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Dean  Mitchell, Regulatory Risk Practice Director

The author

Dean Mitchell

Regulatory Risk Practice Director

These new arrangements are of particular interest to banks who are currently applying for authorisation as a deposit taker, or banks that have been authorised in the last several years (less than 5 years). That statement also serves as a useful reminder of a wide range of prudential risk requirements.

This briefing note summarises the Supervisory Statement and discusses the main changes announced.

Background to changes

Competition from new entrants, in the UK banking sector is a relatively new phenomenon, with the advent of neo banks only starting to materialise after the 2008/9 financial crises.  In 2013, to support increased competition in the UK Banking sector, the Bank of England published a report outlining changes they would introduce to support new banking entrants. 

While the changes, such as dedicating additional support to new banks and allowing banks to be authorised with perhaps some restrictions (referred to as mobilisation), have been broadly welcomed, there remained discussions within the sector on the practicality of the 2013 changes. 

The recent changes, outlined in SS3/21, go further and provide a degree of proportionality for new banks, allowing them the ability to develop and mature their risk management framework as their business transitions from business planning stage onto operational stage and finally to a mature organisation.

Summary of new requirements

The PRA has recognised seven areas – Business Model, Governance, Risk Management, Capital, Liquidity, Operational Resilience and Recovery & Resolvability - where new or smaller banks have to some extent struggled to meet all of the expectations of an established bank.  The PRA have summarised their expectations of new/smaller banks across 3 transition periods, 0 to 3 years, 3 to 5 years and 5 plus years. After each tranistion period, the banks are expected to reach a new level of maturity for each area.  The following table, reproduced from the Supervisor Statement, summarises the transition phases.

 

 

Year 0

Year 3

Year 5

Business model

  • Untested business model
  • Most banks loss-making
  • Business model refined based on experience.
  • Forecasts are more accurate.
  • Credible strategy to achieve profitability
  • Settled business model
  • Either profitable or a creditable strategy to achieve profitability with definite capital support to achieve that
  • Realistic forecasts
 

Governance

  • Appropriate number of independent non-executive directors. Established good practice is at least two.
  • Chair must not perform an executive function and there is a strong expectation that they should be independent
 
  • Appropriate number of independent non-executive directors. Established good practice is at least three, including the chair.
 
  • Appropriate number of independent non-executive directors. Established good practice is at least a majority board.

Risk Management

  • Framework and policies in place
  • Untested as firm has not yet operated as a bank
 
  • Bank is testing and refining framework and policies in light of experience.
  • Risk management is fit for purpose, with a focus on developing risk management and controls for the most material risks
 
  • Mature control environment
  • Fully embedded risk management framework linked into stable business model
  • Framework provides forward looking view across all risk types
  • Continuous improvement to ensure framework remains fit for purpose given business and regulatory developments

Capital

  • PRA buffer set on new bank basis (six months forward operating expenses)
  • In addition to buffers, hold enough capital to meet business plan while remaining above buffers for 12 months
  • Internal Capital Adequacy Assessment Process (ICAAP) meets minimum standards but untested, and is fit for purpose
 
  • PRA buffer set on new bank basis (6 months forward operating expenses)
  • Undertaking advanced stress testing and a clear plan for transitioning to stress test buffer
  • Forward looking view of capital to ensure buffers are not used in the usual course of business
  • ICAAP meets minimum standards and is fit for purpose
 
  • PRA buffer set on stress test basis
  • Sophisticated capital management with credible capital models
  • ICAAP is a robust document which is an integral part of the firm’s management process and decision making

Liquidity

  • Internal Liquidity Adequacy Assessment Process (ILAAP) meets minimum standards but untested, and is fit for purpose
 
  • ILAAP meets minimum standards and is fit for purpose.
 
  • ILAAP is a robust document which is an integral part of the firm’s management process and decision making.

Operational Resilience

  • Design operational resilience into business processes and controls from the outset, and follow all relevant policies.

