Harrowing the ploughed field: addressing capital requirements in UK banking

05 April 2017

How regulators will address capital requirements as they seek to promote competition in UK banking

Full marks to the Prudential Regulation Authority (PRA) for immediacy of response. PwC’s John Lyons, the first speaker at a recent BBA-PwC event, raised the extent of divergence between the capital requirements under the standardised and the Internal Ratings Based (IRB) approaches for credit risk and its potential impact on competition. The second speaker, Martin Stewart, PRA’s Director of Banks, Building Societies and Credit Unions, detailed some of the work already done to bridge these divergences and outlined how the PRA hopes to respond to these concerns.

PwC’s latest research, based on interviews with more than 25 CEOs of so-called challenger banks, had indeed identified capital requirements as a key issue for many such banks. The different capital requirements applied to banks and building societies (henceforth referred to as ‘firms’) with IRB status compared to those that follow the Standardised Approach (SA) is seen as creating an uneven playing field which favours the larger players in the market who have the resources and data to gain IRB approval.

Martin went on to explain that whilst there is a distinction between IRB and SA firms’ capital requirements, the unlevel playing field isn’t as skewed against them as is often claimed. Some aspects favour IRB firms, while others help their SA rivals. To reinforce this point, Martin touched upon the potentially constraining nature of the Leverage Ratio (‘LR’) and the additional capital buffers some of the larger firms may be subject to.

For this reason, he describes the PRA’s challenge as “harrowing the ploughed field” – that is, to smooth out the ridges and furrows created by the differing requirements on IRB and SA banks. The regulator now intends to pursue this goal with three different initiatives:

1.  Working with the Basel Committee to create greater risk sensitivity in the standardised capital approach

The PRA and the Bank of England continue to be actively engaged in the Basel Committee’s work to potentially revise the capital rules for credit risk, including adjustments to both the standardised and IRB approaches. Their primary areas of focus are around pushing for greater risk sensitivity in the standardised approach together with potential constraints on outputs of IRB capital models. The revisions, first announced in December 2014, were due to be finalised by the end of 2016, but discussions are ongoing.

 Martin did not share the view that the proposed reforms to the capital rules amount to the launch of “Basel IV”, and instead saw these reforms as the PRA’s way of continuing reforms set out under the objectives of the Basel III regime.

2.  Refining the PRA’s Pillar 2A capital framework for SA banks and building societies

The PRA launched a consultation on potential refinements to the Pillar 2A capital framework in late February within which they outline proposals to address the following 2 key areas:

  • The lack of risk sensitivity in the current standardised risk weights. The PRA is concerned that the lack of sensitivity combined with a mechanistic approach to calculating capital requirements under Pillar 2, could result in SA firms being forced to hold inappropriately large amounts of regulatory capital (hence potentially contributing to “the ploughed field”).
  • The introduction of new accounting standard for impairments, IFRS 9, from 1st January 2018. The PRA believes that the introduction of IFRS 9 could impact a firm’s capital requirements in such a way as to further the divergence between the standardised and IRB approaches.

During his presentation at the BBA conference, Martin explained how the regulator hopes to counter these problems by offering firms the opportunity to deviate from the mechanistic calculation of Pillar 2 capital, by considering firms’ business models and the IRB benchmarks for individual asset classes. These benchmarks are derived from UK firms currently deploying IRB models and the PRA expects to update these annually. In certain circumstances, SA banks will be able to use these benchmarks to perform their assessments under Pillar 2, which could lead to them concluding that they need to hold less capital under Pillar 2. The PRA will need to consider whether use of the benchmarks is appropriate in each separate case.

 Interestingly, Martin described this area of consultation as a reflection of the PRA focus on firms assessing their capital adequacy at the aggregate level. The manner in which the PRA expects SA firms to benefit from this consultation is two-fold: (1) the assessment for Pillar 2A will be performed at the aggregate portfolio level, i.e. conservative estimates of capital in one asset class may be used to compensate for a shortfall in another segment; and (2) a separate IRB benchmark to account for the impact of IFRS 9 and the possibility that SA risk-weights may consider both expected and unexpected losses in the credit risk framework.

 3.  Reforming the application process for those firms wanting to move from SA to IRB status

The third initiative under the PRA’s approach to “harrowing the ploughed field” is a direct response to the calls to consider proportionality within the requirements for IRB accreditation for smaller firms. The PRA believes that clearer communication and understanding of both the IRB requirements and the PRA’s expectations for a successful application will help provide more support to firms looking to making the transition from SA to IRB status.

 Again, at the conference, Martin re-affirmed the PRA view that the IRB journey is not designed, nor intended, to be an easy one and represents a significant step for firms of any size which would bring with it substantial investment in form of costs, time and resources. However, Martin did go on to state that this third initiative set out the regulator’s commitment to work more closely with firms during the pre-application process, setting out more extensive information on its expectations and engaging with such firms directly. The PRA will also reform its application review process, making the IRB application process more modular - 10 distinct modules have been proposed - so firms know where they stand in the process.

 On a more detailed topic, PRA intends to provide greater clarity specifically on the “data conundrum” for firms that find it difficult to build up the data required for IRB models. This is likely to take the form of a consultation on how external data might be used to augment a firm’s internally available data resources.

So, what does this all mean? Taken together, these three initiatives confirm that the PRA acknowledges the issues cited by CEOs in PwC’s research – and that it takes them seriously. Even though the detail of its response is subject to further announcements and consultation, this is a welcome stance and reflects the PRA’s desire to level out the playing field. As Martin pointed out, while the PRA’s primary objective is to maintain the safety and soundness of regulated firms, it also has a secondary objective “to facilitate effective competition”. To resolve the challenges cited by CEOs of firms that can provide such competition would be a crucial step forward for the UK banking market.

 

To find out more please read our report: Who are you calling a ‘challenger bank’?  and John Lyon's takeaways from the BBA-PwC conference. 

David Kenmir: View David Kenmir's profile on LinkedIn   

Rishi Patel: View Rishi Patel's profile on LinkedIn   

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