members with clear lines of authority over the units responsible for establishing and managing positions.

2.8F

A firm's management body should regularly review timely and sufficient information for assessing the performance of its delegates in monitoring and controlling IRRBB and credit spread risk in the non-trading book in accordance with its framework and its risk appetite.

2.8G

A firm’s management body or its delegates should establish and maintain an adequate risk management framework for IRRBB. The PRA expects that the framework should include measures to establish, apply and maintain at least the following:

1. (i) appropriate limits on IRRBB;
2. (ii) procedures for ensuring compliance with the limits in (i);
3. (iii) an approvals process for exceptions from the limits in (i);
4. (iv) adequate systems, standards and controls for measuring IRRBB;
5. (v) standards for measuring IRRBB, valuing positions and measuring performance;
6. (vi) an appropriate reporting and review process for IRRBB;
7. (vii) adequate internal controls and management information systems for IRRBB;
8. (viii) an adequate approval process for approving major hedging or risk-taking initiatives prior to implementation;
9. (ix) appropriate governance processes for ensuring the adequacy of the models;
10. (x) a formal policy process for the validation of IRRBB measurement methods and assessment of corresponding model risk; and
11. (xi) a process to regularly measure IRRBB based on outcomes of economic value and earnings-based measures.

2.8H

A firm's management body or its delegates should approve major hedging or risk-taking initiatives relating to IRRBB in advance of their implementation.

2.8I

A firm should ensure that the functions responsible for identification, measurement, monitoring and control of IRRBB are, where appropriate to its nature, size and complexity as well as business activities and overall risk profile, sufficiently independent from risk-taking functions and report directly to the management body or its delegates.

2.8J

A firm should review and evaluate the effectiveness of its framework on a regular basis, and at least annually. Where appropriate to its nature, size and complexity as well as business activities and overall risk profile, the reviews and evaluations should be carried out by individuals that are sufficiently independent of the individuals responsible for designing and implementing the framework.

2.8K

A firm should have its framework reviewed by an independent internal auditing function on a regular basis.

2.9

[Moved to 2.11A]

2.9A

A firm should ensure that the internal risk measurement system used to comply with the obligation in the PRA Rulebook capture all material sources of IRRBB exposures. If the PRA determines the internal risk measurement systems of a firm inadequate in risk capture or for other reasons, the firm should take such steps as the PRA may direct or require, including use of the standardised framework under Internal Capital Adequacy Assessment 9.13 when performing the evaluation under Internal Capital Adequacy Assessment 9.2 and 9.4A.

2.9B

Under Internal Capital Adequacy Assessment 9.4A, a firm is required to calculate the impact of the change in interest rates described in Internal Capital Adequacy Assessment 9.7 on the economic value of equity of a firm’s non-trading book activities. A firm should perform this calculation regularly, and at least quarterly. When performing the calculation, a firm should, where appropriate to its nature, size and complexity as well as business activities and overall risk profile, apply the following principles:

1. (i) the calculation should exclude the firm’s own equity;
2. (ii) the change in EVE (ΔEVE) should be computed with the assumptions of a run-off balance sheet;
3. (iii) a maturity-dependent post-shock interest rate floor should be applied for each currency starting with -100 basis points for immediate maturities and increase by 5 basis points per year, eventually reaching 0% for maturities of 20 years and more (where the observed rates are lower than the current lower reference rate of -100 basis points, a firm should apply the lower observed rates);
4. (iv) when calculating the aggregate ΔEVE for each interest rate shock scenario, a firm should add together any negative and positive ΔEVE occurring in each currency and any positive changes should be weighted by a factor of 50%;
5. (v) the automatic and behavioural options, including the assumptions identified in 2.9K should be reflected in the calculation;
6. (vi) the assumed behavioural repricing date for retail and non-financial wholesale deposits without any specific repricing dates (non-maturing deposits) should be constrained to a maximum average of 5 years for each individual currency;
7. (vii) the calculation should include all cash flows from all interest rate-sensitive assets (assets which are not deducted from Common Equity Tier 1 capital and which exclude (i) fixed assets such as real estate or intangible assets as well as (ii) equity exposures in the non-trading book), liabilities and off-balance sheet items in the non-trading book in the computation of their exposure; and
8. (viii) if commercial margins and other spread components are included in the cash flows calculated for measurement of IRRBB, the firm should also include commercial margins and other spread components in the rates used for discounting those cash flows.

2.9C

Alongside the requirement to monitor and evaluate the potential impact of changes in interest rates on economic value, the PRA expects firms to monitor and evaluate the potential impact on earnings volatility. As appropriate to its nature, size and complexity as well as business activities and overall risk profile, a firm should include in its evaluation:

1. (i) assessment based on an appropriate timeframe of three to five years;
2. (ii) the firm’s forward-looking view of product volumes and pricing, based on its proposed business model during the scenario, and the projected path of interest rates;
3. (iii) careful consideration should be given to how any resulting volatility is managed;
4. (iv) consideration on the effects on its cash flow (ie interest income and expenses), and for large or more complex firms, the projected cash flow under different interest rate scenarios;
5. (v) consideration on the effects of the market value changes of interest rate sensitive instruments; and
6. (vi) the firm’s careful consideration to managing any resulting volatility on its’ earnings.

