Prudential Regulation Update – new model requirements for stress testing
Is AI ready to fulfil its potential in credit scoring?
Prudential Regulation Update – a regular view on new developments
26 April 2018
Prudential regulation is changing. Its complex nature means that updates to existing guidelines and new principles are constantly being developed. All regulated firms face the challenge of understanding these developments in the context of their own business model, and to implement them in a timely manner.
In this blog, we explore some recent developments in prudential regulation and supervision that may impact UK lenders:
- 2018 stress testing – new approaches and expectations around 2018 scenario setting
- Credit risk mitigation – stricter rules regarding the positioning of guarantees
- Non-performing loans – introduction to minimum coverage requirements
2018 Stress Testing
In March, the Bank of England (BoE) released scenarios for banks and building societies to perform stress testing in 2018. This included the scenario for the concurrent stress testing exercise for the seven largest UK firms, and the Internal Capital Adequacy Assessment Process (ICAAP) scenario for all other Prudential Regulation Authority (PRA) regulated firms.
The concurrent scenario is similar to the 2017 scenario as it tests the resilience of the UK banking system to deep simultaneous recessions in the UK and global economies, large falls in asset prices and a separate stress of misconduct costs. Repeating the same scenario is a different approach to prior years. The BoE has previously looked to test a different element of UK systemic risk each year. A major factor in the decision in 2018 is so firms can demonstrate the impact of IFRS 9 on expected credit losses under similar stressed conditions.
The ICAAP scenario is for firms not participating in the concurrent activity. This scenario is designed to act as a benchmark for firms to produce their own scenarios to stress their balance sheets as part of an Internal Capital Adequacy Assessment Process (ICAAP) submission. In a departure from previous years, the BoE provides two separate scenarios, one with high-interest rates, one with low-interest rates. The firm must choose which is most challenging in relation to their risk drivers and to their balance sheet. A full scenario or range of scenarios must be produced around this benchmark.
The ICAAP scenario is a challenge for firms given the limited number of variables provided and the lack of any commentary that might suggest causes of the downturn. Also, there is no corresponding base case provided. The challenge to smaller firms is to provide specialist application to construct a coherent scenario from such a limited starting point.
However, the purpose of the activities must be considered. The concurrent scenario assesses structural risk in the UK market. Examining the largest firms on an equivalent basis is a powerful tool for a regulator to assess respective resilience to stress and impact on the wider economy in the event of a severe downturn. The smaller firms are not examined through the same lens given their relative influence on financial stability. Instead, this is another measure the regulator can use to make firms demonstrate they understand the key risk drivers in their business. Getting the scenario right is a key driver of a firm’s individual capital requirement.
Credit Risk Mitigation – Unfunded Credit Protection
In February the Prudential Regulation Authority (PRA) released a consultation paper (cp6/18) that proposed clarification and enhancements to be made to ss17/13 – Credit Risk Mitigation (CRM). The changes relate to the use of a guarantee as a form of unfunded credit protection. The credit risk on the firm’s exposure is reduced due to the obligation of a third party to pay if the borrower falls into default.
The paper clarifies the PRA’s expectations as to what a firm must do to meet the strict requirements in chapter four of CRR to qualify for mitigating credit risk. The purpose is to ensure that capital relief is only achieved where the risk has been sufficiently transferred to the guarantor. In summary, the PRA propose that guarantees must be:
- Legally effective and enforceable
- Clearly defined and incontrovertible
- Without any clauses that will render the guarantee ineligible for CRM
- Be set up to pay out in a timely manner
The framework for CRM has also been assessed by the European Banking Authority (EBA) report on credit risk mitigation framework issued in March 2018. The report examines the provision of techniques, eligibility and methods of mitigation available under each approach to credit risk measurement. Particularly pertinent to the PRA paper is the EBA’s overview of the substitution approach for unfunded credit protect which expands on the description provided in chapter four of CRR.
The enhanced guidance provides an opportunity for firms to examine whether unfunded credit protection is a viable method for reducing capital requirements. There will be an element of retrospective assessment by those firms already benefiting from protection to ensure they meet the newer conditions.
While the papers appear to make the eligibility criteria more stringent, the clarifications mean firms are more easily able to assess whether or not they can benefit from protection without the need for as much regulatory intervention. Underwriters and Credit Risk decision makers will now be able to more accurately consider credit protection when assessing the commercial viability of a loan.
Management of non-performing and forborne exposures
In March 2018 the EBA released Draft Guidelines on management of non-performing and forborne exposures. These guidelines are designed to reduce the build-up of non-performing exposures (NPEs) on the balance sheet of firms, and so that supervisors provide suitable guidance to ensure firms effectively manage forborne exposures (FBEs) and NPEs. The guidelines also focus on the necessity of treating customers fairly at every stage of a loan’s lifecycle.
The guidelines propose measures to ensure that firms have a robust strategy in place to manage NPEs and FBEs, both on an ongoing basis and through a proportional reduction over time. A firm’s governance should cover both their operational requirements and responsibilities to their customers. Forbearance measures should only be considered in situations where sustainable payments can be restored. Policies for estimating future cash-flows, valuation of collateral and for ensuring timely write-offs are also proposed.
The EBA also published a report on the impact of statutory backstops. The backstops were proposed by the European Commission in November 2017 to strengthen the requirement on firms to plan for the emergence of non-performing loans (NPLs). Supervisory intervention is currently necessary through setting pillar 2 capital requirements, these proposals look to make the pillar 1 requirements more consistent by introducing regulatory minima. The aim is to reduce systemic risk through introduction of a minimum coverage requirement for non-performing exposures. If the minimum coverage is not met, a regulatory deduction from Common Equity Tier 1 (CET1) capital is made. As a prudential requirement, this would not impact P&L (neither income nor equity are impacted as in the case of provisioning) but would still impact regulatory measures of capital adequacy.
The EBAs assessment was performed using prudent assumptions and assessed the impact backstops would have on current pillar 1 requirements, pillar 2 assessments and the relationship with IFRS 9 provisioning. They summarise that the proposals would produce a strategic change to firms provisioning practices in line with the desired effect of the proposals. Financially the aggregate impact was estimated to be 56bps to CET1 ratios over a seven-year period, by which time banks and regulators would be able to fully adapt to the changes. Those firms with already conservative provisioning practices would not see any impact.
For more information or advice on any of the three hot topics raised in this regulatory round-up, please email [email protected].