Recovery and Resolvability

  • Credible recovery plans in place – sufficiently detailed and practical to ensure they reflect the complexity and size of the firm and would be useable in a stress.
  • Board approved SWD plan in place (while bank is on the new bank buffer approach)
  • Undertake a forward-looking realistic assessment of how its preparations for resolution would enable the bank to achieve the outcomes for resolvability.
  • Meet the PRA rules on depositor protection

Understanding the changes

These changes are relevant for small and growing UK registered banks or institutions who are currently in the process of obtaining a banking license. By issuing the Supervisory Statement the PRA have acknowledged two important factors.  In the first instance they have acknowledged that new and growing banks may not retain the experience and resources that perhaps a more mature bank has developed, and secondly, and perhaps the most important acknowledgment, is that they will measure new banks against a slightly different criteria than established banks. 

Interestingly, the PRA’s expectations for two of the areas, Operational Resilience and Recovery and Resolvability, are not afforded any time to mature and develop and organisations must meet the minimum requirements from the very start.  There is some acknowledgement that smaller banks will have fewer options when it comes to recovery or resolvability and that in all cases a bank must ensure that they can execute a SWD (Solvent Wind Down). This approach not only reflects the importance the PRA places on these areas but also recognises that with increased competition comes an increased chance that a new banks business model may not be sufficiently robust enough to remain sustainable in the longer term and that wind downs or insolvencies are possible.

Of the remaining five areas outlined in the statement, two are of particular interest – Governance and Capital Expectations.

Governance

The PRA view poor governance as a leading indicator for possible financial sector failings.  In a new organisation the Board has a pivotal role in ensuring the bank is sustainable and the Board is expected  to identify weaknesses in the operating model and implement decisions to remedy the shortcomings.

New organisations will often diverge from their original business plan, and it is important the Board is able to evolve as the business changes. For this reason, the PRA have stipulated that it is important the Chair of the Board does not also carry out an executive role within the organisation.  This division of duties, at the highest level of the organisation is seen as key to maintaining good governance.

Risk management controls in a new organisation are, understandably, often untested.  The PRA are therefore expecting that Boards focus on a continuous assessment of the risk management framework within the bank during the early years.  This testing and subsequent adjustments should be overseen by the Board, particularly as the organisation grows and evolves.

By year 5, the expected end of the transition period from new bank to established bank, the PRA is expecting to see proportionate but mature risk management frameworks.  Core processes such as Internal Capital Adequacy Assessment Process (ICAAP), Internal Liquidity Adequacy Assessment Process (ILLAP) and Recovery Plans should be fully developed in line with the business’s requirements.

In our experience as a consultancy firm, we regularly help new banks, pre or post authorisation, to address the expectations of the PRA with regard to Governance related matters. Oversight of ICAAP and ILAAP  processes  are a good example   where an outside assessment  is very helpful in resetting the nature and direction of the risk management framework.

Capital expectations

In a similar vein to Governance, the PRA views poor capital management as another key indicator for possible financial failure.    Naturally the PRA takes a very poor view of firmsfirms that fail to address capital requirements at an early enoughstage, often only after the firm has started to dip into their capital buffers.  Where this occurs it will always result in increased scrutiny by the PRA. The message from the PRA is very clear, organisations must hold sufficient capital in the early years, before the organisation becomes profitable, to ensure that sufficient capital remains in the business to absorb the loss-making years without using the capital buffers.

In 2013 the PRA simplified the way capital buffers were calculated for new banks by moving away from calculating stress test scenarios based on severe but plausible events, which often led to very high levels of capital buffer requirements, towards holding a capital buffer that is equal to the wind down costs of the bank. As banks often took different approaches to calculating wind down costs, this approach resulted in wide variations, and therefore the PRA have simplified the calculation again.

The capital Buffer is now to be set as the amount equal to six months of projected operating expenses.  This new approach is applicable to all banks that have been operating less than 5 years and have yet to reach profitability in an entire financial year.  Banks who adopt this method of calculation will need to prepare in advance for the transition to the more sophisticated way of calculating the PRA buffer through stress testing.  See figure below for a summary of the Capitals stack.

PRA buffer explanation

How can Jaywing help?

Jaywing specialise in assisting banks with implementing, practical, proportionate, and fit for purpose risk management frameworks. Our consultants, many of which have a blend of banking and consulting experience, assist banks at all stages of their organisational development, to refine and improve Governance, Capital & Liquidity Management and Stress Testing frameworks.  If you would like to speak to one of our experts please contact, Dean Mitchell, Regulatory Risk Practice Director. You can contact Dean at [email protected] or by calling 07825169633.