2.9D

The models used to comply with the obligation in the PRA Rulebook should incorporate a wide and appropriately prudent range of interest rate shock and stress scenarios by currency. Those scenarios should include:

1. (i) interest rate shock scenarios selected by the firm reflecting its risk profile in accordance with Internal Capital Adequacy Assessment 9.2;
2. (ii) historical and hypothetical interest rate stress scenarios;
3. (iii) the interest rate shock scenarios in Internal Capital Adequacy Assessment 9.7; and
4. (iv) any additional interest rate shock scenarios required by the PRA.

2.9E

For the range of interest rate shock scenarios, a firm should ensure:

1. (i) they encompass a wide range of severe and plausible interest rate shock scenarios relevant to the firm's material sources of IRRBB;
2. (ii) where relevant to the firm's own material sources of IRRBB, the scenarios consider gap risk, basis risk, and option risk (including sensitivity to interest rate movements); concentrated risks; and interaction with other risks;
3. (iii) the scenarios consider vulnerability to reduced economic value or earnings under stressful market conditions – including the breakdown of key assumptions;
4. (iv) they assess the effect of adverse changes in the spreads of new assets/liabilities replacing those assets/liabilities maturing over the horizon of the forecast on its earnings-based measures; and
5. (v) the scenarios consider potential changes in the firm's non-trading book activities.

2.9F

In addition to considering the range of interest rate shock scenarios in 2.9E for the purpose of ongoing management, a firm should also use other larger and more extreme shifts and changes in interest rates for testing vulnerabilities under stressed condition.

2.9G

Under Internal Capital Adequacy Assessment 9.12, a firm should either determine the interest rate shock scenarios for material positions in currencies not listed in Internal Capital Adequacy Assessment 9.11 by considering the following, or use interest rate shock scenarios produced by a third party that are consistent with the following:

1. (i) a sufficiently long time-series of daily ‘risk-free’ interest rates for each currency for relevant maturities;
2. (ii) the baseline global shock parameters on the average interest rate, which comprises: (i) 60% for parallel shocks; (ii) 85% for short rate shocks; and (iii) 40% for long rate shocks; and
3. (iii) a floor of 100 basis points and caps of: (i) 500 basis points for the short-term; (ii) 400 basis points for the parallel; and (iii) 300 basis points for the long-term interest rate shock scenario.

2.9H

A firm should develop and implement an effective stress testing framework that:

1. (i) is commensurate with its nature, size and complexity as well as business activities and overall risk profile;
2. (ii) is performed regularly, at least annually and more frequently in times of increased interest rate volatility and increased IRRBB levels;
3. (iii) where relevant, stress testing should incorporate the risks identified in 2.9E;
4. (iv) includes relevant qualitative and quantitative reverse stress tests in order to:
   
   1. (a) identify interest rate scenarios that could significantly threaten the firm’s capital and earnings; and
   2. (b) reveal vulnerabilities arising from the firm’s hedging strategies and the behavioural reactions of its customers.

2.9I

A firm should reflect in its risk management framework how an instrument’s actual maturity or repricing behaviour may vary from the instrument’s contractual terms because of behavioural optionalities.

2.9J

A firm should establish and maintain documentation setting out the key behavioural assumptions and modelling assumptions it uses in measuring IRRBB.

2.9K

For the documentation of behavioural and modelling assumptions, a firm should set out:

1. (i) expectations for the exercise of explicit and embedded interest rate options by both the firm and its clients under specific interest rate shock and stress scenarios;
2. (ii) treatment of balances and interest flows arising from non-maturity deposits;
3. (iii) the treatment of fixed rate loan commitments;
4. (iv) the treatment of fixed term deposits with risk of early redemption;
5. (v) treatment of own equity in economic value measures;
6. (vi) the implications of accounting practices for IRRBB; and
7. (vii) how the assumptions in 2.9J may affect the firm's hedging strategies.

2.9L

A firm should review significant assumptions at least annually, and when market conditions change significantly. These assumptions should be aligned with the firm’s business strategies.

2.9M

For the assumptions identified in 2.9J, a firm with significant exposure to products with embedded customer optionality should consider and identify the following:

1. (i) the potential impact on current and future loan prepayment speeds arising from the interest rate scenario, underlying economic environment, and contractual features;
2. (ii) the responsiveness of product rates to changes in market interest rates; and
3. (iii) the migration of balances between product types as a result of changes in their features, terms and conditions.

2.9N

For the assumptions identified in 2.9J, a firm with significant exposure to products without specific repricing dates should consider and identify the following:

1. (i) the proportion of 'core' balances that are stable and unlikely to reprice even under significant changes in interest rate environment;
2. (ii) the depositor characteristics (eg retail/wholesale) and account characteristics (eg transactional/non-transactional);
3. (iii) the potential migration between deposits without specific repricing dates and other deposits that could modify, under different interest rate scenarios, key behavioural modelling assumptions;
4. (iv) the potential constraints on the repricing of retail deposits in low or negative interest rate environment;
5. (v) ensure that assumptions about the decay of core and other modelled balances are prudent and appropriate in balancing the benefits to earnings against the additional economic value risk entailed in locking in a future interest rate return on the assets financed by these balances, and the potential forgone revenue under a rising interest rate environment; and
6. (vi) the impact of the assumptions on the firm’s own chosen risk measurement outputs and internal capital allocation decisions, including by periodically calculating sensitivity analyses on key parameters (eg percentage and maturity of core balances on accounts and pass-through rate) and the measures using contractual terms rather than behavioural assumptions to isolate the impact of assumptions on both economic value and earnings.

