The Prudential Regulation Authority’s Approach to Banking Supervision – further details announced

The PRA’s objective

The PRA’s overarching statutory objective will be to “promote the safety and soundness of firms”, and it will be required to do so by seeking to “avoid adverse effects on financial stability”. The PRA therefore intends to prioritise its resources towards those firms with the greatest potential to damage financial stability, whether through the way firms carry on their business or through their failure. It will identify these firms through ongoing assessment against the statutory “Threshold Conditions” (see Figure 1) and against the PRA’s own policies. While the PRA will inherit much of the FSA’s prudential policy framework, it will weight some factors differently and will have some new expectations of firms. It will expect firms to comply with both the letter and the spirit of its policies, and in particular will expect firms not to “engage in ‘creative compliance’ or regulatory arbitrage”.

Figure 1 – Threshold Conditions

Once the PRA and FCA come into effect, firms will need to meet both the PRA-specific and FCA-specific Threshold Conditions in order to be permitted to carry on regulated activities. The draft PRA-specific Threshold Conditions for banks, building societies, credit unions and affected investment firms require, in summary:

• A firm which is incorporated in the UK to have its head office in the UK
• A firm’s business to be conducted in a prudent manner, maintaining appropriate financial and non-financial resources
• A firm to be fit and proper, and to have staff with the appropriate skills and experience
• A firm and its group to be capable of being effectively supervised

While the PRA will not aim to ensure that no firm fails, it will seek to ensure that any failing firms do so in an orderly way without public funds being put at risk.

The PRA’s approach to supervision

The PRA proposes to adopt a “judgement-based”, forward-looking approach to supervision. Its supervisors will form judgements about the current and future risks posed by firms, including the risks that the firm is running, the risks that it poses to the PRA’s objective and whether it will continue to satisfy the Threshold Conditions. The PRA acknowledges that it is inherent in this approach that the supervisor’s judgements will at times vary from those of the regulated firm and that in some cases it will transpire that the supervisor’s judgement was incorrect, and to minimise this risk it plans to ensure that its staff have the relevant experience and skills. The PRA will assess firms on a cyclical basis, regularly updating its assessment.

The PRA intends to divide all the firms it supervises into five “categories”, from high impact (1) to low impact (5), based on their potential impact on the stability of the UK’s financial system. The highest impact (“Category 1”) firms will be the most significant firms, which by virtue of their size, complexity, interconnectedness and business type have the capacity to cause “very significant disruption” to the financial system in the UK; the lowest impact (“Category 5”) firms will be those who have almost no capacity to cause disruption alone, but may have the potential to contribute to disruption where difficulties exist across a sector or subsector of the financial system. The categorisation will initially be based on quantitative scoring and will then be finessed by the firm’s supervisor, taking into account qualitative analysis. The PRA will tell firms which category they have been assigned to (and therefore the level of supervision they can expect) and will publish statistics on the number of firms in each category.

The PRA also plans to develop a Proactive Intervention Framework, capturing its judgements as to firms’ relative proximity to failure. This will aim to ensure that the PRA can respond promptly to emerging risks. The Proactive Intervention Framework will have five escalating stages (see Figure 2). Again, as a firm moves up through these stages the intensity of supervision will increase, the PRA may require the firm to carry out more, and more significant, recovery actions, and the contingency planning by the PRA and the Bank’s Special Resolution Unit will be stepped up. Unlike a firm’s categorisation, the PRA does not intend to inform firms of their rating on the PIF, to protect firms from being obliged to publicly disclose this rating.

Figure 2 – The five stages in the Proactive Intervention Framework

The typical levels of elevation in a supervisory relationship from Stage 1, Business as Usual, through to Stage 5, resolution or winding up.

1 – Low risk to viability of firm

The “business as usual” scenario where the firm is subject to the normal supervisory risk assessment process and required to plan for stressed conditions and identify appropriate recovery actions or exit strategies. The PRA will assess a firm’s recovery and resolution planning.

