Internal Capital Adequacy Assessment

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2

Adequacy of Financial Resources

Overall financial adequacy rule

2.1

A firm must at all times maintain overall financial resources, including own funds and liquidity resources, which are adequate both as to amount and quality, to ensure there is no significant risk that its liabilities cannot be met as they fall due.

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3

Strategies, Processes and Systems

Overall Pillar 2 rule

3.1

A firm must have in place sound, effective and comprehensive strategies, processes and systems:
  1. (1) to assess and maintain on an ongoing basis the amounts, types and distribution of financial resources, own funds and internal capital that it considers adequate to cover:
    1. (a) the nature and level of the risks to which it is or might be exposed;
    2. (b) the risk in the overall financial adequacy rule in 2.1; and
    3. (c) the risk that the firm might not be able to meet the obligations in Part Three of the CRR in the future;
  2. (2) that enable it to identify and manage the major sources of risk referred to in (1) including the major sources of risk in each of the following categories where they are relevant to the firm given the nature and scale of its business:
    1. (a) credit and counterparty risk;
    2. (b) market risk;
    3. (c) liquidity risk;
    4. (d) operational risk;
    5. (e) concentration risk;
    6. (f) residual risk;
    7. (g) securitisation risk, including the risk that the own funds held by a firm in respect of assets which it has securitised are inadequate having regard to the economic substance of the transaction including the degree of risk transfer achieved;
    8. (h) business risk;
    9. (i) interest rate risk in the non-trading book;
    10. (j) risk of excessive leverage;
    11. (k) pension obligation risk; and
    12. (l) group risk.
  3. (3) to ensure that the firm's own funds can absorb potential losses resulting from stress scenarios, including those identified under the supervisory stress test.

[Note: Art 73 (part) and Art 104b (part) of the CRD]

3.2

As part of its obligations under the overall Pillar 2 rule in 3.1, a firm must identify separately the amount of common equity tier one capital, additional tier one capital and tier two capital and each category of capital (if any) that is not eligible to form part of its own funds which it considers adequate for the purposes described in the overall Pillar 2 rule.

3.3

The processes, strategies and systems required by the overall Pillar 2 rule in 3.1 must be comprehensive and proportionate to the nature, scale and complexity of the firm’s activities.

3.4

A firm must:

  1. (1) carry out regularly the assessments required by the overall Pillar 2 rule in 3.1; and
  2. (2) carry out regularly assessments of the processes, strategies and systems required by the overall Pillar 2 rule in 3.1 to ensure they remain comprehensive and proportionate to the nature, scale and complexity of the firm’s activities.

[Note: Art 73 (part) of the CRD]

3.5

As part of its obligations under the overall Pillar 2 rule in 3.1, a firm must:
  1. (1) make an assessment of the firm-wide impact of the risks identified in accordance with that rule, to which end a firm must aggregate the risks across its various business lines and units, taking appropriate account of any correlation between risks; and
  2. (2) take into account the stress tests that the firm is required to carry out under the general stress test and scenario analysis rule in 12.1 and any stress tests that the firm is required to carry out under the CRR.

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4

Credit and Counterparty Risk

4.1

A firm must base credit-granting on sound and well-defined criteria and clearly establish the process for approving, amending, renewing and re-financing credits.

[Note: Art 79(a) of the CRD]

4.2

A firm must have internal methodologies that:
  1. (1) enable it to assess the credit risk of exposures to individual obligors, securities or securitisation positions and credit risk at the portfolio level;
  2. (2) do not rely solely or mechanistically on external credit ratings; and
  3. (3) where its own funds requirements under Part Three of the CRR are based on a rating by an ECAI or based on the fact that an exposure is unrated, enable the firm to consider other relevant information for assessing its allocation of financial resources and internal capital.

[Note: Art 79(b) of the CRD]

4.3

A firm must operate through effective systems the ongoing administration and monitoring of its various credit risk-bearing portfolios and exposures, including for identifying and managing problem credits and for making adequate value adjustments and provisions.

[Note: Art 79(c) of the CRD]

4.4

A firm must adequately diversify credit portfolios given its target markets and overall credit strategy.

[Note Art 79(d) of the CRD]

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5

Residual Risk

5.1

A firm must address and control, by means which include written policies and procedures, the risk that recognised credit risk mitigation techniques used by it prove less effective than expected.

[Note: Art 80 of the CRD]

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6

Concentration Risk

6.1

A firm must address and control, by means which include written policies and procedures, the concentration risk arising from:

  1. (1) exposures to each counterparty including central counterparties, groups of connected counterparties and counterparties in the same economic sector, geographic region or from the same activity or commodity;
  2. (2) the application of credit risk mitigation techniques; and
  3. (3) risks associated with large indirect credit exposures such as a single collateral issuer.

[Note: Art 81 of CRD]

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7

Securitisation Risk

7.1

A firm must evaluate and address through appropriate policies and procedures the risks arising from securitisation transactions in relation to which the firm is investor, originator or sponsor, including reputational risks, to ensure in particular that the economic substance of the transaction is fully reflected in risk assessment and management decisions.

