2.1 This chapter sets out the methodology the PRA uses to inform the setting of a firm’s Pillar 2A capital requirement for credit risk.

Definition and scope of application

2.2 Credit risk is the risk of losses arising from a borrower or counterparty failing to meet its obligations as they fall due.

2.3 A firm’s capital requirements for credit risk are determined in accordance with Pillar 1 of the Capital Requirements Regulation (CRR). However, the PRA believes that there are asset classes for which the standardised approach (SA) underestimates the risk (eg zero risk-weighted sovereigns). The PRA therefore assesses credit risk as part of its Pillar 2 review of firms’ capital adequacy.

2.4 The methodology detailed below is applied to all firms using the SA. It will also be applied to those portfolios capitalised using the SA by firms employing internal ratings-based (IRB) models (the methodology is therefore applied to exposures subject to a partial use exemption). Application of the methodology may be expected to be significant where a firm has higher-risk exposures on the SA and lower-risk exposures on the IRB approach, or where the SA treatment is especially favourable (eg sovereigns).

2.5 Where the underestimation of Pillar 1 capital is due to deficiencies in IRB models, the PRA addresses the capital shortfall by requiring the firm to remediate the shortcomings of the Pillar 1 models rather than setting Pillar 2A capital requirements.

Methodology for assessing Pillar 2A capital for credit risk