2 – Moderate risk to viability of firm

Supervisors may have identified vulnerabilities in a firm’s financial position or deficiencies in its risk management and/or governance practices. In this case:

• Recovery: The intensity of supervision would further increase. The PRA might set additional reporting requirements and use further information gathering powers. It would require the firm to act to address deficiencies identified over an appropriate timeframe. The PRA would consider the case for setting restrictions on the firm’s business activities until such actions had been taken, and the firm would be required to update its recovery plan and may activate it.
• Resolution: The PRA and SRU would undertake a joint review of the firm’s resolution plan in order to identify and initiate any necessary contingency planning, including information required, for resolution. The FSCS would evaluate the quality of data provided to support a single customer view and any obstacles to payout or deposit transfer.

3 – Material risk to viability of firm

Significant threats to a firm’s financial safety or soundness may have been identified. In this case:

• Recovery: The PRA may require a change to management and/or the board; limits on capital distribution; restrictions on existing or planned business activities; a limit on balance sheet growth and/or stricter leverage limits; and setting tighter liquidity guidelines and/or capital requirements. The firm would be required to draw on the menu of options set out in its recovery plan as appropriate.
• Resolution: The SRU would intensify engagement on contingency planning for resolution.

4 – Imminent risk to viability of firm

The PRA assesses there is a real risk the firm will fail to meet requirements for ongoing authorisation but some possibility of corrective action remains. In this case:

• Recovery: The PRA would review the key deficiencies identified and the scale of the recovery needed including in relation to liquidity and capital. Actions initiated following activation of the recovery plan, including on asset disposal (or sale of firm) would need to be completed.
• Resolution: The SRU and FSCS would confirm that all necessary actions to prepare for the resolution of the firm had been taken, including that relevant data were readily available.

Stage 5 – Resolution / winding-up under way

The PRA would trigger the special resolution regime and the SRU would oversee its resolution or winding up. The FSCS might need to effect depositor payout or fund deposit transfer or resolution.

The PRA will have a variety of supervisory tools available to it, including analysis of information provided by firms and in the public domain; meeting with firms; conducting inspections, on-site testing and stress testing; and liaising with firms’ external auditors and the FCA. The level of “core” supervisory activity it will engage in with a firm will be proportionate to the firm’s category; however, it will have discretion to carry out additional work beyond the core where there are particular areas of concern.

Enforcement

Where firms do not comply with the PRA’s policies, or its directions or restrictions, the PRA will have the power to impose financial penalties or publicly censure firms. However, the PRA plans to focus on resolving issues ‘ex ante’ through remedial action; this policy would mean that PRA enforcement action against firms was rare, although the PRA may still take enforcement action against individuals (see below).

The PRA’s approach to risk management and mitigation

The PRA has proposed a risk framework taking in a firm’s potential impact on financial stability, the business context and risks it faces, and its mitigating factors (including its management and governance, its capital and liquidity, and its resolvability). It will expect higher standards of mitigation from firms that pose a greater risk to the stability of the financial system and will, where possible, take a holistic view of a firm’s risk mitigation, although firms must meet a minimum level of mitigation across all areas.

The PRA’s assessment of risk will take into account the substitutability of the firm’s services and the wider external context in which it operates including system-wide risks (e.g. excess credit growth) and sector-specific risks. It will also use business model analysis to identify the sustainability and vulnerabilities in a firm’s business model and the level of detail of this analysis will be proportionate to the risk the firm poses to the stability of the system. The analysis will be used to project the firm’s future returns and risk profile, and will allow the PRA to assess whether the firm’s mitigation strategies are adequate. Notably, the PRA will have the power to require a firm to change its business model where risk is not appropriately mitigated.

Management and Governance

Each firm’s board and management will be expected to manage the firm prudently, which will mean going beyond the letter of the PRA’s policies and requirements and beyond the core responsibilities for all boards and management. This will encompass the firm’s working culture, the competency of the board and management, and structure and accountability. The firm itself must satisfy the requirement to be ‘fit and proper’, and in reaching this judgement the PRA will take into account the firm’s record as well as those of its directors and managers.

A firm’s board will be responsible for embedding the principle of safety and soundness into its working culture, and all individuals must take responsibility for acting consistently with this principle. In particular, firms will be expected to implement remuneration and incentive structures which minimise incentives for excessive risk-taking and promote prudent management. Boards will also be responsible for ensuring that business is conducted prudently, and will not be able to delegate this responsibility.