[Note: Art 82(1) of CRD]

7.2

A firm which is an originator of a revolving securitisation transaction involving early amortisation provisions must have liquidity plans to address the implications of both scheduled and early amortisation.

[Note Art 82(2) of the CRD]

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8

Market Risk

8.1

A firm must implement policies and processes for the identification, measurement and management of all material sources and effects of market risks.

[Note: Art 83(1) of the CRD]

8.2

A firm must take measures against the risk of a shortage of liquidity if the short position falls due before the long position.

[Note: Art 83(2) of the CRD]

8.3

A firm’s financial resources and internal capital must be adequate for material market risks that are not subject to an own funds requirement.

8.4

A firm which has, in calculating own funds requirements for position risk in accordance with Part Three, Title IV, Chapter 2 of the CRR, netted off its positions in one or more of the equities constituting a stock-index against one or more positions in the stock-index future or other stock-index product, must have adequate financial resources and internal capital to cover the basis risk of loss caused by the future's or other product's value not moving fully in line with that of its constituent equities.

8.4A

A firm must have adequate internal capital where it holds opposite positions in stock-index futures which are not identical in respect of either their maturity or their composition or both.

8.5

A firm using the treatment in Article 345 of the CRR must ensure that it holds sufficient financial resources and internal capital against the risk of loss which exists between the time of the initial commitment and the following working day.

[Note: Art 83(3) of the CRD]

8.6

As part of its obligations under the overall Pillar 2 rule in 3.1, a firm must consider whether the value adjustments and provisions taken for positions and portfolios in the trading book enable the firm to sell or hedge out its positions within a short period without incurring material losses under normal market conditions.

[Note: Art 98(4) of the CRD]

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9

Interest Risk Arising from Non-Trading Book Activities

General requirements

9.1

A firm must implement systems to identify, evaluate and manage the risk arising from potential changes in interest rates that affect a firm’s non-trading activities including the risks of such changes impacting either or both of the following:

  1. (1) the economic value of the firm's non-trading activities;
  2. (2) the earnings in respect of the firm's non-trading activities.

[Note: Art 84 of the CRD]

9.1A

A firm must in addition implement systems to monitor and assess credit spread risk in respect of its non-trading activities.

9.1B

As an alternative to implementing internal systems under 9.1(1), and only where appropriate to its nature, size and complexity as well as business activities and overall risk profile, a firm may elect to implement the standardised framework set out in 9.13 to 9.43 to identify, evaluate and manage the risk arising from potential changes in interest rates that affect the economic value of the firm’s non-trading activities.

9.1C

A firm shall notify the PRA prior to any implementation of the standardised framework pursuant to 9.1B or, if it elects to cease implementing the standardised framework, prior to doing so.

9.2

As part of its obligations under the overall Pillar 2 rule in 3.1, a firm must carry out an evaluation of its exposure to the interest rate risk arising from its non-trading activities, including an evaluation of its exposure to risk arising from potential changes in interest rates that affect either or both of the following:
  1. (1) the economic value of the firm's non-trading activities;
  2. (2) the earnings in respect of the firm's non-trading activities.

9.3

[Deleted.]

9.4

[Deleted.]

9.4A

A firm must regularly carry out an evaluation in respect of the interest rate shock scenarios in 9.7 and immediately notify the PRA if any evaluation under this rule indicates that, as a result of the application of the interest rate scenarios in 9.7, the EVE would decline by more than 15% of the sum of its common equity tier one capital and its additional tier one capital.

9.5

A firm must carry out the evaluation under 9.2 as frequently as necessary for it to be reasonably satisfied that it has at all times a sufficient understanding of the degree to which it is exposed to the risks referred to in 9.2 and the nature of that exposure. In any case it must carry out those evaluations no less frequently than once a year.

[Note: Art 98(5) of the CRD]

9.6

A firm’s management body must oversee and approve the firm’s risk appetite and risk management framework for managing interest rate risk from non-trading book activities.

Interest rate shock scenarios

9.7

For the purposes of the evaluation in 9.4A, a firm must apply the following prescribed interest rate scenarios to all material currencies as determined in 9.8:

scenario 0: current interest rates;

scenario 1: parallel shock up;

scenario 2: parallel shock down;

scenario 3: steepener shock (short rates down and long rates up);

scenario 4: flattener shock (short rates up and long rates down);

scenario 5: short rates shock up; and

scenario 6: short rates shock down.

9.8

For the purposes of 9.7 and 9.15, a firm shall determine which currencies are material currencies using the following tests:

  1. (1) each currency that has non-trading book assets in that currency more than 5% of total non-trading book assets shall be a material currency;
  2. (2) where the sum of non-trading book assets in material currencies as identified under (1) does not exceed 90% of total non-trading book assets, a firm must select additional currencies to be deemed material currencies such that the sum of non-trading book assets in material currencies as identified under (1) and (2) is at least 90% of total nontrading book assets;
  3. (3) each currency that has non-trading book liabilities in that currency more than 5% of total non-trading book liabilities shall be a material currency; and
  4. (4) where the sum of non-trading book liabilities in material currencies as identified under (3) does not exceed 90% of total non-trading book liabilities, a firm must select additional currencies to be deemed material currencies such that the sum of nontrading book liabilities in material currencies as identified under (3) and (4) is at least 90% of total non-trading book liabilities.