2.9O

A firm should have assumptions which are conceptually sound and reasonable, and consistent with historical experience, and establish and apply a robust process for testing the validity of the assumptions. The testing process should include sensitivity analyses to monitor the impact of the assumptions on economic value and earnings-based measures.

2.9P

Where a firm decides to adopt a policy intended to stabilise earnings arising from its own equity, it should:

1. (i) have an appropriate methodology for determining what elements of equity capital should be considered eligible for such treatment;
2. (ii) determine what would be a prudent investment maturity profile for the eligible equity capital that balances the benefits of income stabilisation arising from taking longer-dated fixed-return positions against the additional economic value sensitivity of those positions under an interest rate stress, and the risk of earnings underperformance should rates rise;
3. (iii) include appropriate documentation of these assumptions in its policies and procedures, and include a process for keeping them under review;
4. (iv) understand the impact of the chosen maturity profile on the firm’s own chosen risk measurement outputs, including by regular calculation of the measures without inclusion of the equity capital to isolate the effects on both EVE and earnings perspectives; and
5. (v) undertake stress testing to understand the sensitivity of risk measures to changes in key assumptions for equity capital, taking the results of such tests into account in its IRRBB internal capital allocation decisions.

2.9Q

The data on which a firm’s measurement systems and models for IRRBB are based should be sufficiently accurate and appropriately documented.

2.9R

A firm should set up appropriate processes to ensure that the data referred to in 2.9Q is consistent with the data used for financial planning.

2.9S

A firm should establish, maintain and apply appropriate governance processes for ensuring the ongoing adequacy of the models. This includes ensuring models are subject to adequate controls and testing, including any data mapping, to provide assurance on the accuracy of their calculations. A firm should ensure that its internal audit function annually reviews the integrity and effectiveness of the risk management system and the model risk management process.

2.9T

Prior to deployment, and on a regular basis, the model should be reviewed and validated independently of model development.

2.9U

A firm should establish exception trigger events that require notification to the management body or its delegates under 2.8E in a timely manner if those events occur.

2.9V

When using third-party models, a firm should:

1. (i) document and explain model specification choices as part of the validation process;
2. (ii) ensure the models can be adequately customised to properly reflect the specific characteristics of the firm; and
3. (iii) determine if inputs to models that are provided by third parties are reasonable for its business and the risk characteristics of its activities.

2.10

[Moved to 2.12A]

2.10A

The management body or its delegates should receive:

1. (i) the outcomes of the firm’s measurement of IRRBB; and
2. (ii) reports on the level and trend of the firm's IRRBB. This should be at least quarterly, and more frequently for firms with greater or more complex risk profiles.

2.10B

The reporting referred to in 2.10A(ii) should be broken down by the appropriate levels of consolidation and currency and include at least:

1. (i) summaries of the firm’s aggregate exposures to IRRBB, including information on exposures to gap risk, basis risk and option risk;
2. (ii) explanation of assets, liabilities, cash flows and strategies that are driving the level and direction of the firm’s IRRBB;
3. (iii) reports showing the extent of compliance of current exposures with policies and limits in 2.8B, 2.8C;
4. (iv) the key modelling assumptions, such as characteristics of non-maturity deposits, prepayments on fixed rate loans, early withdrawals of fixed term deposits, drawing of commitments, currency aggregation and treatment of commercial margins;
5. (v) the results of stress tests and measurements from the scenarios referred to in 2.9D, including sensitivity analysis for key model assumptions and parameters;
6. (vi) the results of the calculation under Internal Capital Adequacy Assessment 9.4A;
7. (vii) comparisons of past forecasts or risk estimates with actual results to inform potential modelling shortcomings on a regular basis; and
8. (viii) identification of portfolios that may be subject to significant mark-to-market movements.

2.11

[Deleted]

2.11A

Under Internal Capital Adequacy Assessment 13.1, a firm is required to make a written record of its assessments made under those rules. A firm’s record of its approach to evaluating and managing interest rate risk as it affects the firm’s non-trading book activities should cover the following issues as appropriate:

