Pillar 2A Phase 1: what are the PRA's final rules?

The PRA’s Pillar 2A review aims to improve transparency, proportionality and consistency across banks’ capital frameworks. It is the most significant reform to Pillar 2A in recent years, bringing supervisory capital add-ons closer to firms’ individual risk profiles and putting greater emphasis on the quality of a firm’s Internal Capital Adequacy Assessment Process (ICAAP). Split into two phases, the first targets alignment with Basel 3.1, while the second will explore specific methodologies, with further consultation due next year.

In addition to a range of minor changes from the consultation paper, the final policy statement shifts implementation deadlines to 1 January 2027. This single deadline aims to streamline firms’ preparatory work and improve Basel 3.1 alignment. 

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Credit risk – what’s changed?

Despite mixed feedback, the PRA has confirmed that it will remove the benchmarking methodology, including internal ratings-based (IRB) benchmarks. This is because risk-weighted assets under Basel 3.1 will capture risk more effectively under the standardised approach, and reduce the unnecessary operational burden of maintaining IRB benchmarks. As such, the PRA shifts the focus to firms’ ICAAPs and internal risk analysis to support credit risk management.  

At the same time, the PRA has recognised two exposure types where the standardised approach may understate risk, and has introduced targeted systematic methodologies to address this. For central governments and central banks (CG/CBs) and regional governments and local authorities (RG/LAs), the PRA sets minimum effective risk weights, applying mainly to certain non-UK sovereign and public sector exposures.

For unconditionally cancellable commitments in the retail exposure class (retail UCCs), the PRA sets a 20% conversion factor reference point, compared with 10% applied under the Basel 3.1 standardised approach. Firms will need to apply this add-on unless they can evidence a lower conversion factor, subject to a 10% floor. In the final policy statement, the PRA has opted to exclude small and medium enterprises from scope to support growth.

More flexibility over credit scenario analysis

In the PRA’s proposed rules, banks were expected to apply credit scenario analysis across their SA portfolios to assess idiosyncratic credit risk. In response to concerns around proportionality, the PRA has introduced greater flexibility, and banks only need to carry out a detailed assessment for SA exposures that may carry higher idiosyncratic risks. This includes, but isn’t limited to, lending to niche markets, lending across new products and some types of mortgages.

Operational risk – what’s changed?

The PRA’s Pillar 2A final policy statement hasn’t made significant changes to the proposed operational risk rules, but there are a few clarifications and refinements, notably:

• Greater proportionality for smaller firms when undertaking scenario analysis.
• The decision not to publish pre-determined parameters or loss data used to calculate operational risk capital to avoid over-reliance on these as industry benchmarks.
• Clarification over inclusion of critical third parties in the Pillar 2A assessment.
• Operational clarifications to FSA073-075 reporting templates.  

The PRA has made minor clarifications and updates to draft SS4/25 and draft SoP5/25 to proportionately align these Pillar 2A operational risk rules to expectations for Small Domestic Deposit Takers (SDDT firms). 

Pension obligation risk – what’s changed?

The final policy statement on treatment of pension obligation risk under Pillar 2A is largely unchanged from the consultation paper. However, the PRA has updated the FSA081 reporting template and instructions to ensure partially bought-in schemes with significant residual surplus would be eligible for the reporting exemption.

The regulator has also made the following clarifications: 

• The Financial Services Compensation Scheme must be excluded from the residual risk assessment.
• Firms should be able to provide the necessary data for their FSA081 submission if a scheme's funding ratio falls below 130% near the ICAAP reference date.
• An FSA081 submission may be needed for the Banking Capital Stress Test, even if the pension scheme is exempt under Pillar 2A reporting requirements.
• Confirmation that the PRA doesn’t expect pension scheme trustees to be involved in ICAAP or Pillar 2A submission.  

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Market risk – what’s changed?

The PRA's final policy on market risk doesn’t introduce any changes to its Pillar 2A methodology, but makes some clarifications. Notably, it has confirmed that intraday exposures can require Pillar 2A capitalisation for some firms (not simply monitoring).

The regulator has also reconfirmed that it will prevent double counting by reducing Pillar 2A capital requirements in light of the off-cycle review of firm-specific capital requirements (as per PS9/24).

Greater focus on the ICAAP

While the new rules don't overhaul the ICAAP expectations, removing IRB benchmarking and the shift to firm-led credit risk assessment will undoubtedly bring them under closer regulatory scrutiny. Firms will need to demonstrate that their ICAAPs are accurate, proportionate and fully stress-tested for credibility. They also need to be forward-looking with realistic action plans to address a range of scenarios and include key actions to demonstrate effective capital management.

When completing the ICAAP, firms will also need to consider interaction with a broader range of regulatory requirements. This includes resolution planning, stress testing requirements and climate risk management, which could all affect Pillar 2A capital requirements and will need to be fully reflected in the documentation. 

What firms need to do now

With the 1 January deadline looming, firms should start with a gap analysis to identify where existing approaches no longer apply, and where new methodologies will affect Pillar 2A capital requirements. From there, it’s essential to update governance procedures and supporting documentation, noting the PRA’s emphasis on firm-led assessment, greater transparency and clearer guidance on supervisory judgement.

Data and modelling capability could be the most demanding part of the transition. With fewer benchmarks available for reference, firms may need to develop their own approaches, which will depend on further investment in reliable internal models, robust evidence and clear audit trails. 

While planning the Pillar 2A changes, it’s essential to identify synergies with Basel 3.1 implementation, and fold them into the broader programme of work. Firms that treat these as a single integrated programme may achieve more streamlined processes to support a more coherent capital framework, which will be easier to manage in the long term. 

For further information on Basel 3.1 or Pillar 2A, contact Kantilal Pithia.