9.9

For the interest rate scenarios specified in 9.7, a firm shall determine the change to interest rates in accordance with the following formulae:

for scenario 0: ΔRc(tk) = 0
for scenario 1: ΔRc(tk) = +
for scenario 2: ΔRc(tk) = —
for scenario 3: ΔRc(tk) = —0.65 . |ΔRshort,c(tk)| + 0.9 . |ΔRlong,c(tk)|
for scenario 4: ΔRc(tk) = +0.8 . |ΔRshort,c(tk)| — 0.6 . |ΔRlong,c(tk)|
for scenario 5: ΔRc(tk) = +ΔRshort,c(tk)
for scenario 6: ΔRc(tk) = —ΔRshort,c(tk)


Where:

c = the index that denotes currency;

k = the index that denotes the buckets in accordance with Table 2 in 9.17 below;

tk = the bucket midpoint of bucket k, measured in years;

ΔRc(tk) = the change in interest rate at the point tk for currency c;

= the prescribed parallel interest rate shock for currency c determined in accordance with column two of Table 1 in 9.11;

ΔRshort,c(tk) = the change in short interest rate at the point tk for currency c determined in accordance with the formulae in 9.10; and

ΔRlong,c(tk) = the change in long interest rate at the point tk for currency c determined in accordance with the formulae in 9.10.

9.10

For the purposes of 9.9, a firm shall determine the value of ΔRshort(tk) and ΔRlong(tk) in accordance with the following formulae:

  1. (1) for ΔRshort,c(tk): ΔRshort,c(tk) = +Rshort,c_ . e
  2. (2) for ΔRlong,c(tk): ΔRlong,c(tk) = +Rlong,c . (1 – e )
  3. Where:
    1. c = the index that denotes currency;
    2. k = the index that denotes the buckets in accordance with Table 2 in 9.17 below;
    3. e = the mathematical constant that is the base of the natural logarithm;
    4. x = 4;
    5. tk = the bucket midpoint of bucket k, measured in years;
    6. ΔRshort,c(tk) = the change in short interest rate at the point tk for currency c;
    7. ΔRlong,c(tk) = the change in long interest rate at the point tk for currency c;
    8. = the prescribed short interest rate shock for currency c determined in accordance with column three of Table 1 in 9.11; and
    9. = the prescribed long interest rate shock for currency c determined in accordance with column four of Table 1 in 9.11.

9.11

For the purposes of 9.9, the interest rate shock scenarios for individual currencies are those in Table 1 below:

Table 1. Specified size of interest rate shocks for each currency (bps)

Currency Parallel Short Long
ARS 400 500 300
AUD 300 450 200
BRL 400 500 300
CAD 200 300 150
CHF 100 150 100
CNY 250 300 150
EUR 200 250 100
GBP 250 300 150
HKD 200 250 100
IDR 400 500 350
INR 400 500 300
JPY 100 100 100
KRW 300 400 200
MXN 400 500 300
RUB 400 500 300
SAR 200 300 150
SEK 200 300 150
SGD 150 200 100
TRY 400 500 300
USD 200 300 150
ZAR 400 500 300

9.12

For material positions in currencies not listed in 9.11, a firm must use appropriate shocks for the scenarios listed in 9.7.

Standardised Framework

Calculating Loss in Economic Value

9.13

Using the standardised framework, a firm shall carry out the evaluation in 9.1(1) by calculating the loss in EVE (EV Eloss) in accordance with the following formula:

Where:

i = the index that denotes the interest rate shock scenarios in accordance with 9.15;

c = the index that denotes the material currencies in accordance with 9.15; and

ΔEV Ei,c = the change in economic value in currency c for interest rate scenario i as calculated in accordance with 9.14.

9.14

For the purposes of 9.13, a firm must calculate the change in economic value in a given currency for a given interest rate scenario in accordance with the following formula:

ΔEV Ei,c = NA0i,c + KA0i,c

Where:

i = the index that denotes the interest rate shock scenarios in accordance with 9.15;

c = the index that denotes the material currencies in accordance with 9.15;

ΔEV Ei,c = the change in economic value in currency c for interest rate scenario i;

NA0i,c = the non-automatic option risk in currency c for interest rate scenario i as calculated in accordance with 9.16; and

KA0i,c = the automatic option risk in currency c for interest rate scenario i as calculated in accordance with 9.41.

9.15

For the purposes of 9.13 and 9.14, a firm must calculate the change in economic value in a given currency for a given interest rate scenario, ΔEV Ei,c, for every possible pair of:

  1. (1) interest rate scenarios, i in 9.7; and
  2. (2) each material currency, c as determined in 9.8.