1. (i) the internal definition of the boundary between ‘banking book’ and ‘trading activities’;
2. (ii) the definition of economic value and its consistency with the method used to value assets and liabilities (eg discounted cash flows);
3. (iii) the size and the form of the different shocks to be used for internal calculations;
4. (iv) the use of a dynamic and/or static approach in the application of interest rate shocks;
5. (v) the treatment of commonly called ‘pipeline transactions’ (including any related hedging);
6. (vi) the aggregation of multi-currency interest rate exposures;
7. (vii) the inclusion (or not) of non-interest bearing assets and liabilities (including capital and reserves);
8. (viii) the treatment of current and savings accounts (ie the maturity attached to exposures without a contractual maturity);
9. (ix) the treatment of fixed-rate assets or liabilities where customers still have a right to repay or withdraw early;
10. (x) the extent to which sensitivities to small shocks can be scaled up on a linear basis without material loss of accuracy (ie covering both convexity generally and the non-linearity of pay-offs associated with explicit option products);
11. (xi) the degree of granularity employed (eg offsets within a time bucket);
12. (xii) whether all future cash flows or only principal balances are included;
13. (xiii) the results of the calculation under Internal Capital Adequacy Assessment 9.4A;
14. (xiv) the use of conditional or unconditional cash flow modelling approaches;
15. (xv) the internal definition of commercial margins and adequate methodology for internal treatment of commercial margins;
16. (xvi) the definition of earnings risk and its consistency with the method used for developing financial plans and financial forecasts;
17. (xvii) the size and tenor of internal limits on IRRBB, and whether these limits are reached at the point of capital calculation;
18. (xviii) the effectiveness and expected cost of hedging open positions that are intended to take advantage of internal expectations of the future level of interest rates;
19. (xix) the sensitivity of the internal measures of IRRBB to key modelling assumptions;
20. (xx) the impact of shock and stress scenarios on positions priced off different interest rate indices (basis risk);
21. (xxi) the impact on economic value and earnings of mismatched positions in different currencies;
22. (xxii) the impact of embedded losses;
23. (xxiii) the distribution of capital relative to risks across legal entities that form part of a capital consolidation group, in addition to the adequacy of overall capital on a consolidated basis;
24. (xxiv) the drivers of the underlying risk; and
25. (xxv) the circumstances under which the risk might crystallise.

2.12

[Moved to 2.9C]

2.12A

For building societies, interest rate risk should also be managed with reference to PRA Supervisory Statement SS20/15, ‘Supervising building societies’ treasury and lending activities’^[9]. Only societies not on the administered or matched approach to financial risk management should incur any significant interest rate risk.

2.12B

Firms implementing the standardised framework under Internal Capital Adequacy Assessment 9.13 should generally consider the most recent 10 years of data when determining the core portion of non-maturing deposits under Internal Capital Adequacy Assessment 9.34(1).

2.13

Firms should provide in their ICAAP document sufficient supplementary evidence, to an auditable standard, which shows how the firm’s capital add-on for market risk is calculated. Specifically, firms need to provide evidence of sound approaches for assigning liquidity horizons in stressed situations, and demonstrate a conservative translation of liquidity horizons into appropriately severe stress scenarios.

2.14

The PRA expects firms to submit this supplementary internal methodology documentation, when pertinent, on a quarterly basis.

2.15

To this end, the PRA expects firms to:

• identify illiquid, one-way or concentrated positions;
• stress these positions (or risk factors) over an appropriate holding period (ie greater than ten days) and confidence level;
• identify any capital mitigants already in place that directly relate to the illiquid, one-way or concentrated positions (eg capital for Risks not in VaR (RNIVs), capital for the Incremental Risk Charge (IRC) and reserves (such as bid/ask and prudential valuation reserves)); and
• suggest a Pillar 2A capital amount based on the stressed losses and capital mitigants or reserves.

2.16

Under the PRA Rulebook a firm is required to have adequate, sound and appropriate risk management processes and internal control mechanisms for the purpose of assessing and managing its own exposure to group risk, including sound administrative and accounting procedures.^[10]

2.16A

Group risk, as defined in the PRA Rulebook,^[11] means the risk that the financial position of a firm may be adversely affected by its relationships (financial or non-financial) with other entities in the same group or by risk which may affect the financial position of the whole group, including reputational contagion.

2.16AA

Where a firm is a member of a consolidation group, it should provide in its ICAAP document sufficient information to demonstrate how it is meeting the requirements under ICAA 14.8 and 14.9 to allocate the total amount of financial resources, own funds and internal capital between different parts of the consolidation group in a way that adequately reflects the nature, level, and distribution of the risks to which the consolidation group is subject. This assessment should cover all sources of risk within the group, including risks of financial sector entities that do not have an individual capital requirement but that nevertheless contribute to the consolidated risks of the group. Firms for which the PRA is not the global consolidating supervisor are not expected to conduct this assessment or provide the relevant analysis in their ICAAP document, unless the PRA requests otherwise.

2.16AB

Specifically, where a financial sector entity’s^[12] contribution to the consolidation group’s risk weighted assets (RWAs) exceeds 5%, and its capital ratio (defined as own funds divided by total RWAs) is lower than the consolidation group’s total capital requirement, the firm is expected to:

• identify in its ICAAP document any mitigating actions it is taking to manage this under-allocation;^[13] or
• demonstrate that there is no group risk from the under-allocation of capital to this entity (eg because there is no current or foreseen material, practical, or legal impediment to the prompt transfer of resources to that entity; the shortfall is temporary; or the safety and soundness of the entity is not material to the financial position of the firm or the consolidation group of which it is a member).

