Reviewing Pillar 2 regulations: credit concentration risk

Author:Lukasz Prorokowski, Hubert Prorokowski, Georgette Bongfen Nteh
Position:Institute of Financial Complex Systems, Masaryk University, Brno, Czech Republic
Pages:280-302
SUMMARY

Purpose This paper aims to analyse the recent changes to the Pillar 2 regulatory-prescribed methodologies to classify and calculate credit concentration risk. Focussing on the Prudential Regulation Authority’s (PRA) methodologies, the paper tests the susceptibility to bias of the Herfindahl-Hirscham Index (HHI). The empirical tests serve to assess the assumption that the regulatory... (see full summary)

 
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Reviewing Pillar 2 regulations:
credit concentration risk
Lukasz Prorokowski
Institute of Financial Complex Systems, Masaryk University, Brno, Czech Republic
Hubert Prorokowski
Department of Risk Research Management, H.L. Prorokowski LLC,
San Francisco, USA, and
Georgette Bongfen Nteh
Department of Risk Research Management, H.L. Prorokowski Consultancy,
Luxembourg, Luxembourg
Abstract
Purpose This paper aims to analyse the recent changes to the Pillar 2 regulatory-prescribed
methodologies to classify and calculate credit concentration risk. Focussing on the Prudential Regulation
Authoritys (PRA)methodologies, the paper tests the susceptibility to bias of the HerndahlHirschamIndex
(HHI). The empirical tests serve to assess the assumption that the regulatory classication of exposures
within the geographical concentration is subject to potential misuse that would undermine the PRAs
objectiveof obtaining risk sensitivity and improved banking competition.
Design/methodology/approach Using the credit exposure data from three global banks, the HHI
methodology is applied to the portfolio of geographically classied exposures, replicating the
regulatory exercise of reporting credit concentration risk under Pillar 2. In doing so, the validity of the
aforementioned assumption is tested by simulating the PRAs Pillar 2 regulatory submission exercise
with different scenarios, under which the credit exposures are assigned to different geographical
regions.
Findings The paper empirically shows that changing the geographical mapping of the Eastern
European EU member states can result in a substantial reduction of the Pillar 2 credit concentration risk
capital add-on. These empirical ndings hold only for the banks with large exposures to Eastern Europe
and Central Asia. The paper reports no material impact for the well-diversied credit portfolios of global
banks.
Originality/value This paper reviews the PRA-prescribed methodologies and the Pillar 2 regulatory
guidance for calculating the capitaladd-on for the single name, sector and geographical credit concentration
risk. In doing so, this paper becomesthe rst to test the assumptionsthat the regulatory guidance around the
geographical breakdown of credit exposures is subject to potential abuse because of the ambiguity of the
regulations.
Keywords Capital adequacy, Credit concentration risk, Pillar 2, PRA, Regulatory reporting
Paper type Research paper
1. Introduction
Pillar 2 of Basel Accords provides a framework for dealing with different types of banks
residual risks, including the creditconcentration risk. European regulators view the Pillar 2
framework as a means of enhancing banks risk management (EBA, 2017). A review of risk
JEL classication F37, G21, G28
JFRC
27,3
280
Received21 February 2018
Revised25 June 2018
Accepted29 August 2018
Journalof Financial Regulation
andCompliance
Vol.27 No. 3, 2019
pp. 280-302
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2018-0033
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
reporting regulations by Barakat and Hussainey (2013) informs that Pillar 2 reporting is
relevant for banks and other nancial services rms operating within the Capital
Requirements Regulation(CRR) of the Capital Requirements Directive (CRD IV).
In the UK, the Pillar 2 reporting requirementsare transposed into local regulations by the
Prudential Regulation Authority (PRA). Since January 2016, under the Pillar 2 framework,
the PRA-designated banksare required to submit two data templates (FSA078 and FSA079)
that inform about their credit concentrationexposures in the following portfolio buckets:
Single name: Here, the top 20 largest exposures are measured by the Exposure at
Default (EAD).
Sector: Here, industry sectors are classied by the Standard Industry Classication
codes.
Geographical: Here, geographical regions are grouped by the International Monetary
Fund (IMF).
This paper reviews the PRA-prescribedmethodologies and the Pillar 2 regulatory guidance
for calculating the capital add-on for the single name, sector and geographical credit
concentration risk. In doing so, this paper tests the assumptions that the regulatory
guidance around the geographical breakdown of credit exposures is subject to potential
abuse owing to the ambiguity of the regulations. According to Prorokowski (2017), the
potential area of intended/unintended abuse of assessing the Pillar 2 capital stems fromthe
opaque geographical division that is not supported by any regulatory notes and lacks
clarity.
This paper is focussed on reviewing the UKs regulatory framework for the credit
concentration risk under the Pillar 2 reporting requirements. To date, no academic study
challenged the PRA-prescribed methodologies for calculating capital add-on for the credit
concentration risk. With this in mind,the main objective of this paper is to investigate how
the capital held under the Pillar 2 credit concentration risk can be lowered bychanging the
geographical composition of exposures. Because of the regulatory ambiguity, this paper
assumes that for the same portfolio of entities, but assigned to different geographical
regions during the Pillar 2 exercise, a bank can calculate different (higher/lower) levels of
capital. This may result in the inabilityof the banks to maintain sufcient regulatory capital
to adequately cover credit concentration risk while still being compliant with the overall
capital adequacyrules.
The validity of the aforementioned assumptionis tested by simulating the PRAs Pillar 2
regulatory submission exercise with different scenarios under which the credit exposures
are assigned to different geographical regions.At this point, no PRAs rules concerning the
reporting under Pillar 2 are breached. For the purpose of reporting practical ndings, the
exposure data for the simulationshave been aggregated from three tier-1 banks domiciledin
the UK. Therefore, the simulations reect the reality faced by the PRA-designated banks
and show how the PRAs rules can be exploited to the advantage or disadvantage of the
global banks.
As indicated in the study of Prorokowski (2018), using theoreticalportfolios of exposers
prevents practitionersfrom beneting from the ndings reported in a study. Thus, using the
realistic portfolios sourced from credit institutions bridges theory and practice and further
contributes to the originality of this paper. There is a relatively small number of academic
studies that contain sensitive data of banks owing to the fact that the information shared
with the researchers is condential.Given the fact that the banking industry remainshighly
competitive (Claessens and Laeven,2004;Osborne et al., 2017), banks would be reluctant to
Pillar 2
regulations
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