9.16

For the purposes of 9.14, a firm must calculate the non-automatic option risk in currency c for interest rate scenario i (NA0i,c) in accordance with the following formula:

Where:

i = the index that denotes the interest rate shock scenarios in accordance with 9.15;

c = the index that denotes the material currencies in accordance with 9.15;

k = the index that denotes the buckets in accordance with Table 2 in 9.17;

DFi,c(tk) (respectively DF0,c(tk)) = the discount factor for bucket k in currency c for interest rate scenario i (respectively for interest rate scenario 0), calculated in accordance with 9.18; and

CFi,c(k) (respectively CF0,c(k)) = the net repricing cash flow for bucket k in currency c for interest rate scenario i (respectively for interest rate scenario 0), calculated in accordance with 9.19 to 9.40.

9.17

For the calculation of discount factors and notional repricing cash flows in 9.18 and 9.19, a firm must project all notional repricing cashflows on to the following bucket intervals or bucket midpoints:

Table 2

Time bucket intervals and mid points (M = months, Y = years)
Bucket number (k) Bucket interval Bucket midpoint
Short-term rates 1 Overnight 0.0028Y
2 > Overnight and <= 1M 0.0147Y
3 > 1M and <= 3M 0.1667Y
4 > 3M and <= 6M 0.375Y
5 > 6M and <= 9M 0.625Y
6 > 9M and <= 1Y 0.875Y
7 > 1Y and <= 1.5Y 1.25Y
8 > 1.5Y and <= 2 Y 1.75Y


Medium-term rates 		9 >2 Y and <= 3Y 2.5Y
10 > 3Y and <= 4Y 3.5Y
11 > 4Y and <= 5Y 4.5Y
12 > 5Y and <= 6Y 5.5Y
13 > 6Y and <= 7Y 6.5Y



Long-term rates


14 > 7Y and <= 8Y 7.5Y
15 > 8Y and <= 9Y 8.5Y
16 >9 Y and <= 10Y 9.5Y
17 > 10Y and <= 15Y 12.5Y
18 > 15Y and <= 20Y 17.5Y
19 20Y 25Y


9.18

  1. (1) For the purposes of 9.16, a firm must calculate the discount factor for bucket k in currency c for interest rate scenario i (DFi,c(tk)) in accordance with the following formula:
    1. Where:
    2. i = the index that denotes the interest rate shock scenarios in accordance with 9.15;
    3. c = the index that denotes the material currencies in accordance with 9.15;
    4. k = the index that denotes the buckets in accordance with Table 2 in 9.17;
    5. e = the mathematical constant that is the base of the natural logarithm;
    6. tk = the bucket midpoint of bucket k in accordance with Table 2 in 9.17; and
    7. Ri,c(tk)= subject to (2), the risk-free zero coupon rate at bucket midpoint tk in currency c for interest rate scenario i, including any commercial margin and other spread components.
  3. (2) A firm may elect to use the risk-free zero coupon rate Ri,c(tk) excluding commercial margin and other spread components, provided the firm either (i) implements a prudent and transparent methodology for deducting commercial margins and other spread components from the initial repricing cash flows CFα in 9.26 or (ii) determines that the effect of deducting commercial margins and other spread components is not material.

9.19

In accordance with 9.21, 9.22, 9.23 and 9.24, a firm must assign each interest rate risk position arising from non-trading activities to one of the following categories:

category 1: automatic interest rate options;
category 2: non-maturing deposits;
category 3: fixed rate loans with retail borrowers that are subject to prepayment risk;
category 4: term deposits by retail depositors subject to early redemption risk; and
category 5: other positions.

9.20

A firm must perform the allocation in 9.19 for all interest rate-sensitive non-trading book:

  1. (1) assets, excluding assets that are:
    1. (a) deducted from common equity tier one capital;
    2. (b) fixed assets, including real estate and intangible assets; or
    3. (c) equity exposures in the non-trading book;
  2. (2) liabilities, including all non-remunerated deposits and excluding common equity tier one capital; and
  3. (3) off-balance sheet items.

9.21

Under 9.19, term deposits that satisfy either of the following conditions may be treated as other positions in 9.19:

  1. (1) the depositor has no legal right to withdraw the deposit; or
  2. (2) an early withdrawal results in a significant penalty that at least compensates for the loss of interest between the date of withdrawal and the contractual maturity date and the economic cost of breaking the contract.

9.22

For the purposes of 9.19, and subject to 9.23, a firm must bifurcate any position with an embedded automatic interest rate option into two positions:

  1. (1) a position excluding the embedded automatic interest rate option, which must be allocated to the other positions category in 9.19; and
  2. (2) the embedded automatic interest rate option, which must be allocated to the category of automatic interest rate options in 9.19.

9.23

Where a firm is able to demonstrate that the embedded optionality is not material, the firm may choose not to perform the bifurcation in 9.22 and may directly allocate the position to the other positions category in 9.19.

9.24

For the purposes of 9.19, automatic interest rate options include:

  1. (1) term deposits by wholesale depositors that do not meet the conditions in 9.21;
  2. (2) wholesale fixed rate loans subject to prepayment risk; and
  3. (3) mortgage loans with embedded caps and/or floors.

9.25

For each position allocated to the categories 2 to 5 in 9.19, a firm must determine a set of initial repricing cash flows, CFα, per currency, in accordance with 9.26 and 9.27.