2.16AC

Where a firm is a member of a consolidation group, and the group includes an entity established outside the United Kingdom, the PRA expects the firm, when it is assessing group risk, to consider any capital requirements or buffers applied to the entity^[14] established outside the United Kingdom. Specifically, the PRA expects a firm to consider the extent to which:

• for any given risk type, the minimum requirements applied to the entity exceed the entity’s share of the consolidated group requirements for the same underlying risk; and
• any buffers applied to the entity exceed the entity’s share of the consolidated group buffer applied for the same underlying risk.^[15]

2.16AD

An entity’s share of a particular consolidated group capital requirement or buffer can be determined by multiplying that consolidated group capital requirement or buffer by the proportion of the consolidated group’s Pillar 1 RWAs that are attributable to that entity. The consolidated group’s RWAs that are attributable to an entity is calculated as the entity’s Pillar 1 RWAs minus the risk-weighted exposures of the entity to other group entities.

2.16AE

Firms for which the PRA is not the global consolidating supervisor are not expected to conduct this assessment or provide the relevant analysis in their ICAAP documents, unless the PRA requests otherwise.

2.16AF

The PRA does not expect firms to include in this assessment requirements imposed on entities established outside the United Kingdom that are attributable to risks that:

• are already mitigated through the risk-based capital framework (including requirements that are higher than the equivalent requirement applied on a consolidated basis because of a difference of approach between the PRA and the regulatory authority in the jurisdiction concerned)^[16] or by other means;^[17] or
• net off in consolidation (eg intragroup risks and offsetting positions).

2.16AG

Under ICAA 13.1, a firm must make a written record of the assessments required under the ICAA part of the PRA Rulebook. A firm’s record of its approach to making the assessment in paragraph 2.16AC should cover the following, as appropriate:

• for any given risk type, the minimum requirements or buffers applied to an entity established outside the United Kingdom that exceed the entity’s share of the consolidated group requirements for the same risk or buffer;
• any such differences that the firm considers are already mitigated through the risk-based capital framework or by another means; and
• how any additional capital to cover group risk has been calculated.

2.16AH

Under the Senior Managers Regime (SMR),^[18] firms are required to allocate a Prescribed Responsibility (PR) for managing the allocation and maintenance of the firm’s capital, funding and liquidity to an individual performing a Senior Management Function (SMF).^[19] The PRA expects:

• the SMF allocated this PR to ensure that the firm conducts the assessments specified in paragraphs 2.16AA to 2.16AG, and to document them in the firm’s ICAAP submissions, and
• firms to ensure this expectation is explicitly reflected in the relevant SMF’s Statement of Responsibilities.

2.16B

RFB group risk means, in relation to a consolidation group containing an RFB sub-group,^{[20] [21]} the risk that the financial position of a firm on a consolidated basis may be adversely affected by the minimum capital and buffers applicable at the level of the RFB sub-group, such that there is insufficient capital within (or an inappropriate distribution of capital across) the consolidated group to cover the risks of the consolidated group.

2.16C

The PRA therefore expects a firm that is a member of a consolidation group containing an RFB sub-group to ensure that the minimum capital and buffers applicable at the level of the RFB sub-group do not result in the consolidated group having insufficient capital within it, or an inappropriate distribution of capital across it, to cover the risks faced by the consolidation group; and in order to ensure that RFB group risk is adequately covered in consolidated group capital, firms are expected to take account of this risk when carrying out an ICAAP on a consolidated basis.

2.16D

When a firm is assessing RFB group risk as part of its ICAAP on a consolidated basis, the PRA expects it to consider, to the extent not already covered by other elements of the capital framework, the following:

• the extent to which any other systemically important institutions buffer (O-SII buffer) exceeds the RFB sub-group’s share^[22] of any group-wide global systemically important bank (G-SIB) buffer;
• the extent to which the amount of capital applicable at the level of the RFB sub-group to cover the credit concentration risk on a sub-consolidated basis exceeds the RFB sub-group’s share^[23] of the capital applicable at the level of the consolidated group to cover the credit concentration risk on a consolidated basis;
• any minimum capital and buffers applicable at the level of the RFB sub-group attributable to risk-weighted exposures of the RFB sub-group to group entities that are not members of the RFB sub-group (to the extent RFB group risk in relation to those exposures is not already captured by the assessment of other aspects of RFB group risk covered in this paragraph); and
• as appropriate, the amount by which the minimum capital or buffers applicable at the RFB sub-group level to cover any other risk exceed the RFB sub-group’s minimum capital or buffers applicable at the consolidated group level to cover the same risk. (This could include, for example, interest rate risk in the banking book, operational risk or the risk of the consolidated group being undercapitalised following the application of PRA rules on deduction of significant investments in financial sector entities at the level of the RFB sub-group.)^[24]

