Ruling the waves or waiving the rules? The UK’s options for deregulation and competitiveness after Brexit: Part 2 – Prudential regulation

Intended audience

• Heads of regulatory affairs, regulatory strategy or public policy at UK or EU regulated entities.
• Other senior executives and NEDs interested in understanding the potential for UK-EU regulatory divergence.
• Risk and capital planning teams at UK or EU banks, insurers and asset managers.

Reading time: 12 minutes

At a glance

• While the UK remains committed to upholding international financial regulatory standards, it is looking to diverge from the EU’s approach to a number of important prudential regulations including CRD/CRR, Solvency II and the IFD/IFR.
• Over time we expect the UK regulators to move away from a more prescriptive, rules‑based system of regulation, instead preferring an “outcomes‑based” approach which leaves greater scope for judgement and interpretation. The UK will remain committed to meeting high prudential standards but is open to reforming the ways it secures its desired outcomes.
• We expect the UK to approach such divergence on a case‑by‑case basis, doing what it thinks is appropriate in each instance, rather than taking a generalised approach of pushing either to lower or increase its standards when compared to the EU.
• In the banking sector, the UK is seeking to adopt more proportionate prudential rules for smaller banks and will not be implementing the EU’s revised regulatory treatment of banks’ software assets.
• The UK is also undertaking a review of Solvency II, which amongst other changes is likely to see the UK reduce the sensitivity of the risk margin to interest rates and reduce its quantum in periods of low interest rates, increase the breadth and flexibility of the matching adjustment to avoid the need for internal securitisations to achieve eligibility, and to streamline insurers’ reporting requirements to reduce the burden and frequency, particularly for smaller firms.
• The UK’s new prudential regime for investment firms may also differ from the EU’s in how a firm’s liquidity is treated when it is part of a larger group and in not applying the €30bn designation threshold for conversion to a bank due to the PRA’s existing designation powers for systemically important investment firms.

Introduction

This blog is the second in a series discussing the UK’s scope for regulatory reform as it leaves the EU and explores its options to boost its economic growth and competitiveness.

In our first blog we set out the overall direction of travel for financial regulation. We reviewed recent statements by politicians and regulators on the future of regulation and assessed the UK’s room for regulatory divergence whilst trying to maintain access to EU markets through equivalence. We also considered how political and public perception may constrain any reforms.

In this blog we delve into the detail of some of the prudential rules and regulations that the UK might revisit or reform.

What is likely to change?

The UK is unlikely to unpick the major prudential pillars of the post-financial crisis regulatory landscape. Many of these regulations, for example those related to bank capital and derivative clearing, result from international agreements amongst the G20 and Basel Committee. These are agreements that the UK Government has argued for strong levels of adherence to, both when it was a member of the EU and shaping the EU’s implementation of these global agreements, and now that it is not.

In September 2020, the UK’s Financial Policy Committee (FPC) nailed its colours to the mast of these international standards, saying that “irrespective of the UK’s future relationship with the EU… the FPC remains committed to the implementation of robust prudential standards in the UK… which exceeds that required by international baseline standards.” [1]

However, while it is unlikely that the UK will diverge from these international agreements, it is using its new post-Brexit flexibility to revisit parts of CRD5/CRR2 and Solvency II so that these respective prudential regimes are better fitted to the needs of UK banks and insurers. The UK will also have the freedom to tailor its approach and timeline for implementing Basel 3.1 and other new international agreements, which could lead to further divergence between the UK and EU’s approaches over time.

For example, the UK has announced that it is delaying the implementation of the UK investment firms prudential regime (IFPR) and its equivalent to CRR2, shifting the deadline for these reforms from June 2021 to 1 January 2022. In this case, the UK has decided to give firms more time to implement these reforms due to the volume of regulatory change already taking place in 2021. However, in other areas the UK may use its newfound freedom to move further and faster than the EU.

