The Prudential Regulation Authority (PRA) undertook a review of 20 non-systemic deposit taking firms which exhibit faster asset growth than the market as a whole ("fast growing firms" or "FGFs"). As the PRA notes in its Dear CEO letter dated 12 June, "the review aimed to test the financial resilience of fast growing firms..." . Key observations from the review were summarised in the Letter for firms to consider.
I encourage firms to consider the contents of this letter and reflect upon the messages from the PRA - there are some useful pointers that we believe are applicable to firms not covered by the FGF review too.
In my own personal view, the "big rocks" are:
#1: The critical importance of governance and risk management capabilities
This is a thematic concern that potentially overtakes all other supervisory observations. Consistently, across business models, and across supervisory activities, PRA has raised the concern that governance arrangements and risk management capabilities need to be aligned to the business model and risk profile of firms. In an FGF environment where business decisions are made with agility and growth is an imperative, governance and risk management capabilities may be accorded secondary importance.
Make no mistake - the supervisors will expect no compromise when it comes to these aspects.
#2: Stress testing
Stress testing is an important component through which the supervisors assess the financial resilience of firms. Some observations:
a) The letter suggests that firms are affected by "optimism bias": they are overly optimistic about the potential impact of a stress scenario and potentially display a limited recognition of "how much things could get worse" in an extreme but plausible stress.
In previous discussions with firms, we have discussed the presence of "disaster myopia" and the very personal bias of "bad things happen to others". Stress testing (and indeed reverse stress testing) are very practical ways of overcoming the limitations of personal and group biases.
b) A clear understanding of linkage between stress drivers and the business model was not evident in all cases: Firms were unable to justify the assumptions, their relevance to the business model or an understanding of the sensitivities of their business model to underlying risk drivers.
In my experience, many firms do receive this feedback from the supervisors, principally driven by a lack of analytical rigour in developing the stress scenarios and contextualising them against their business model. A less understood, and weakly implemented, aspect is around risk appetite when devising stress scenarios and in my view firms need to do more around this.
c) Lack of credible management actions: This is also an area of on-going supervisory scrutiny. In my experience, management actions are seen to be either poorly defined, or not necessarily credible or justified - either in context of historical performance or against the stress scenario described. Similar to point 2c) above, management can be overtly optimistic about the credibility and strength of their management actions in alleviating stress impacts.
#3: Asset quality reviews
Many FGFs operate in the high credit risk segments of the market and a number of important asset quality concerns become relevant:
a) Firms need to broaden the range or risk metrics and enhance data quality and risk MI: Supervisors have been concerned about the quality of risk appetite frameworks as well as the reporting being provided to senior management for them to be able to make appropriate decisions. Details about the quality of assets are a material element of the business model of firms operating in higher credit risk segments of the market and must be appropriately monitored and reported.
b) Many FGFs have untested collection capability and their forbearance practices were seen to be inadequate. This could further compound the challenges discussed in relation to stress testing since they could mask the overall level of arrears, particularly under a stress scenario.
c) Some FGFs also displayed weaknesses in relation to underwriting of commercial loans - primarily driven by weak financial analysis, limited evidence of challenge and more importantly, high levels of lending outside policy. This again raises the questions regarding governance and risk management arrangements and the implementation of risk appetite in firms.
One important contextual point to note is that many FGFs have not gone through a macro-economic downturn or experienced significantly impaired books - that may inhibit their ability to forecast downturns or to manage them once they crystallise.
#4: Funding and liquidity analysis
Linking to the growth ambitions of FGFs, the PRA notes that their "...pursuit of aggressive balance sheet growth targets was driven from the asset side of the balance sheet requiring firms to maximise funding from all available funding sources including non-core funding such as secured funding, wholesale funding, SME and corporate deposits, all of which could increase execution and refinance risks."
I think this is a telling commentary on the liquidity and funding risks FGFs are exposed to as they try to achieve balance sheet growth while managing the liability side. To manage risks appropriately, firms would need to consider the potential pricing of funds and assets (both sides of the balance sheet) as well potential flows during stresses (through analysis of LCR and NSFR and internal liquidity stress testing). Again, the PRA notes an element of "over optimism" in funding spreads assumed in many FGF's plans.
Firms and market participants would do well to take note of these observations and use them as important guard rails in developing their strategy and managing their risks.
The PRA will provide further feedback at a conference in July to Chairs and NEDs of non-systemic banks and building societies.
"Our findings warrant a more general reminder of the importance for all firms to ensure their governance and risk management capabilities remain aligned with their business model risk profile and appetite." "Better FGFs ensured that their risk functions remain adequately resourced with experienced staff to provide challenge and oversight. This practice should guard against pressure to meet growth targets leading to them taking on unplanned higher levels of risk."