2.16E

Pension obligation risk: As set out in SS8/16, the PRA expects an RFB to ensure it has fully and appropriately considered group risk arising in respect of its pension arrangements when conducting its assessment of pension obligation risks at the level of the RFB sub-group. The PRA expects an RFB to consider all relevant factors when performing its assessment, including, but not limited to, its current share of consolidated group pension obligations, and its expected future share where it is making changes to its pension arrangements. An RFB’s assessment should not be limited to a simple allocation of a share of the consolidated group’s pension obligation risk. A full assessment may therefore result in a higher capital requirement than if the RFB were to apply a ‘share-of-group’ approach, particularly in the period prior to 1 January 2026. The PRA also expects to apply its existing policy, as set out in this supervisory statement, when assessing the pension obligation risk of a consolidated group containing an RFB. The PRA expects the assessment of RFB group risk at group level to be unaffected by the assessment of the pension obligation risk for the RFB sub-group given:

• the transitional nature of the risk; and
• assuming the sum of the amount of pension risks at the level of the RFB sub-group and group entities that are not members of the RFB sub-group is not expected to increase to a level above that of the consolidated group in the event that the RFB will have to assume the pension liabilities of group entities that are not members of the RFB sub-group.

2.16F

This exception only applies to the assessment of pension risk and should not be taken to mean that other risks with proportionately higher requirements should not be included in the assessment of RFB group risk.

2.16G

In respect of the obligation under Internal Capital Adequacy Assessment 13.1, the PRA expects that firms should provide in their ICAAP document sufficient supplementary evidence, to an auditable standard, to demonstrate clearly how the additional capital to cover RFB group risk is calculated. Specifically, firms should provide a breakdown of the total amount of the additional capital, identifying the amount of capital attributable to each part of the assessment referred to in paragraph 2.16D.

2.17

In meeting the general standard referred to in Internal Capital Adequacy Assessment 10.1, a firm that undertakes market-related activities should be able to demonstrate to the PRA:

• in the case of a firm calculating its capital requirements for operational risk using the Basic Indicator Approach or Standardised Approach, that it has considered; or
• in the case of a firm with an Advanced Measurement Approach (AMA) permission, that it has complied with, the Committee of European Banking Supervisor’s Guidelines on the management of operational risk in market-related activities published in October 2010.^[25]

2.18

In meeting the general standard referred to in Internal Capital Adequacy Assessment 10.1, a firm with an AMA approval should be able to demonstrate to the appropriate regulator that it has considered and complies with Section III of the EBA’s Guidelines on the AMA – Extensions and Changes, published in January 2012.^[26]

2.19

Business continuity plans are also a key component of operational risk management. Plans should include consideration of:

• resource requirements such as people, systems and other assets, and arrangements for obtaining these resources;
• the recovery priorities of the firm’s operations;
• communication arrangements for internal and external concerned parties (including the PRA, clients and the media);
• escalation and invocation plans that outline the processes for implementing the business continuity plans, together with relevant contact information;
• processes to validate the integrity of information affected by the disruption; and
• regular stress testing of the business continuity plan in an appropriate and proportionate manner.

2.20

In addition, the PRA does not expect that smaller firms will complete the operational risk data items but expects such firms to provide in their ICAAP document at least the following information (historical losses at an aggregate level are regularly available to the PRA via COREP 17):

1. (i) forecast operational risk losses, broken down between conduct and non-conduct losses and by future year; and
2. (ii) information on the operational risk scenarios they have considered in their ICAAP, covering a description of such scenarios and an assessment of their impact and likelihood.

2.21

The PRA’s framework for Pillar 2A pension obligation risk capital consists of two elements:

• the firm’s own assessment of the appropriate level of Pillar 2A pension obligation risk capital; and
• a set of stresses on the accounting basis which will be used by the PRA in assessing the adequacy of the firm’s own assessment of the level of capital required.

2.22

The firm’s own assessment and the stress tests on the accounting basis can be reduced by:

• offsets and management actions; and
• any pension scheme deficit deducted from Common Equity Tier 1 (CET1).

2.23

The PRA expects firms to carry out their own assessment of the appropriate level of Pillar 2A pension obligation risk capital in their ICAAP. Firms should use methodologies and assumptions that are consistent with their approach to risk management and are therefore not restricted to using the IAS 19 basis in carrying out this assessment.

2.24

In carrying out their assessment, firms should consider risks to the financial position of their pension schemes consistent with a stress event that has no more than a 1 in 200 probability of occurring in a one-year period.

2.25

For the purpose of firms’ own assessment of Pillar 2A pension obligation risk capital, the PRA expects firms to use stress testing and scenario analysis where appropriate to quantify the gross impact on the existing scheme surplus or deficit. The PRA does not necessarily favour a stochastic approach over a deterministic one. Firms should decide which approach is most appropriate.

2.26

As part of their ICAAP submission, firms are required to calculate and (if they have a defined benefit pension scheme) report the stressed accounting value of their pension scheme’s assets and liabilities using stress scenarios specified by the PRA in accordance with PRA Statement of Policy, ‘The PRA’s methodologies for setting Pillar 2 capital’ and Reporting Pillar 2, 2.6 as set out in the PRA Rulebook. This requirement is in addition to the firm’s own assessment referred to above, unless the data required in that data item have already been reported to the PRA by other means. In doing so firms are expected to:

• calculate the stressed value of assets and liabilities assuming all the elements of the stress apply instantaneously and simultaneously;
• decompose the IAS 19 discount rate into a risk-free element and a credit spread element. Firms should make use of their own methodology to do so but should provide a description of the approach taken in their ICAAP. The long-term interest rate stress should be applied to the risk-free element and the credit stress to the credit spread element in order to derive the stressed discount rate; and
• use their own methodology to decompose the yield on bonds into a risk-free element and a credit spread element and describe the approach taken in their ICAAP.

