You can use the search function to find a range of UK Finance material, from consultation responses to thought leadership to blogs, or to find content on a range of topics from Capital Markets & Wholesale to Payments & Innovation.
Since the PRA published its approach to setting Pillar 2A risk capital back in 2015, most firms have based their Pillar 2A assessment on the Herfindahl-Hirschman indicator (HHI) approach as recommended by the PRA. The requirements are prescriptive and involve calculating the add-on for certain exposures based on pre-defined geographic, single name and sector categories.
What are the issues with following the PRA's approach?
The main criticism of HHI is its simplicity, which gives rise to add-ons that are less relevant to firms? business models. For example, the HHI uses a geographic breakdown which includes the UK and eight other regions and specifically excludes residential mortgages. This may be a sensible split for a large international bank or a well-diversified UK building society, but it does oversimplify the actual concentration risk by ignoring regional concentration and concentrated mortgage portfolios in one particular area.
The example below illustrates this point where a firm has an £80 million portfolio of corporate exposures - in Western Europe (£20 million), Scotland (£20 million), London (£20 million) and the rest of the UK (£20 million).
Current HHI approach
Geographical Area
RWAs
HHI
UK
£60m
56.25%
Western Europe
£20m
6.25%
Total
£80m
62.50%
HHI approach with additional UK regions
London
Scotland
Rest of UK
25%
The impact of adding additional regions is significant and it greatly reduces the HHI factor, resulting in a reduction in the Pillar 2A capital midpoint add-on from 1.03 per cent of RWAs to 0.35 per cent although there is no change in the underlying risk. This issue is amplified for small UK focused banks where the UK concentration risk HHI requirement is the most significant add-on (normally 1.33 per cent of the relevant credit RWAs).
How do firms manage concentration risk?
Approaches to concentration risk vary from firm to firm and there is still inconsistency in the way firms apply HHI concentration risk in their ICAAPs. Some of the approaches firms have taken include:
A sample of SREP reviews have shown that a number of firms have not developed adequate risk appetite and limit structures within their risk management framework to support the management of concentration risk.
Not following the PRA's HHI approach has resulted in firms being penalised by SREP add-ons for concentration risk, coupled with scalars to address management deficiencies regarding concentration risk appetite.
How can firms improve the management of Pillar 2A concentration risk?
Some common themes:
Oivind Andresen, Director, BDO
17.04.24
15.04.24
12.04.24
By downloading this document, you understand and agree that any sharing, distribution or republishing of the content, without prior written authorisation from the author or content managers at UK Finance, shall be constituted as a breach of the UK Finance website terms of use.