The Bank of England Monetary Policy Committee (BoE MPC) today confirmed that PRA-regulated firms – banks and insurers – will need to be ready for the possible implementation of a negative interest rate at any point from six months’ time. While the MPC was categorical that this does not imply a commitment to implement a negative rate in future, they concluded that it was necessary for firms to take steps now to develop the capability to implement negative rates if called upon to do so. Sam Woods – CEO of the PRA – has written to firms to elaborate. His letter makes clear that the PRA is expecting firms to implement tactical solutions – that is, short-term fixes – in order to be ready on this timeframe.
In this blog, we provide a summary of what the PRA is asking for and set out our views of how banks should approach the issue of negative rates in the UK.
In discussions with firms in recent months, both in the UK and in jurisdictions where negative rates have already been set, we have been struck by three recurring issues.
- First, some firms underestimate the scale of the challenge, focusing on some systems (e.g. product systems) to the exclusion of others (e.g. back-office functions).
- Second, some firms initially treated this as only a systems problem, overlooking other crucial factors, such as customer communications and staff training. The systems issues are nevertheless significant, and banks should expect to encounter tricky problems when they get into the details.
- Third, some firms tended to treat negative rates as a single point-in-time event, whereas the negative rate environment has in fact evolved – encroaching further into retail banking in particular.
Our expectation is that banks will now undertake a broad-based readiness check/gap analysis to ensure they are addressing all the necessary questions and covering all relevant bases, as well as taking the opportunity to leverage insights from other major programmes with systems elements (such as LIBOR transition). While the PRA has indicated that it expects only tactical solutions for negative rates to be developed within the next six months, banks should also consider the longer-term and broader strategic issues raised which may warrant or necessitate more permanent changes.
These issues are likely to be more acute for domestically focused UK banks that have not previously had to address negative rates that have already been set in other jurisdictions.
The PRA’s “Dear CEO” letter focuses on firms adopting tactical rather that strategic solutions. The PRA states that “the majority” of firms would be able to implement tactical solutions within a six-month period without creating undue operational risks. Furthermore, with industry having indicated that larger-scale strategic solutions would take “significantly longer” – that is, 12-18 months – and would potentially entail having to reprioritise “other important projects”, industry is not expected to proceed with such solutions unless they were otherwise intending to.
The letter provides only very high-level feedback on the PRA’s previous “Dear CEO” exercise. The PRA found that many wholesale banks are either already used to dealing with negative rates in other countries or have more modern and more easily adaptable systems. Insurance firms “generally presented fewer operational challenges” as a result of rarely using Bank Rate in policyholder contracts. It is retail banks that face the greatest challenge, and the PRA noted that there is a need for significant work “to enable [legacy systems] to accept and process a negative number”.
Banks provided the PRA with details of potential tactical solutions, but in a crucial passage the PRA notes that not all of the workarounds banks had proposed would “result in a negative rate on retail products such as mortgages and current or savings accounts”. Since the PRA has nonetheless proceeded to ask firms to implement tactical solutions, we conclude that its focus in the immediate near-term is on ensuring that systems can function adequately - even if banks are constrained in terms of their broader strategic options for responding to a negative rate environment.
All systems go, but it’s not all about systems
The PRA’s first concern has understandably been to examine the implications for banks’ systems, given that this determines firms’ fundamental ability to implement a negative rate. However, in the longer-term, negative rates will necessitate banks considering a broader range of factors. In our view, there are in four main areas needing attention:
- Risk, finance and audit;
- Business strategy; and
- Customers, conduct and contracts.
We highlight below some of the challenges banks could encounter in each of these four areas.
Systems: Systems issues identified by banks in response to the PRA’s October 2020 Dear CEO letter provide a foundation for work in this area. Banks need to review these plans before making them operational, ensuring that the coverage of systems is comprehensive. In our experience, banks may have focused on core banking and customer management systems, while giving lower priority to more shared systems. Banks should then contact owners of systems (and End User Computing (EUCs)), with two particular concerns in mind: does the system or EUC take interest rates as a feed? And does it have inbuilt data validation checks that do not allow negative values? Banks should also aim to leverage existing projects that are looking at systems or EUCs in order to gain insights on the technical limitations of these systems, as well as to understand how a negative rates programme might interact with ongoing work, with LIBOR providing one obvious example.
Risk, finance and audit. Negative rates will have knock-on consequences for other parts of the organisation. Risk functions and owners of models should explore models to understand potential constraints around negative rates, given that certain types of models may not function with a negative input. Banks may also want to review risk appetite frameworks to understand whether the novel risks posed by negative rates can be appropriately incorporated. Negative rates may also complicate the assessment of the riskiness of loans, and banks should explore the potential effects on underwriting quality and on their loan portfolios more broadly. Banks will also want to consider how a negative interest rate environment affects their confidence in their financial reporting, particularly as a consequence of the systems changes being made – alterations to the direction of the flow of interest, for instance, may create challenges. This in turn will bring audit risks.
Business strategy. Negative rates will inevitably have an impact on bank business models and profitability. Evidence from the EU suggests that if a negative rate environment remains in place for some time, it will inevitably encroach into the retail sphere – even if initially banks choose not to pass on negative rates. Banks will need to work through product pricing (and related pricing models), and determine whether and how to pass negative rates onto customers. Given increased pressure on interest margins, banks also need to explore ways to generate non-interest income through fees and commissions. This will inevitably raise the question of whether to move away from free-if-in-credit banking.
Customers, conduct and contracts. In the near-term banks need to be ready to deal with any customer enquiries triggered by the MPC’s announcement that it has asked the banks to prepare for negative rates. Certainly, if the MPC subsequently sets negative rates, enquiries will increase. Banks need to ensure they have a customer communications strategy in place, and that customer-facing staff are trained to respond appropriately. Beyond communications, banks also need to work through the implications of their response to negative rates for their customers, including conduct of business risks. Two areas of FCA concern that banks should particularly consider are customer vulnerability and pricing transparency. On the first, banks should ensure that their responses do not (disproportionately) affect already struggling customer groups. On the latter, banks should remain alert to the FCA’s general interest in ensuring that fees are fair and transparent to customers. Banks will also need to review contractual terms to identify where these may constrain their ability to manoeuvre.
The PRA has fired the starting gun on preparations for negative rates. The immediate focus will be on achieving operational readiness within the six-month timeframe provided. However, banks should also now begin to engage with the substance of the broader implications for their businesses.
First and most importantly, banks need to undertake a broad-based readiness check/gap analysis to ensure they have identified the areas in which they are affected, as well as to identify potential stumbling blocks.
Banks should consider the governance and oversight of their negative rates programme. In the case of LIBOR transition programmes, regulators required a specific SMF be given responsibility for the transition; no such requirement exists for negative rates, but banks should still consider which individuals are best placed to oversee this process and ensure that activities are well coordinated and appropriately sequenced across the business.
[T]he PRA should engage with PRA-regulated firms to ensure they commence preparations in order to be ready to implement a negative Bank Rate at any point after six months.