CRD and Pillar 2 (P2R): Output Floor Interaction

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Alessandro Micagni
On January 24th, 2025

Capital Requirements Directive (CRD) and Pillar 2 Requirements (P2R) address institution-specific risks, with Basel III's output floor ensuring comparability in risk-weighted assets. The EBA's guidance mitigates overlaps, manages double counting, and aligns P2R with regulatory reforms.

CRD and Pillar 2 (P2R): Output Floor Interaction


The Capital Requirements Directive (CRD) and Pillar 2 Requirements (P2R) are essential components of the European Union's prudential supervision framework. These regulatory pillars aim to ensure financial stability and institutional resilience while allowing for supervisory flexibility tailored to specific risks. However, the introduction of the output floor under Basel III reforms has created challenges for aligning P2R with evolving regulatory requirements.


On January 21, 2025, the European Banking Authority (EBA) issued an Opinion clarifying the interaction between P2R and the output floor. This guidance provides a harmonized approach to managing overlaps, ensuring compliance, and addressing double counting. This article explores the technical, legal, and operational implications of these developments, offering actionable insights for institutions.




Understanding the Capital Requirements Directive (CRD)


The Capital Requirements Directive (CRD), established under Directive 2013/36/EU, forms the foundation for prudential supervision in the EU. Its objectives include:


  • Ensuring Capital Adequacy: Mandating sufficient capital to absorb risks.
  • Promoting Financial Stability: Harmonizing supervisory practices to mitigate systemic vulnerabilities.
  • Facilitating Tailored Oversight: Allowing competent authorities to impose additional institution-specific requirements through the Supervisory Review and Evaluation Process (SREP).

The CRD framework is divided into three pillars:


  1. Pillar 1: Sets uniform minimum capital requirements.
  2. Pillar 2: Allows supervisory authorities to impose additional requirements based on an institution's risk profile.
  3. Pillar 3: Enhances market discipline through disclosure requirements.


Pillar 2 Requirements (P2R): A Tailored Risk Management Tool


Pillar 2 Requirements (P2R) are an essential supervisory mechanism within the Capital Requirements Directive (CRD) framework, enabling regulators to impose additional capital requirements tailored to the unique risks of individual institutions. These requirements address vulnerabilities and deficiencies not fully captured under Pillar 1, ensuring a more dynamic and institution-specific approach to risk management.


Institution-Specific Risks Addressed by P2R


P2R focuses on risks that standardized regulatory capital frameworks under Pillar 1 may overlook, including:


  • Governance Deficiencies: Issues such as weak board oversight, inadequate internal controls, or failures in decision-making processes that could increase institutional risk.
  • Concentration Risk: Exposure to single counterparties, industries, or geographic regions that create systemic vulnerabilities.
  • Regulatory Model Inadequacies: Deficiencies in internal models that underestimate risk-weighted assets (RWA) and lead to insufficient capital buffers.
  • Emerging Risks: Risks arising from innovation, market volatility, or geopolitical events that traditional frameworks may not yet address.


Key Features of P2R


  1. Customization P2R allows competent authorities to impose bespoke capital add-ons that reflect the unique risk profiles of individual institutions. Unlike Pillar 1, which applies uniform capital requirements, P2R provides the flexibility to:
  2. Dynamic Adjustments The dynamic nature of P2R ensures that supervisory requirements evolve in line with changes in:
    • Risk Profiles: Adjustments are made as institutions expand operations, introduce new products, or face heightened market risks.
    • Regulatory Frameworks: Supervisors can revise P2R to align with updates to prudential regulations, such as the implementation of the output floor under Basel III. This adaptability strengthens the resilience of financial institutions, enabling them to respond effectively to shifting risk landscapes.
  3. Transparency and Fairness P2R calculations adhere to CRD guidelines, promoting consistency across Member States. Supervisors are required to:
  • Clearly communicate the rationale behind P2R adjustments to enhance institutional accountability.
  • Ensure that P2R requirements are proportional to the risks identified, avoiding undue burdens on institutions. Transparency fosters trust between regulators and institutions while ensuring equitable treatment across the European banking sector.

The Output Floor: Comparability in Risk-Weighted Assets
The Output Floor: Comparability in Risk-Weighted Assets

The Output Floor: Comparability in Risk-Weighted Assets


The output floor, a significant Basel III reform, imposes a lower limit on risk-weighted assets (RWA) calculated using internal models. This floor ensures that RWA cannot fall below 72.5% of the value calculated using standardized approaches, enhancing:


  • Comparability: By reducing discrepancies between banks using internal models and those relying on standardized approaches.
  • Transparency: Ensuring that internal models do not result in artificially low RWA estimates that could compromise financial stability.