9.26

For each position, a firm must determine a set of initial repricing cash flows CFα as:

  1. (1) any repayment of principal;
  2. (2) any repricing of principal; and
  3. (3) any interest payment on a tranche of principal that has not yet been repaid or repriced.

9.27

A firm must determine the set of initial repricing cash flows CFα for floating rate positions as:

  1. (1) a series of coupon payments until the next repricing; and
  2. (2) a par notional cash flow at the point of the next repricing.

9.28

In accordance with 9.32 to 9.40 for each material currency c identified in accordance with 9.15 and for interest rate scenario i, a firm must allocate each notional repricing cash flow CFi,c to one of the buckets in Table 2 in 9.17 based on the repricing date, where repricing date means the date of each repayment, repricing or interest payment.

9.29

A firm may first choose to split an initial repricing cash flow determined in 9.25, CFα , into two cash flows with tenors equal to the two bucket mid-point tenors in column 4 of Table 2 in 9.17 that are adjacent to the tenor of the initial repricing cash flow CFα.

9.30

Where a firm chooses to apply the methodology in 9.29, that firm must:

  1. (1) split each initial repricing cash flow determined in 9.25, CFα such that:
    1. (a) the sum of the resulting two cash flows is equal to the initial repricing cash flow, CFα; and
    2. (b) the weighted average maturity of the resulting two cash flows equals the initial repricing cash flows’ maturity; and
  2. (2) document the methodology that the firm implements to split cash flows.

9.31

For 9.16, the net repricing cash flow for bucket k in currency c for interest rate scenario i, (CFi,c(k)) shall be determined as the sum of CFi,c as determined in 9.28 which:

  1. (1) are derived from initial repricing cash flows CFα that are allocated to currency c for interest rate scenario i in accordance with 9.28; and
  2. (2) allocated to bucket k in accordance with Table 2 in 9.17.

Non-maturing deposits

9.32

For non-maturing deposits as determined in 9.19, a firm must allocate each position into one of the following categories:

  1. (1) retail deposits defined as deposits placed with a firm by a natural person and where either regular transactions are carried out or the deposits are non-interest bearing;
  2. (2) any other deposits with a firm by a natural person which are not covered in (1); or
  3. (3) other deposits.

9.33

For the purposes of 9.32(1) deposits made by small businesses, legal entities, sole proprietorships or partnerships managed as retail exposures provided the total aggregated liabilities are less than £877,000 may also be treated as retail deposits.

9.34

For each category in 9.32, a firm must allocate each position to the following categories:

  1. (1) the core portion, consisting of deposits that are found to remain undrawn with a high degree of likelihood using data history of an appropriate length, and unlikely to reprice even under significant changes in the interest rate environment; and
  2. (2) the non-core portion, consisting of deposits not allocated to the core portion.

9.35

For non-maturing deposits as determined in 9.34, the notional repricing cash flows in currency c for each interest rate scenario i, CFi,c, must be:

  1. (1) for the core portion, the initial notional repricing cash flows in currency c for interest rate scenario i with the firm’s own estimates of tenors; and
  2. (2) for the non-core portion, the initial notional repricing cash flows in currency c for interest rate scenario i with an overnight tenor.

9.36

For the allocation in 9.34 and the calculation of CFi in 9.35, a firm must ensure that the proportion and average repricing date of core deposits is no greater than the caps in Table 3:

Table 3: Caps on core deposits

Cap on proportion of core deposits (%) Cap on average repricing date of core deposits (years)
Transactional retail deposits (as referred to in 9.32(1)) 90 5
Other retail deposits (as referred to in 9.32(2)) 70 4.5
Other deposits (as referred to in 9.32(3)) 50 4

Fixed Rate Loans

9.37

For fixed rate loans with borrowers that are subject to prepayment risk as determined in 9.19, a firm must:

  1. (1) allocate each position to a single portfolio of homogeneous positions p denominated in a single currency c;
  2. (2) for each portfolio of homogeneous positions, determine and notify the PRA a baseline monthly conditional prepayment rate () in currency c under the current term structure of interest rates;
  3. (3) for each portfolio of homogeneous positions, determine the conditional prepayment rate in currency c for interest rate scenario i, (CPRi,c) in accordance with the following formula:

  1. where γi refers to the prescribed scalar multiplier for each interest rate shock scenarios given in Table 4 below.

Table 4

Scenario number i Interest rate shock scenarios γi (scenario multiplier)
0 Current interest rates 1
1 Parallel up 0.8
2 Parallel down 1.2
3 Steepener 0.8
4 Flattener 1.2
5 Short rate up 0.8
6 Short rate down 1.2
  1. (4) for each portfolio of homogeneous positions, determine the notional repricing cash flows CFi,c allocated to bucket 1 in accordance with Table 2 in 9.17, CFi,c(1), in accordance with the following formula:

  1. Where:
    1. (1) = the initial repricing cash flows CFα for interest rate scenario i with tenor that corresponds to bucket 1 in accordance with Table 2 in 9.17; and
    2. Ni(0)= the notional currently outstanding before any repayments.