Banking

One area where the UK is seeking to diverge from the EU’s approach to prudential regulation is in looking to adopt more proportionate prudential rules for smaller banks and building societies. Sarah Breeden, Executive Director of Supervision for UK deposit takers at the PRA, said in a speech on 22 July 2020 that the PRA would be “considering, in particular, whether there might be scope to introduce a new regime for smaller banks following the UK’s departure from the European Union”, albeit with the caveat that it would have to be “compatible with any international agreements”.

In his Mansion House speech of November 2020, PRA CEO, Sam Woods, confirmed that having already simplified the prudential regime for credit unions, the UK would “have another look at the next-smallest set of UK deposit-takers – small UK banks and building societies  – and ask whether we could do something similar for them.” He stressed that while he saw merit in the UK having a more proportional regime, it was important not to create barriers to growth as small banks grew into larger ones, and that any new regime would need to address this issue carefully. Woods also noted that the PRA could also take a similar approach for the insurance sector, where it could change the way it regulates and supervises smaller insurers.

The UK could also be tempted to revise prudential rules where it lost out on internal EU battles in how various international agreements would be implemented. For example, the UK was opposed to the bank bonus cap present in CRD’s remuneration rules and could seek either to lift or scrap the cap (whilst keeping in place rules around deferred payments and clawbacks, which it argued for) in future.

The PRA has also signalled that it disagrees with some of the EU’s prudential rule changes present in its CRR “quick fix” package and in December 2020 the PRA issued a statement expressing its intention to reverse the benefit of some of the EU’s bank capital support measures, particularly on the capital treatment of software assets (see our blog here for more detail). This example serves to highlight that the UK may also use its regulatory freedom to set higher standards than it would under the EU’s rulebook.

It’s also worth noting that the PRA’s objections to these CRR “quick fix” rule changes stem from its belief that they deviate too far from international standards. This signals that any future UK prudential rule changes could see the UK take a stricter approach to following international agreements when compared to the EU, hewing closer to both the letter and spirit of these, with fewer local derogations or tweaks.

Whilst the example above shows that the PRA may adopt a tougher approach to banking capital compared the EU, there may be other cases where it will decide to adopt a less restrictive approach. For example, following the end of the transition period, the PRA amended the Maximum Distributable Amount (MDA) framework, removing some CRD5 related regulatory barriers on banks making distributions that would trigger MDA restrictions, and allowing banks to increase the size of their MDA by including profits from the past four calendar quarter. This shows that the PRA will approach such issues on a case by case basis, doing what it thinks is appropriate in each instance, rather than taking a generalised approach of pushing either to lower or increase its standards when compared to the EU.

Insurance

While the essential features of the UK’s insurance prudential regime are unlikely to change, the PRA and UK Government have recently published a call for evidence setting out a series of potential reforms to the UK’s Solvency II regime. These will include, but will not be limited to, the risk margin, the matching adjustment, reporting requirements for insurers, branch capital requirements for foreign insurers, and the operation of internal models.

The UK is set to change the way in which the risk margin is calculated. At present the risk margin can be overly sensitive to interest rate fluctuations, particularly for products with long term guarantees, such as annuities. This has led to a significant upswing in the amount of longevity risk written by UK insurers being reinsured in jurisdictions like Bermuda. Consequently, reducing the interest rate sensitivity of the risk margin is likely to be a key area for reform in the UK. This may see the PRA, for example, move towards the less interest rate sensitive International Capital Standard approach.

The matching adjustment (MA) is also likely to change. In a March 2021 speech, Sam Woods said that the PRA wanted to make changes to the “breadth of eligibility and process improvements” in the MA. The PRA is likely to support reforms that would allow equity release mortgages  to be included in MA portfolios without the need for complex restructuring, though without relaxing the requirements so far as to allow a wider range of assets with weaker matching to liabilities. The call for evidence also suggests the potential for the PRA to have more options than the current binary “yes” or “no” on use of the MA, consistent with the overall direction of the call for evidence towards greater regulatory flexibility.