However, the output floor introduces challenges when aligning P2R with adjusted RWA:


  • Double Counting Risks: Some risks addressed by the output floor may already be accounted for in P2R, necessitating careful supervisory reviews.
  • Arithmetic Effects: The increase in RWA under the output floor can lead to proportional increases in nominal P2R amounts, even when underlying risks remain unchanged.


EBA’s Opinion: Mitigating Overlaps Between P2R and the Output Floor


In its Opinion issued on January 21, 2025, the EBA outlined strategies to address the interplay between P2R and the output floor. The guidance focuses on:

  1. Temporary Caps: Stabilizing P2R during the transition to the output floor.
  2. Double Counting: Eliminating overlaps between risks covered under P2R and those addressed by the output floor.
  3. Arithmetic Effects: Ensuring that P2R adjustments reflect genuine risk rather than mechanical increases caused by the output floor.


1. Temporary Cap on P2R


To ensure proportionality during the transition:


  • Supervisors should apply P2R to unfloored Total Risk Exposure Amount (TREA) during the transitional period.
  • The P2R percentage from the most recent SREP cycle should be frozen and applied to unfloored TREA until supervisory reviews are completed.

This approach avoids penalizing institutions for increases in floored RWA that are unrelated to their actual risk profiles. By maintaining stability in P2R during this period, the temporary cap ensures fairness while giving institutions and supervisors time to assess the impact of the output floor.



2. Addressing Double Counting


Double counting is a critical issue that arises when risks addressed under Pillar 2 Requirements (P2R) overlap with those already covered by the output floor, leading to redundant capital requirements. This overlap primarily stems from regulatory model deficiencies, where supervisors impose P2R add-ons to address flaws in internal models that underestimate risk-weighted assets (RWA). The European Banking Authority (EBA) emphasizes the need for proportionate and targeted adjustments to resolve this issue effectively.



3. Managing Arithmetic Effects


The output floor, by design, increases the RWA of institutions using internal models, ensuring they do not fall below 72.5% of standardized approach calculations. While this reform enhances transparency, it can inadvertently cause arithmetic effects in P2R calculations. These effects occur when supervisors use percentage-based methodologies to determine P2R, resulting in unintended nominal increases in capital requirements as TREA rises.


EBA’s Approach to Mitigating Arithmetic Effects


To address this issue, the EBA recommends:


  1. Proportional Adjustments: Supervisors must ensure that increases in P2R amounts reflect actual changes in risk profiles, not mechanical distortions caused by the output floor. This involves recalibrating methodologies to account for the higher TREA without inflating nominal P2R amounts unnecessarily.
  2. Refined Supervisory Methodologies: Supervisors relying on scoring frameworks or bucketing systems, where P2R is assigned as a percentage of TREA, should assess whether their methodologies need adjustments. For example:
    • If an institution’s TREA increases from EUR 100 billion (unfloored) to EUR 150 billion (floored), the corresponding P2R should not rise disproportionately unless justified by underlying risk factors.
  3. Frequent Reviews: Supervisors should conduct ad hoc reviews to ensure that arithmetic effects do not lead to unfair or excessive capital requirements. These reviews can be completed outside the regular Supervisory Review and Evaluation Process (SREP) cycle, enabling more responsive adjustments.

Preserving Fairness and Proportionality


By mitigating arithmetic effects, supervisors can ensure:

  • Equitable Treatment: Institutions are not penalized for changes in TREA unrelated to actual risk.
  • Efficient Capital Allocation: Capital requirements remain aligned with genuine risk levels, promoting stability without imposing undue burdens on institutions.


4. Enhancing Transparency Through Pillar 3 Disclosures


Transparency is a cornerstone of the Capital Requirements Directive (CRD), particularly under Pillar 3, which mandates detailed disclosures to foster market discipline. In the context of P2R and the output floor, the EBA emphasizes the importance of clear and comprehensive disclosures to build stakeholder trust and enhance regulatory accountability.


Disclosure Requirements


Institutions should provide detailed information on:


  1. Temporary P2R Caps: Disclose the rationale and methodology behind the temporary cap applied to unfloored TREA during the transitional period.
  2. Adjustments from Double Counting Reviews: Clearly explain how supervisors identified and resolved overlaps between P2R and the output floor. This includes:
    • The specific P2R add-ons adjusted.
    • The methodology used to calculate offsets.
  3. Impact on Capital Requirements: Highlight the overall impact of the output floor on P2R amounts and how these adjustments align with the institution’s risk profile.

Benefits of Enhanced Transparency


  • Stakeholder Confidence: Transparent disclosures reassure stakeholders, including investors, regulators, and the public, that the institution is managing its capital requirements responsibly and in line with regulatory expectations.
  • Regulatory Alignment: By adhering to Pillar 3 requirements, institutions demonstrate compliance with the broader CRD framework, reducing the risk of regulatory scrutiny.
  • Market Discipline: Detailed disclosures empower market participants to assess the institution’s financial health and risk management practices, promoting better-informed investment decisions.