  1. (5) for each portfolio of homogeneous positions, determine the notional repricing cash flows CFi,c allocated to each bucket k in Table 2 where k > 1, CFi,c(k), in accordance with the following recursive formula:

    1. Where:
    2. k = the index that denotes the buckets in accordance with Table 2 in 9.17;
    3. W(k) = the width of bucket k measured in months and capped at 1200;
    4. = the initial repricing cash flows CFα in currency c for interest rate scenario i with tenor that corresponds to bucket k;
    5. N(k – 1) = the notional outstanding after notional repricing cash flows in bucket k− 1 have transpired; and
    6. = the sum of CFi determined for preceding buckets 1 to k − 1 .

9.38

For the purpose of 9.37, firms may adjust the formulas in 9.37 (4) and (5) to reflect a base monthly conditional prepayment rate that varies over the life of each loan in the portfolio. In that case, it is denoted as for each time bucket k or time bucket midpoint tk in accordance with Table 2 in 9.17.

Term Deposits Subject to Early Redemption Risk

9.39

For term deposits by depositors subject to early redemption risk as determined in 9.19, a firm must:

  1. (1) allocate each position to a single portfolio of homogeneous positions p denominated in each material currency c;
  2. (2) for each portfolio of homogeneous positions, determine and notify the PRA a baseline term deposit redemption ratio in currency c under the current term structure of interest rates;
  3. (3) for each portfolio of homogeneous loans, determine the conditional term deposit redemption ratio in currency c for interest rate scenario i, in accordance with the following formula:

  1. where ui refers to the prescribed scalar multiplier for each interest rate shock scenarios given in Table 5 below.

Table 5.

Scenario number (i) Interest rate shock scenarios ui (scenario multiplier
0 Current interest rates 1
1 Parallel up 1.2
2 Parallel down 0.8
3 Steepener 0.8
4 Flattener 1.2
5 Short rate up 1.2
6 Short rate down 0.8
  1. (4) for each portfolio of homogeneous positions, determine the notional repricing cash flows CFi,c allocated to bucket 1 in Table 2 in 9.17, CFi,c(1), in accordance with the following formula:
  4. Where:
    1. = the initial repricing cash flows in currency c for interest rate scenario i with tenor that corresponds to bucket 1 in accordance with Table 2 in 9.17; and
    2. TDc = the total term deposits subject to early redemption for currency c.
  6. (5) for each portfolio of homogeneous positions, determine the notional repricing cash flows CFi allocated to bucket k in Table 2 other than bucket CFi(k), in accordance with the following formula:

  1. Where:
    1. k = the index that denotes the buckets in accordance with Table 2 in 9.17; and
    2. = the initial repricing cash flows in currency c for interest rate scenario i with tenor that corresponds to bucket k.

Other positions

9.40

For other positions as determined in 9.19, a firm must determine the notional repricing cash flows CFi,c allocated to bucket k in Table 2 other than bucket 1, CFi(k), in accordance with the following formula:

Where:

k = the index that denotes the buckets in accordance with Table 2 in 9.17; and

= the initial repricing cash flows in currency c for interest rate scenario i with tenor that corresponds to bucket k.

Automatic interest rate options

9.41

For 9.14, and subject to 9.42, a firm must determine the automatic option risk in currency c for interest rate scenario i (KA0i,c) for all automatic interest rate options as determined in 9.19 and 9.22 in accordance with the following formula:

Where:

nc = the index that denotes the number of all sold automatic options in currency c;

mc = the index that denotes the number of all bought automatic options in currency c;

= the change in value of sold automatic option p for interest rate scenario i, calculated in accordance with 9.43; and

= the change in value of bought automatic option q for interest rate scenario i, calculated in accordance with 9.43.

9.42

A firm may choose to include in the calculation of only bought automatic options that are used for hedging sold automatic interest rate options, provided that the firm must add to KA0i,c in 9.41 the value of bought automatic options that are not for hedging sold automatic interest rate options that is included in the firm’s own funds.

9.43

  1. (1) For 9.41, a firm must calculate the change in value of sold automatic option p (respectively bought automatic option q) for interest rate scenario i other than interest rate scenario (respectively ), as the increase in value of the option to the option holder:
    1. (a) from the value of the option for interest rate scenario 0; and
    2. (b) to the value of the option for interest rate shock scenario i with a relative increase in implied volatility of 25%.
  2. (2) For 9.41, a firm must set the change in value of sold automatic option p (respectively bought automatic option q) for interest rate scenario (respectively), as 0.
  3. (3) A firm must notify the PRA of the methodology used to estimate the value of automatic options in (1).

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10

Operational Risk

10.1

A firm must implement policies and processes to evaluate and manage the exposure to operational risk, including model risk and risks resulting from outsourcing and to cover low-frequency high severity events. Without prejudice to the definition of operational risk, a firm must articulate what constitutes operational risk for the purposes of those policies and procedures.

[Note: Art 85(1) of the CRD]

10.2

A firm must have in place adequate contingency and business continuity plans aimed at ensuring that in the case of a severe business disruption the firm is able to operate on an ongoing basis and that any losses are limited.