With respect to insurers’ reporting requirements, the PRA is likely to reform the current requirements in view of its own specific needs to supervise the UK market, as well as potentially broadening the scope of the exemptions from certain aspects of reporting available to smaller and less complex insurers.

The call for evidence also suggests that the Government is considering how to improve the competitiveness of the UK as an international insurance hub. Its section on branch regulation says the Government aims to “increase the attractiveness of the UK” as a destination for branches of foreign insurers, and notes that “A reduction in regulatory burdens on branches may encourage insurance firms located outside the UK to establish branches in the UK.” This presages a clear move to make the UK’s insurance prudential regime less burdensome for branches of foreign insurers.

Changes to model approval are also on the table, with Sam Woods remarking that the PRA wants to simplify the “bottom-up process” for approving internal models. The PRA seems minded to move away from Solvency II’s pass/fail approach applied to model methodology, towards a more flexible approach closer to that applied in the banking sector. This could include more scope for add-ons to model results or conditionality within the approval process and/or the application of “guard rail” minima to prevent modelled capital requirements falling below a certain level, coupled with a more flexible model approval process.

Insurers interested in further detail on potential reforms can read our blog on the Solvency II call for evidence.

The PRA’s future approach

While there are a number of areas where the PRA might make formal rule changes as part of any regulatory divergence, it could also make changes to its day-to-day supervisory approach and toolkit, which would also have a significant effect on how firms are regulated in practice.

At present, the PRA is unable to give waivers to articles in EU regulations other than where they have explicit discretion to do so; post-Brexit this constraint no longer exists, giving the PRA greater flexibility to act more quickly and opening up more policy options.

This desire for greater flexibility is likely to become a central feature of the supervisory changes we see emerging from the UK regulators post Brexit. As we set out in our previous blog, senior regulators have expressed a desire to move away from a more prescriptive, rules‑based system of regulation, instead preferring an “outcomes‑based” approach; one in which there will be more discretion for supervisors to make judgements about firms’ regulatory obligations and whether these are being fulfilled.

While firms may welcome a reduction in the number and detail of the rules they have to follow, greater discretion may also lead to firms being on the receiving end of unexpected supervisory judgements, as firms and regulators may disagree over how to interpret broad based principles. In such circumstances it will become increasingly important for there to be clear guidance on how regulators and supervisors will interpret any high-level regulatory principles in different circumstances, so that firms can have greater certainty over what is and is not expected of them.

Investment firms

While the capital frameworks for banks and insurers are likely to be at the forefront of any divergences in UK and EU prudential rulesets, the UK is also seeking to take its own approach when it comes the prudential regulation for MiFID investment firms.

The FCA has published a discussion paper setting out its overall approach to the IFPR. It has also published the first in a series of three consultation papers, setting out its detailed proposals for this new prudential regime. As we are yet to see the content of the two forthcoming consultations, there remains a degree of uncertainty over what the FCA’s final proposals will be and how far they may diverge from the EUs. However, while the UK’s regime is based around the EU’s investment firm regulation and directive (IFR/IFD), the FCA’s discussion paper sets out a number of areas where the UK could take a different approach to the EU.  

Potential areas of divergence include the use of waivers to exempt firms from particular rules or requirements, as well how liquidity would be considered for investment firms that are part of a larger group. The UK has also said that due to the PRA’s existing designation power for systemically important investment firms, it will not require investment firms which exceed the €30bn threshold (set out in the EU legislation) to apply for authorisation as banks.

The UK is also looking to make itself a more attractive location to base investment funds. To this end the government has published a call for input on the UK Funds Regime. While the UK has traditionally been a hub for portfolio management, the Government’s proposals look to make the UK a more attractive location to domicile funds, and its tax proposals seem aimed at putting the UK on an equal competitive footing with EU locations such as Ireland and Luxembourg.

 [1] Record of the Financial Policy Committee Meeting on 30 September 2020, p3