Pillar 2A under the spotlight: Navigating the UK PRA’s new direction on operational risk

The Prudential Regulation Authority (PRA) has now published Policy Statement PS15/26, providing feedback on responses to Consultation Paper CP12/25 and confirming its final policy decisions on Phase 1 of its review of the Pillar 2A capital framework.

For banks and credit institutions, the announcement provides greater clarity on how the PRA intends to assess operational risk capital within Pillar 2A, while reaffirming its expectations around risk management and scenario analysis.

As firms continue to prepare for the implementation of Basel 3.1, understanding the PRA’s direction of travel will be essential for maintaining effective capital planning and operational resilience frameworks.

Pillar 2A and Basel 3.1

Pillar 2A capital requirements are designed to address risks that are not fully captured, or not captured at all, under Pillar 1 requirements. The PRA’s review seeks to enhance the consistency, transparency and risk sensitivity of the framework.

Importantly, the PRA has confirmed that it plans to mechanically adjust firms’ Pillar 2 operational risk requirements, in line with changes in Pillar 1 RWA due to Basel 3.1 implementation, so that total nominal operational risk requirements for most firms would remain unchanged as a result of Basel 3.1 standards being implemented.

This provides welcome certainty for firms seeking to assess the combined capital impacts of forthcoming regulatory changes.

A Greater Focus on Forward-Looking Conduct Risk Assessment

One of the most significant messages within PS15/26 relates to the assessment of conduct.  With the PRA making clear that its assessment will focus on the risk of losses from events that are currently unknown.

Observations: We believe historical losses have an important role in informing future unexpected losses. But, should be used in conjunction with robust forward-looking structured scenario analysis, developed through detailed exposure-based assessment, to inform potential future unexpected losses.

Insurance Use for Pillar 2A Capital Offset

The PRA has reaffirmed its long-standing position that it will not permit insurance use as a capital offset for Pillar 2A; and that insurance should not be considered as a capital mitigant in risk assessment through scenario analysis.

Observations: Much like a risk-control, insurance is an important risk management tool. We believe insurance has a valuable role to play in reducing exposure to calculated risks and subsequent calculation of any Pillar 2A add-on within a firm’s economic capital framework and its ICAAP.

Key considerations in the PRA's assessment of firms' risk assessment quality

The PRA has also provided further insight into the factors it will consider when assessing the quality of a firm's operational risk assessment.  These include analysis robustness and appropriateness. This includes data used, the strength of evidence provided and methodological rigour.

Observations: Past experience has demonstrated that operational risk can be a significant cause of bank failure and financial distress. In light of the banking sector's importance to the real economy, firms are expected to maintain a thorough understanding of their operational risk exposures, underpinned by robust data, strong governance, and methodological rigour

Should there be a mechanical link between capital requirements and past losses?

Historical losses form an important input into PRA’s assessment. However, supervisory judgement may be applied in evaluating the relevance of past losses to a firm’s forward-looking risk profile.

Observations: Research has found historical losses to be a robust indicator of future losses, in terms of both frequency and severity.  However, businesses evolve and controls improve, meaning a forward-looking assessment of risk, using structured scenario analysis, is recommended to complement any back-ward looking view.

Basel Event Types

The PRA has confirmed that for the purposes of Pillar 2A assessment, operational risk reporting should be mapped to cover the Basel event types.

Observations: Despite certain limitations, the Basel event type framework remains a widely adopted industry standard. Its long-standing use has generated a substantial volume of internal and external loss data, providing a valuable reference point for evaluating operational risk exposures and facilitating peer benchmarking.