[Note: Art 85(2) of the CRD]

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11

Risk of Excessive Leverage

11.1

A firm must have in place policies and procedures for the identification, management and monitoring of the risk of excessive leverage.

11.2

Those policies and procedures must include, as an indicator for the risk of excessive leverage, the leverage ratio determined in accordance with Article 429 of the CRR and mismatches between assets and obligations.

[Note: Art 87(1) of the CRD]

11.3

A firm must address the risk of excessive leverage in a precautionary manner by taking due account of potential increases in that risk caused by reductions of the firm's own funds through expected or realised losses, depending on the applicable accounting rules. To that end, a firm must be able to withstand a range of different stress events with respect to the risk of excessive leverage.

[Note: Art 87(2) of the CRD]

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12

Stress Tests and Scenario Analysis

General stress test and scenario analysis rule

12.1

As part of its obligation under the overall Pillar 2 rule in 3.1, a firm must, for the major sources of risk identified in accordance with that rule, carry out stress tests and scenario analyses that are appropriate to the nature, scale and complexity of those major sources of risk and to the nature, scale and complexity of the firm's business.

12.2

In carrying out the stress tests and scenario analyses in 12.1, a firm must identify an appropriate range of adverse circumstances of varying nature, severity and duration relevant to its business and risk profile and consider the exposure of the firm to those circumstances, including:
  1. (a) circumstances and events occurring over a protracted period of time;
  2. (b) sudden and severe events, such as market shocks or other similar events; and
  3. (c) some combination of the circumstances and events described in (a) and (b), which may include a sudden and severe market event followed by an economic recession.

12.3

In carrying out the stress tests and scenario analyses in 12.1, the firm must estimate the financial resources that it would need in order to continue to meet the overall financial adequacy rule in 2.1 and the obligations laid down in Part Three of the CRR under the adverse circumstances being considered.

12.4

In carrying out the stress tests and scenario analyses in 12.1, the firm must assess how risks aggregate across business lines or units, any material non-linear or contingent risks and how risk correlations may increase in stressed conditions.

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13

Documentation of Risk Assessments

13.1

A firm must make a written record of the assessments required under this Part. These assessments must include assessments carried out on a consolidated basis and on an individual basis. In particular it must make a written record of:
  1. (a) the major sources of risk identified in accordance with the overall Pillar 2 rule in 3.1;
  2. (b) how it intends to deal with those risks; and
  3. (c) details of the stress tests and scenario analyses carried out, including any assumptions made in relation to scenario design, and the resulting financial resources estimated to be required in accordance with the general stress test and scenario analysis rule in 12.1.

13.2

A firm must maintain the records referred to in 13.1 for at least three years.

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14

Application of this Part on an Individual Basis, a Consolidated Basis and a Sub-Consolidated Basis

The ICAAP rules

14.1

A firm that is neither a subsidiary of a parent undertaking incorporated in or formed under the law of any part of the UK nor a parent undertaking must comply with the ICAAP rules on an individual basis.

14.2

A firm that is not a member of a consolidation group must comply with the ICAAP rules on an individual basis.

[Note: Art 108(1) of the CRD]

14.2A

If the ICAAP rules apply to a firm on an individual basis, the firm must comply with the ICAAP rules to the same extent and in the same manner as it is required to comply with the obligations laid down in Parts Two to Four and Part Seven of the CRR.

14.3

A firm which is a UK parent institution must comply with the ICAAP rules on a consolidated basis.

14.4

[Deleted.]

14.4A

A PRA approved parent holding company or a PRA designated parent holding company must comply with the ICAAP rules on the basis of its consolidated situation and a PRA designated intermediate holding company or a PRA designated institution responsible for meeting CRR requirements on a consolidated basis must comply with the ICAAP rules on the basis of the consolidated situation of its UK parent financial holding company or UK parent mixed financial holding company.

14.4B

A PRA designated institution controlled by a UK parent financial holding company or a UK parent mixed financial holding company must comply with the ICAAP rules on the basis of the consolidated situation of that holding company, if the PRA is responsible for supervision of the firm on a consolidated basis.

[Note: Art 108(2) of the CRD]

14.5

[Note: Art 108(4) of the CRD]

14.6

If the ICAAP rules apply to an Article 109 undertaking on a consolidated basis or on a sub-consolidated basis that person must carry out consolidation to the same extent and in the same manner as it is required to comply with the obligations laid down in the CRR on a consolidated basis or sub-consolidated basis.