2.27

The PRA expects the valuation measure of liabilities to be the same as that used for International Financial Reporting Standards (IFRS) reporting. The PRA expects firms’ approaches to setting the valuation assumptions to be stable over time and any changes to the approach should be justified in the ICAAP document.

2.28

More information on the scenarios is available in PRA Statement of Policy, ‘The PRA’s methodologies for setting Pillar 2 capital’. The PRA scenarios are highly simplified by design and firms should decide which stresses to apply to individual asset and liability classes. The broadest possible interpretation should be used (eg a single stress is specified for equity prices); and this should be applied to all categories of investments that exhibit properties similar to listed equities, such as UK equities, overseas equities, unlisted equities, private equity and limited partnerships.

2.29

Where firms believe that the scenarios produce inappropriate levels of capital for their pension schemes, they should provide evidence of this together with a detailed explanation in their ICAAP document.

2.30

When considering management actions and offsets, firms must clearly demonstrate that offsets are valid and that management actions are realistic. They must also demonstrate that both offsets and management actions do not result in double counting and would be effective under stressed conditions.

2.31

Firms should ordinarily hold pension obligation risk capital against the total liability resulting from past or present employment:

1. (i) with the firm (including any legacy or overseas entities); and
2. (ii) outside the firm, pro-rated according to whether the pension fund principal beneficiaries’ service was performed for the benefit of the firm.

2.32

Firms should also consider whether they may be exposed to pension obligation risk greater than that captured by these general criteria, given the potential for The Pensions Regulator to impose a contribution notice or a financial support direction on any company associated with an employer.

2.33

When Pillar 2A pension obligation risk capital is calculated at group level, these expectations apply to the group as a whole. Accordingly, firms must allocate Pillar 2A pension obligation risk capital to entities within the group in a way that adequately reflects the nature, level and distribution of the risks to which the group is subject.

2.34

There are situations where liabilities related to a defined benefit pension fund may, as the sponsor firm’s financial condition deteriorates, increase substantially and unexpectedly above the stressed deficit which is covered under Pillar 2A.^[27]

2.35

Should such events materialise as a firm’s financial condition deteriorates, unexpected losses well in excess of Pillar 2A capital already set aside might crystallise prior to the point of resolution.

2.36

In order to address the risk of increased pension losses near the point of resolution, the PRA expects firms to articulate in their ICAAP document how they intend to deal with the defined benefit pension scheme under relevant firm-specific extreme scenarios, bearing in mind the potential for additional loss and describing available management actions. The analysis should be sufficient to demonstrate the institution’s awareness around this tail risk and the adequacy of its mitigating actions. The actions should be consistent with the firms’ recovery and resolution plans. Additionally, under Reporting Pillar 2 2.6 firms with defined benefit pension schemes must calculate and report to the PRA their defined benefit pension scheme deficit if a debt became due under section 75 of the Pensions Act 1995, unless the data required in that data item have already been reported to the PRA by other means.

2.37

Foreign currency lending is defined in the EBA Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP).^[28]

2.38

As part of its obligation under Internal Capital Adequacy Assessment 3.1 a firm that lends in foreign currency to unhedged retail and SME borrowers should determine whether it meets the thresholds of materiality in Title 6, Section 1 paragraph 117 of the EBA’s Guidelines on common procedures and methodologies for the SREP. Where a firm meets the threshold it should notify the PRA and reflect the risk in its ICAAP.

2.39

When a firm assesses risks associated with exposures to securitisation as part of its ICAAP, it should consider the following:

1. (i) the risk characteristics and structural features of a securitisation, including those of the underlying exposures, which could materially impact the performance of any positions in that securitisation held by the firm;
2. (ii) whether the application of another method, namely SEC-IRBA, SEC-ERBA or SEC-SA, insofar as that method may be used, would result in material differences in risk weights for a position relative to the method applied; and
3. (iii) the extent to which differences in risk-weights identified in (ii) may be caused by the risk characteristics and structural features identified in (i) as well as the approach taken by an External Credit Assessment Institution (ECAI) in rating a particular asset class.

2.40

A firm’s record under Internal Capital Adequacy Assessment 13.1 of its approach to evaluating and managing securitisation risk (or credit risk arising from securitisation exposures) should cover the following, as appropriate, taking into account SS9/13 ’Securitisations: Significant Risk Transfer’:

1. (i) the appropriateness of the credit risk weight calculated for the asset classes to which the firm is exposed via securitisation;
2. (ii) risk characteristics and structural features exhibited by securitisations to which the firm is exposed, that may materially impact the performance of the securitisation position, and are not explicitly taken into account by the method applied;
3. (iii) a breakdown of the firm’s aggregate securitisation exposure, split by asset class, risk characteristic or other feature as appropriate, with the following information:
   
   1. (a) for the aggregate exposure risk-weighted under the SEC-IRBA, risk-weighted exposure amounts split by asset class, risk characteristic or other feature as appropriate, which would be arrived at under the SEC-IRBA, SEC-ERBA (for rated positions only) and the SEC-SA insofar as each method may be used; and
   2. (b) for the aggregate exposure which is both risk-weighted under the SEC-SA and rated, risk-weighted exposure amounts which would be arrived at under the SEC-ERBA insofar as that method may be used.
4. (iv) The firms’ aggregate exposure and aggregate risk-weighted exposure amounts to unrated securitisation positions.

