Brexit: Firms should reflect BoE’s proposals in ICAAPs and ILAAPs
28 November 2018
As firms prepare for Brexit, they should take into account the consultation papers published by the Bank of England (BoE) on 25 October 2018 in their ongoing internal capital adequacy assessment process (ICAAP) and internal liquidity adequacy assessment process (ILAAP) preparations.
While the BoE’s proposals are not intended to make any substantive policy changes, some of them may represent a significant change in regulatory approach which may have a capital and/or liquidity impact for some firms.
As we discuss in our recent Hot Topic on the BoE's approach to a no-deal Brexit, the BoE’s proposed changes focus on ensuring that there is a functioning legal framework for financial regulation on 29 March 2019 (‘exit day’). They set out the BoE’s proposed approach to on-shoring EU regulation and changes to existing BoE rules in the event that the UK leaves the EU without a transitional period (‘no deal’).
Despite the agreement between the UK and EU-27 on a draft Withdrawal Agreement there is currently no certainty that it will come in force. So firms should take into account these proposals and reflect any potential impacts in their ongoing ICAAP and ILAAP preparations to ensure that they are in the best position on exit day.
Given the PRA now considers Pillar 2A as a requirement rather than guidance, firms are expected to take an even more prudent and forward-looking approach in their own assessments of capital adequacy. So, as firms develop forward-looking adverse scenarios within their ICAAP, they should explore the potential balance sheet and business model impact of the BoE’s legislative proposals along with any other broader Brexit-related macroeconomic scenarios in their stress scenarios.
The BoE’s proposals contain important changes including ending the preferential treatment of EU-27 exposures and assets for the purposes of bank capital and liquidity requirements and aligning these with the treatment of third country firms and assets. This has implications for UK banks, given the preferential risk weighted assets treatment of exposures to EU-27 assets and the treatment of EU sovereign debt under the liquidity coverage ratio. Firms should incorporate this in their stress testing and scenario analysis not only to assess capital and liquidity needs, but also to decide what risk mitigating management actions should be put in place.
The BoE is also proposing that EEA government debt securities and other EU issued instruments would cease to be automatically eligible as collateral on the same basis as UK Government equivalent instruments. As the EEA assets will be treated as third country assets and will only qualify as collateral if they meet certain credit quality requirements, some firms may see adverse impacts on their margin requirements, bilateral agreements, operational or financial arrangements, or cross-border agreements. While firms take these impacts into account they should particularly reflect any potential cost implications in their ICAAP and ILAAP scenarios.
Another potential change that firms should consider reflecting in their ILAAP is the BoE’s proposal to remove the deposits held by UK firms’ branches in the EEA from the scope of the Financial Services Compensation Scheme after exit day. Given this change might impact the classification of deposits in the LCR and the associated outflow rates, firms should explore deposit insurance coverage post exit and take into account any potential implications on their liquidity planning.
Changes in consolidation rules should also be considered in ICAAPs and ILAAPs. For instance, the BoE proposes that where capital or liquidity consolidation was only required at the EEA level previously, this would now be required at the UK level. Firms should ensure that the arrangements implemented and the capital held provide sound management and adequate coverage of risks to which the firm may become exposed due to Brexit over a planning horizon. And this should be mirrored in the ILAAP for liquidity risk and liquidity held. In line with the PRA’s expectations, they should include any management actions that they plan to take to mitigate the adverse effects of the BoE’s proposals in sufficient detail.
In recognition of the potentially significant impact of these proposed changes, the BoE suggests a phase-in period of up to two years for some of the changes. This may give some firms comfort that they will have until March 2021 to comply with some of the amended requirements. But, the phase-in doesn’t apply to all changes and the PRA’s has an explicit requirement that firms should project their capital resources and capital requirements over a three to five year horizon in their ICAAPs. So, firms would be well advised to incorporate the changes into their current scenario analyses now and think about any mitigating management actions.