Key messages for banks: PRA Annual Report and Accounts 2015

Generally speaking, the publication of a regulator’s annual report and accounts is often not met with much excitement by the regulated community. However, among their numerous pages annual reports often contain useful nuggets of information which can be overlooked which give helpful insight into what the regulator is thinking.

On 15 June 2015, the PRA published its Annual Report and Accounts 2015 and the following sets out some of the key messages that bank’s should bear in mind. It is worth noting that the report comes at a time when bank governance is also back on the agenda, as demonstrated by the PRA’s May consultation paper on Bank board responsibilities entitled “Corporate Governance: Board Responsibilities” and the updated “Corporate governance principles for banks” issued by the Basel Committee on Banking Supervision in July.

In Andrew Bailey’s (Deputy Governor, Bank of England and CEO, PRA) foreword it is mentioned that the largest single initiative for the PRA is not bank related but instead concerns insurance firms and the finalisation and implementation of the EU Solvency II Directive. This may be surprising to some given that we have become accustomed to banking reform dominating the regulatory reform agenda. Arguably it illustrates that we have entered into a new phase of the regulatory reform agenda for banks where the focus is not on the creation of new requirements but on implementation. This sentiment is echoed in Mr Bailey’s foreword where he says that for banks “we continue to work on the implementation of the EU Capital Requirements Directive [IV] which puts Basel III into place in Europe, on changes to our so-called Pillar 2 capital requirements, on depositor protection policy, and the new liquidity ratios. Looking forward, the major task is to introduce the ring-fencing arrangements for the large UK banks.”

A key principle underlying the PRA’s approach to supervision is that it does not operate a “zero failure” regime. Instead it seeks to ensure that where a PRA regulated firm fails it does so in a way that avoids significant disruption to the supply of critical financial services. This approach supports the PRA’s general objective which is to promote the safety and soundness of PRA authorised institutions by, among other things, seeking to minimise the failure that such an institution could be expected to have on the stability of the UK financial system. In addition, it is worth remembering that the PRA has powers to require institutions to address impediments to resolvability. The PRA’s approach to banking supervision explicitly states that the PRA may require institutions to take action, including restructuring, to improve feasibility of orderly resolution.

Over the course of this year, the PRA will review and progress banks’ ring-fencing plans to ensure that both the ring-fenced and non-ring-fenced entities have viable and sustainable business models, and banks’ plans are consistent with the objectives of ring-fencing. The new senior management regime is another important component of the PRA’s work and it expects to finalise and publish rules over the course of this year ahead of the new regime coming into force in March 2016. The implementation of the Bank Recovery and Resolution Directive into the PRA’s continuous supervisory programme is another important step for the PRA. This year the PRA intends to review and progress banks’ recovery plans to ensure that these are feasible.

In addition, earlier this year the Financial Policy Committee (FPC) was granted direction powers over the leverage ratio. The FPC has stated that it intends to implement the minimum leverage ratio requirements for the major UK banks and building societies as soon as practicable. Following direction by the FPC, the PRA expects to implement the transitional UK leverage ratio framework that the FPC set in its recent leverage review. In that review, the FPC proposed a minimum leverage ratio requirement of 3% on major domestic UK banks and building societies along with supplementary and countercyclical leverage ratio buffers. The PRA is working towards implementing the leverage ratio requirements by the end of this year.

This year will also see the introduction of the CRD IV’s liquidity coverage ratio (LCR). The LCR will apply from October 2015, at which point the PRA’s restated approach to regulating liquidity (see consultation paper 27/14) and associated draft supervisory statement will apply. Once the LCR has been introduced the PRA will begin to revise, in 2016, its overall approach to assessing liquidity risk around the new standard.

From 2016, the Bank of England, as the UK’s resolution authority, in consultation with the PRA will need to set a ‘Minimum Requirement for own funds’ (MREL) for each UK bank, building society and investment firm. MREL will be set for each firm, with MREL for UK global-systemically important banks being set in a way that will be consistent with the Financial Stability Board’s standard on “total loss absorbing capacity” which is due to be finalised later this year.

The Annual Report lists some of the key elements of the international regulatory agenda for the next few years. For banks the Basel Committee on Banking Supervision is reviewing the measurement of risk in the capital framework. Key elements of this work are: (i) calibration of leverage ratio requirements alongside risk-weighted capital requirements; (ii) review of the role of internal models in the capital framework; (iii) revised standardised requirements for credit and operational risk; (iv) completion of the Fundamental Review of the Trading Book; (v) the treatment of sovereign risk; and (vi) the development of criteria for simple, transparent and comparable securitisation and their incorporation into the capital framework.

The PRA reports that in 2014/15 section 166 of the Financial Services and Markets Act 2000 was used by the PRA in 42 cases (compared to 33 in 2013/14). The reviews this year focused on governance, controls and risk management frameworks 23 (18 in 2013/14), data and IT infrastructure 2 (2 in 2013/14), prudential (capital adequacy) – deposit takers and recognised clearing houses 6 (5 in 2013/14) and prudential (capital adequacy) – insurance 11 (8 in 2013/14). It will be interesting to see what happens to the figure for governance, controls and risk management frameworks once the new senior managers’ regime is implemented.

The Annual Report notes that almost half of UK banking sector assets are in entities owned by overseas parent groups, which operate either using UK subsidiaries or as branches in the UK. There are over 50 different overseas jurisdictions that have banks operating in the UK and many UK banks operate internationally. The PRA supervises firms which operate in the UK, but it does not consider them in isolation. The overall group to which the bank belongs is also considered.

A major development for the PRA over the past year has been the publication of its approach to the supervision of branches of overseas banks. In particular this document describes the PRA’s risk appetite for branches of non-EEA banks and its approach to how and when it can place reliance upon the home state regulator. It might be worth remembering that in this document the PRA stated that it would be content for non-EEA branches to undertake retail banking activities beyond specified de minimis levels only if there was a very high level of assurance from the home state supervisor over resolution. The PRA also added that it expects new non-EEA branches to focus on wholesale banking and to do so at a level that is not critical to the UK economy (i.e. an interruption to the provision of service would not cause financial instability in the UK). The PRA states that over the coming year it will seek to ensure that its branch strategy is either implemented or that there is a plan for implementation in key jurisdictions.