14.7

For the purpose of the ICAAP rules as they apply on a consolidated basis or on a sub-consolidated basis:
  1. (1) the Article 109 undertaking must ensure that the consolidation group or sub-consolidation group has the processes, strategies and systems required by the overall Pillar 2 rule in 3.1;
  2. (2) the risks to which the overall Pillar 2 rule in 3.1 and the general stress test and scenario analysis rule refer are those risks as they apply to each member of the consolidation group;
  3. (3) the reference in the overall Pillar 2 rule in 3.1 to amounts and types of financial resources, own funds and internal capital (referred to in this rule as resources) must be read as being to the amounts and types that the Article 109 undertaking considers should be held by the members of the consolidation group or sub-consolidation group;
  4. (4) other references to resources must be read as being to resources of the members of the consolidation group or sub-consolidation group;
  5. (5) the reference in the overall Pillar 2 rule in 3.1 to the distribution of resources must be read as including a reference to the distribution between members of the consolidation group;
  6. (6) the reference in the overall Pillar 2 rule in 3.1 to the overall financial adequacy rule in 2.1 must be read as being to that rule as adjusted under 14.14-14.16 (level of application of the overall financial adequacy rule);
  7. (7) an Article 109 undertaking must be able to explain how it has aggregated the risks referred to in the overall Pillar 2 rule in 3.1 and the financial resources, own funds and internal capital required by each member of the consolidation group or sub-consolidation group; and
  8. (8) in particular, to the extent that the transferability of resources affects the assessment in (2), an Article 109 undertaking must be able to explain how it has satisfied itself that resources are transferable between members of the group in question in the stressed cases and the scenarios referred to in the general stress test and scenario analysis rule in 12.1.

14.8

An Article 109 undertaking must allocate the total amount of financial resources, own funds and internal capital identified as necessary under the overall Pillar 2 rule in 3.1 (as applied on a consolidated basis or on a sub-consolidated basis) between different parts of the consolidation group or sub-consolidation group.

14.9

The Article 109 undertaking must carry out the allocation in 14.8 in a way that adequately reflects the nature, level and distribution of the risks to which the consolidation group or sub-consolidation group is subject.

14.10

A Article 109 undertaking must also carry out the allocation in 14.8 in a way that:
  1. (a) takes into account the nature, level and distribution of the risks between all entities within the consolidated group or sub-consolidation group; and
  2. (b) ensures the amount allocated to each Article 109 undertaking adequately reflects the risks to which that Article 109 undertaking is exposed on an individual basis.

The risk control rules

14.11

The risk control rules apply to a firm on an individual basis whether or not they also apply to the firm on a consolidated basis or sub-consolidated basis.

[Note: Art 109(1) (part) of the CRD]

Level of application of the overall financial adequacy rule

14.12

Where a firm, a PRA approved parent holding company, a PRA designated parent holding company, a PRA designated intermediate holding company or a PRA designated institution is responsible for meeting CRR requirements on a consolidated basis, it must ensure that the risk management processes and internal control mechanisms at the level of the consolidation group of which it is a member meet the standards set out in the risk control rules on a consolidated basis.

14.12A

Where a firm, a PRA approved intermediate holding company, a PRA designated intermediate holding company, a PRA designated parent holding company or a PRA designated institution is responsible for meeting CRR requirements on a sub-consolidated basis, it must ensure that the risk management processes and internal control mechanisms at the level of the sub-consolidation group of which it is a member meet the standards set out in the risk control rules on a sub-consolidated basis.

14.13

Compliance with the obligations referred to in 14.12 and 14.12A must enable the consolidation group or sub-consolidation group to have arrangements, processes and mechanisms that are consistent and well integrated and that any data relevant to the purpose of supervision can be produced.

[Note: Art 109(2) (part) of the CRD]

14.14

The overall financial adequacy rule in 2.1 applies to a firm on an individual basis whether or not it also applies to the firm on a consolidated basis or sub-consolidated basis.

14.15

The overall financial adequacy rule in 2.1 applies to an Article 109 undertaking on a consolidated basis if the ICAAP rules apply to it on a consolidated basis and applies to an Article 109 undertaking on a sub-consolidated basis if the ICAAP rules apply to it on a sub-consolidated basis.

14.16

When the overall financial adequacy rule in 2.1 applies on a consolidated basis or sub-consolidated basis, the Article 109 undertaking must ensure that at all times its consolidation group or sub-consolidation group maintains overall financial resources, including own funds and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that the liabilities of any members of its consolidation group or sub-consolidation group cannot be met as they fall due.

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15

Reverse Stress Testing

Application

15.1

This Chapter applies to a CRR firm.

Reverse stress testing

15.2

As part of its business planning and risk management obligations, including under the Risk Control Part of the PRA Rulebook, a firm must reverse stress test its business plan; that is, it must carry out stress tests and scenario analyses that test its business plan to failure. To that end, the firm must:

  1. (1) identify a range of adverse circumstances which would cause its business plan to become unviable and assess the likelihood that such events could crystallise; and
  2. (2) where those tests reveal a risk of business failure that is unacceptably high when considered against the firm's risk appetite or tolerance, adopt effective arrangements, processes, systems or other measures to prevent or mitigate that risk.

15.3

Where the firm is a member of:

  1. (1) a UK consolidation group; or
  2. (2) a third country sub-group;

it must conduct the reverse stress test on an individual basis as well as on a consolidated basis in relation to the UK consolidation group or the third country sub-group, as the case may be.

15.4

The design and results of a firm's reverse stress test must be documented and reviewed and approved at least annually by the firm's senior management or governing body. A firm must update its reverse stress test more frequently if it is appropriate to do so in the light of substantial changes in the market or in macroeconomic conditions.

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