Best Practices for Pillar 3 Disclosures


To maximize the effectiveness of Pillar 3 disclosures, institutions should:


  1. Provide Clear Narratives: Use straightforward language to explain complex regulatory adjustments, ensuring accessibility for all stakeholders.
  2. Include Quantitative Data: Supplement narratives with tables, charts, and examples to illustrate the impact of the output floor and P2R adjustments.
  3. Adopt a Consistent Format: Standardize disclosure formats across reporting periods to facilitate comparability and trend analysis.

Examples of Output Floor and P2R Interaction


Example 1: Temporary Freeze on P2R


Consider a hypothetical institution with:


  • Unfloored TREA (2025): EUR 130 billion.
  • Floored TREA (2026): EUR 137.5 billion.
  • P2R Percentage: 2%.

Under the temporary freeze mechanism outlined by the EBA:


  • The P2R is applied to the unfloored TREA, resulting in a nominal capital requirement of EUR 2.6 billion.
  • If calculated using floored TREA, the nominal P2R would rise to EUR 2.75 billion, despite no actual change in the institution's underlying risk profile.
  • The temporary freeze prevents this unwarranted increase, ensuring proportionality while providing supervisors with time to review and adjust for potential double counting.


Example 2: Supervisory Scoring Framework


In another scenario, a supervisor assigns P2R percentages based on a scoring framework that evaluates risk levels and assigns corresponding percentage add-ons:


  • An institution with 1% P2R applied to EUR 100 billion TREA faces a nominal requirement of EUR 1 billion.
  • If floored TREA increases to EUR 150 billion, the same percentage would result in a nominal P2R of EUR 1.5 billion, despite no change in the institution's risk profile.

Here, the temporary cap ensures that the nominal P2R remains proportionate to the institution’s actual risks until a thorough supervisory review can determine if adjustments are warranted. This approach mitigates arithmetic effects caused by the output floor.



EBA Decision Tree for P2R Adjustments


The EBA’s indicative decision tree provides a streamlined supervisory framework for managing the interaction between P2R and the output floor:


  1. Initial Assessment
    • Determine if the institution is bound or expects to be bound by the output floor. This early assessment is critical for identifying potential impacts and initiating supervisory dialogue.
  2. Temporary Freeze
    • Apply P2R to the unfloored TREA during the transitional period, freezing the percentage established during the most recent SREP cycle. This step prevents unwarranted increases in nominal P2R amounts caused by the output floor.
  3. Review on Double Counting
    • Engage with institutions to identify and address overlaps between P2R add-ons and risks already covered by the output floor. Supervisors should assess offsets and ensure adjustments are proportional and compliant with EBA guidance.
  4. Final Adjustment
  • Communicate the updated P2R, now based on floored TREA, after resolving overlaps and recalibrating methodologies. This final adjustment ensures capital requirements accurately reflect the institution’s risk profile.


Strategic Recommendations for Institutions


Navigating the complexities of P2R adjustments in the context of the output floor requires a proactive and strategic approach. Institutions should prioritize the following actions:


1. Enhance Risk Management Frameworks


  • Regularly review and strengthen risk management systems to address vulnerabilities under both Pillar 1 and Pillar 2.
  • Ensure that internal models align with regulatory expectations and accurately capture risks to minimize the likelihood of P2R add-ons for deficiencies.
  • Conduct scenario analyses to anticipate the impact of output floor adjustments on TREA and capital requirements.

2. Proactively Engage Supervisors


  • Establish clear and proactive communication channels with supervisory authorities.
  • Share early estimates of the output floor’s impact on TREA to facilitate informed and timely supervisory decisions.
  • Provide comprehensive data and supporting documentation to streamline reviews of double counting and P2R adjustments.

3. Monitor Regulatory Developments


  • Stay informed about updates to the EBA Guidelines on SREP, ensuring alignment with the latest supervisory methodologies and expectations.
  • Track legislative changes related to the Capital Requirements Directive (CRD) and Basel III reforms to anticipate shifts in regulatory requirements.
  • Leverage industry forums and advisory services to remain updated on best practices and emerging compliance trends.

4. Improve Disclosures


  • Clearly articulate the rationale for P2R adjustments in Pillar 3 reports, providing stakeholders with detailed insights into:
    • Temporary P2R caps applied during transitional periods.
    • Adjustments made following supervisory reviews of double counting.
    • The overall impact of the output floor on capital requirements.
  • Use visual aids such as tables and charts to make complex adjustments more accessible and understandable for stakeholders.
  • Maintain consistency in disclosure formats across reporting periods to facilitate comparability and enhance transparency.

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