Where there are unregulated entities within the group, the PRA will expect all boards to have regard to its objective and where the most senior legal entity is not authorised the PRA will expect to be in regular contact with its board and senior management.

Approved Persons

The PRA will have discretion to require individuals to seek PRA approval before they take up any role which it designates as a Significant Influence Function (including the Chair, CEO, Finance Director and extending to any other role considered significant in the context of the PRA’s supervision of the firm). The PRA and FCA will then both need to give approval before the individual can take up their position. The PRA may interview these individuals to assess their technical experience and understanding of the firm’s potential impact on the financial system.

In addition to its disciplinary powers against firms, the PRA will have disciplinary powers over individuals holding Significant Influence Functions and, should they breach the code of practice for Approved Persons, it will have the ability to impose financial penalties and non-financial sanctions of public censure, withdrawal of approval and prohibiting the individual from holding future Significant Influence Functions.

Risk management and controls

Firms will be expected to have frameworks for risk management which are proportionate to the nature and size of their business and to have appropriate control functions to oversee these frameworks.

In particular, firms will be expected to articulate their risk appetite, which should be in line with the PRA’s objective, and to operate within this appetite. Risk decisions should be escalated to the appropriate level. The PRA will also expect boards and management to understand the circumstances in which their firm could fail.

Capital

The PRA will expect firms to maintain adequate capital resources which are consistent with the firm’s safety and soundness. The PRA will specify a minimum amount of capital for deposit-takers to hold, which will be comprised of three pillars (see Figure 3); however, this does not detract from firms’ ultimate responsibility for prudently assessing their own capital position. All deposit-takers will be expected to develop frameworks for stress testing and recovery plans to address capital shortfalls, and the PRA will assess the adequacy of these.

The PRA is “sceptical” about the use of internal models to calculate a firm’s Pillar 1 requirements, considering that firms are incentivised to game outcomes by “masking the inherent riskiness of activities”. The PRA will therefore expect any internal models to be “appropriately conservative” and, where it considers that this is not the case, will be able to take action including adjustments to methodology or imposing capital floors. The use of internal models will require prior approval from the PRA.

Figure 3 – Framework for determining regulatory capital

The PRA will determine a minimum regulatory capital level for all deposit-takers, comprised of three parts (expressed under the Basel/CAD risk-weighted framework and to be revised when CAD IV is implemented, for example to take account of G-SIFI requirements):

• Pillar 1 –requirements to protect against credit, market and operation risk, based on internationally agreed methods of calculation
• Pillar 2A – requirements advised by the PRA to reflect estimates of risk not fully addressed by the international standards for Pillar 1 and estimates of the capital required to compensate for deficiencies in other areas of risk mitigation e.g. management and governance
• Pillar 2B – the ‘Capital Planning Buffer’ advised by the PRA, reflecting the capital required to ensure that the minimum level of regulatory capital can be maintained in stressed scenarios

The PRA will expect firms to hold a significant part of their capital as reserves and ordinary shares, and will expect firms to “refrain from innovation” in structuring new capital instruments to meet their regulatory requirements where these are less effective in absorbing loss.

Liquidity

The PRA will expect firms to take responsibility for ensuring they can meet their liabilities, but will specify an appropriate amount of liquidity. In particular, firms will be required to maintain a prudent maturity-mismatch profile, to maintain diverse funding sources and to hold a buffer of unencumbered assets that can be reliably traded in stressed situations. The PRA will regularly review a firm’s liquidity position and its liquidity risk management framework, and will issue it with guidance as to the size and composition of its liquidity buffer.

Resolvability

The PRA will evaluate firms’ resolvability (i.e. the extent to which a firm can fail in a controlled manner) and will expect firms to provide the information required to make this assessment. Deposit-takers will be required to have the capability to produce a “single customer view”, being a snapshot of each depositor’s funds, within a target of seven days (for the majority of customers).

Where the PRA identifies significant barriers to resolvability, it will expect firms to implement appropriate changes to remove these, “in the spirit as well as to the letter”. These resolvability requirements do not apply to credit unions, although they are expected to meet the requirements for a “single customer view”.