Sarah Breeden in her speech introduced a new guide for banks and the PRA published a consultation paper 9/20, on its expectations for new and growing banks, which provided some welcome clarity on the PRA’s risk appetite. The two themes that stood out were the PRA’s commitment to the competition objective and for banks to grow safely.

Like all things, the economic and regulatory landscape in which firms now operate or become authorised has changed significantly. Covid-19, Brexit and Climate Change Risk have now been throw into the mix of risks for new and aspiring banks to contend with when framing strategy with the objective of achieving viability and sustainability. In this blog, we talk about the initiatives the regulator is proposing to ensure that their competition objective is met, ensuring the stability of the UK’s Financial system and how this affects the capitalisation requirements for non-systemic UK banks.  

The Regulatory Initiatives 

Setting up a new bank and subsequently achieving scalability is indeed like scaling a mountain, and the gradient becomes steeper with increasing competitive market forces and regulatory expectations as the bank grows. However, the good news is that the regulator recognises this and wants to address it. The PRA has consulted on initiatives that target their competition objective and the ones that affect capital are as follows:

  • Lessened capital burden on non-systemic banks with reduced Pillar 2A add-ons;
  • Simpler access to IRB model benefits;
  • Incremental increase in capital requirements as a result of moving to stress-      testing from the wind down approach;
  • Considering a new regime for smaller banks, once the UK exits the EU and subject to any agreement made by the UK government.

In addition, to ensure a level playing field, the regulator has consulted on introducing mortgage floors via consultation paper 14/20 for bigger banks on the IRB approach.  Mortgage floors will lessen the current marked difference between capital requirements for bigger banks on IRB models and smaller banks on the standardised models. Thereby, this proposal aims to further the competition objective of the PRA, while making the IRB banks safer. These initiatives target both the competition and financial objectives of the regulator.

Capital is King

The consultation paper 9/20 has provided clarity on capital management and capital buffers and here are a few thoughts:

Current Practice
Proposed Practice
Undertake a wind-down cost analysis, benchmark against 12 months operational expenses and hold the resulting figure as static PRA buffer.
6 months of operational expenses as the capital buffer calculation.
Pros: May result in lower capital buffers for some banks and standardizes the calculation for banks.

Cons: Driven to hold less capital buffers, banks may seek to cut costs. Typically, for new banks the primary drivers of costs are investments in scalability and staff. Therefore, it is imperative that banks remain focussed on controlled and safe growth, because the regulator will remain uncompromising on investments required in supporting risk management. To this effect, the regulator states “expect to invest significantly in risk management and controls, and have a mature control environment typically by five years after authorisation.”
Capital must be available to meet regulatory requirements before they fall due.
Banks must be sufficiently capitalised so that they have equal to or above 12 months of all capital requirements following exit from mobilisation.
Pros: Banks will have sufficient capital in advance to support their strategic initiatives and focus on scalability.

Banks will have ensured that they have clear strategies in place to allow them to accurately, estimate their capital requirements for the next 12 months.

Cons: Banks will have to accelerate their capital raising activities to ensure that they have the right amount of capital in place.

Investors will need to pre-fund on an annual basis and may require more information than before. MREL instruments will also need to be maintained above the typical threshold conditions (Pillar 1+ Pillar2A), should the bank be subject to MREL requirements.
Banks typically move onto a buffer set on a stress-test at a five-year mark post authorisation.
Banks to move onto a buffer set on a stress test at a five-year mark post authorisation. As banks grow and mature following authorisation they should develop their stress-testing capabilities so they are prepared for the transition to a PRA buffer set on stress testing.
Pros: The method of capitalisation remains the same for banks as they hit the 5 years mark. Banks previously had to develop stress testing at the point of application; however, now they will be given the opportunity to develop this capability once authorised.

Cons: Banks will need to prioritise the development of their  stress-testing capabilities at an early stage which and will need to start embedding stress testing into their risk management framework which will require additional resources and investment.
Capital buffers are not to be used in the usual course of business.
Capital buffers are not to be used in the usual course of business, and clarifies regulatory expectation that new and growing banks adopt a forward looking approach to capital management, ensuring that planned capital injections are received sufficiently in advance to avoid the bank entering its buffers.
Pros: the expectations on use of buffers remains the same for all banks in the industry.

Cons: Capital will need to be raised in advance. Capitalisation levels will need to be appropriate and take into account potential events that may result from business as usual disruptions such as operational delays to ensure buffers are not breached.
The PRA expects banks to meet capital equal to Pillar 1 plus Pillar 2A to avoid a breach of Threshold Conditions. The quality of capital must be common equity tier 1 capital that reflects risk weighted capital.
The PRA expects banks to meet both MREL and maintain an amount of Common Equity Tier 1 (CET1) capital that reflects their risk-weighted capital and leverage buffers (if applicable). Banks should not double count CET1 towards both MREL and the amount reflecting the risk weighted capital and leverage buffers (if applicable). Banks can meet MREL with CET1, they do not have to meet it with CET1.
Pros: Banks can simplify their capital quality stacks and meet MREL requirements with CET 1 to avoid funding volatility.

Cons: A breach or likely breach of MREL will trigger supervisory investigation into whether the bank will continue to meet their Threshold Conditions, with a view of taking further action where deemed necessary.

The overall quantity of capital required may be higher for some banks that are subject to MREL rules than it is under the regime whereby MREL was not a binding requirement.

The risks facing the financial system are evolving and the shape of the economy is changing. The UK’s financial system is adapting to this new environment, and these proposed regulatory initiatives are one-step in that direction.  New and aspiring banks will need to understand what new risks their business models face, and how they can optimise their capitalisation levels to ensure appropriate returns in a controlled manner.  Whilst the proposed initiatives are a mixed bag in terms of capitalisation levels, they do encourage banks to think through their risk profiles and mitigate against these risks with appropriate levels of capitalisation.

Our Financial Risk Management and ICAAP teams would be pleased to discuss any aspects of this with you further. Please reach out to the authors for further discussion.