2.41

The PRA expects firms to understand the financial risks from climate change and how they will affect their business model. Firms should use scenario analysis and stress testing to inform the risk identification process and to understand the short- and long-term financial risks to their business model from climate change.

2.42

Refer to SS3/19, ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change’^[29] for the PRA’s expectations for ICAAPs in relation to financial risks from climate change.

2.43

The PRA expects firms to carry out an assessment of the risk of excessive leverage. This is defined as the risk resulting from a firm’s vulnerability to leverage or contingent leverage that may require unintended corrective measures to its business plan, including distressed selling of assets which might result in losses or in valuation adjustments to its remaining assets.

2.44

In carrying out their assessment, firms should consider any contingent leverage risk in transactions and trade structures that receive lower leverage ratio exposure measure values than other economically similar transactions. Contingent leverage risk arises when a firm can no longer rely on these capital-efficient trades, for example in a stress. The PRA considers that trade structures that may be a source of contingent leverage risk include:

• agency repurchase agreements (repos)^[30] and other agency models to transact in security financing transactions (SFTs) or derivatives, SFT and repo netting packages, collateral swaps, and unsecured borrowing or lending of securities; and
• internalised positions^[31] (including written credit derivatives and prime brokerage business).

2.45

Further, firms should also consider any additional trade structures that have a lower leverage ratio exposure value than economically similar trades that firms judge may give rise to material contingent leverage risk.

2.46

The extent to which firms can use these more capital efficient forms of trades may be limited in certain conditions, such as in the event of the default of counterparties, the movement of certain market parameters, or changes to broader market conditions. For example:

• Netting: client withdrawal from one leg of a transaction that is netted, or one-directional markets in stress, could lead to a lack of availability of netting opportunities for firms’ financing activities. This may result in loss of netting and an increase in firms’ total exposure measure for the purposes of the leverage ratio.
• Internalisation: a client may withdraw or default from one leg of a synthetic prime brokerage transaction that is internally offset for hedging purposes. If the firm cannot replace the offsetting synthetic leg, the firm may use a cash hedge for the remaining leg of the transaction, increasing its total leverage exposure. In the case of written credit derivatives (in line with ‘Article 429d’ of the Leverage Ratio (CRR) Part of the PRA Rulebook), the loss of an offsetting leg may result in the loss of conditions that allow the firm to internalise the effective notional amount of the credit derivative, and increase a firm’s total exposure.
• Collateral swaps: some lower-quality forms of collateral may become less available in certain market conditions, and firms may have to replace the affected collateral swaps with other forms of financing.

2.47

Firms should consider the extent to which they would need, and be able, to continue to participate in these trades and the extent to which they would instead need to use economically similar transactions or structures that receive higher leverage ratio exposure measure values. Firms should consider the impact this might have on their leverage ratio and other regulatory measures (such as liquidity or risk-weighted metrics) as relevant.

2.48

Firms may have to continue exposure^[32] to transactions or trade structures that receive higher leverage ratio exposure measure values for a variety of reasons, including contractual obligations, franchise considerations, liquidity management, or other commercial reasons. To the extent that firms would not continue to participate in such trades in certain circumstances, firms should consider what implications this might have for their revenues. Examples of risks and assumptions that firms should pay particular consideration to include, but are not limited to:

• Contractual obligations: firms may be contractually obliged to maintain transactions with certain counterparties, even in circumstances where doing so might be detrimental to the firm’s leverage ratio position.
• Franchise risk: firms, especially prime brokers, often offer their services to maintain a franchise value with their clients in addition to the revenues generated directly by the business activity. As such, a firm may roll over funding transactions at a client’s request even in circumstances where doing so might be detrimental to the firm’s leverage ratio position.^[33]
• Liquidity management: firms should consider the extent to which they may be able to maintain their funding without having to replace their transactions or trade structures with others that receive higher leverage ratio exposure measure values, such as secured borrowing. 

2.49

As part of their ICAAP responses, firms should set out their assessment of contingent leverage risks by each individual trade structure identified in paragraph 2.44 and 2.45 that firms judge may be a material source of contingent leverage risk.

2.50

Factors which firms should consider in assessing the materiality of contingent leverage risk for each trade structure identified in paragraph 2.44 and 2.45 include, for example:

• the extent to which the firm engages in the relevant trade, especially where the trades are subject to contractual obligations, franchise risk, or liquidity management considerations as set out in paragraph 2.48; and
• the size of the impact on the firm’s leverage ratio should the firm lose the capital optimisation benefits from the trade and have to replace it with trades that receive higher leverage ratio exposure measure values.