Refining the PRA s Pillar 2 capital framework

Transcription

1 A response by the British Bankers Association to the PRA s consultation paper CP3/17 on Refining the PRA s Pillar 2 capital framework May 2017 The BBA is the leading association for UK banking and financial services representing members on the full range of UK and international banking issues. We have over 200 banking members active in the UK, which are headquartered in 50 countries and have operations in 180 countries worldwide. Eighty per cent of global systemically important banks are members of the BBA, so as the representative of the world s largest international banking cluster the BBA is the voice of UK banking. All the major banking groups in the UK are members of our association as are large international EU banks, US and Canadian banks operating in the UK, as well as a range of other banks from Asia, including China, the Middle East, Africa and South America. The integrated nature of banking means that our members are engaged in activities ranging widely across the financial spectrum from deposit taking, mortgage lending and other more conventional forms of retail and commercial banking to products and services as diverse as trade and infrastructure finance, primary and secondary securities trading, insurance, investment banking and wealth management. Our members manage more than 7 trillion in UK banking assets, employ nearly half a million individuals nationally, contribute over 60 billion to the UK economy each year and lend over 150 billion to UK businesses. Introduction The BBA is pleased to respond to the Prudential Regulation Authority s (PRA) consultation paper on refining the PRA s Pillar 2 capital framework 1. All our members, small and large, are impacted by the welcome changes proposed in the consultation paper. Smaller banks may benefit as the proposals could smooth out the perceived un-level playing field between banks using the internal ratings based (IRB) approach to modelling credit risk capital requirements and those that calculate it using the standardised approach (SA). Our larger member banks may be impacted too as, although they may predominantly use IRB modelling, they will nonetheless have certain portfolios for which they have regulatory approval to continue using a SA to assess risk weighted assets (RWAs) and these portfolios will cause IFRS 9 based impacts to capital ratios. Key messages We support the objectives of the consultation BBA members all very much welcome the PRA s proposals as an important step in the right direction to refining its approach to the Pillar 2A capital framework. There is a general perception that banks 1 BBA01-# v4-draft_BBA_response_to_PRA_Pillar_2A_consultation.docx 31 May 2017

2 2 using the SA to calculate regulatory capital for credit risk, hold significantly more capital for certain portfolios, such as low loan to value (LTV) mortgages, compared to IRB banks. This potentially conflicts with the PRA s secondary objective to support competition in financial services because of the extra capital SA banks are conservatively required to hold. So we are delighted the PRA is taking steps to address the issue and is correcting the over-prudence of the SA by freeing-up capital which is being used ineffectively. This could be redeployed in lending to the UK s housing market, including first time buyers keen to get on the property ladder. We are unsure of the extent of the capital benefits for standardised banks The changes to the Pillar 2A regime will enable the BBA s specialist and challenger banks members to compete across a wider range of mortgages types. At present the SA regulatory capital framework tends to encourage SA banks to lend at higher LTV ratios due to the higher returns available for the same regulatory capital requirement as lower LTV mortgages. The proposals will rebalance the incentives somewhat to allow such banks to provide lower LTV mortgages. Depending on assumptions about the distribution of mortgage LTVs and the level of Pillar 2A add-on held, the multiples of capital held will fall from almost three times to a little over twice as much capital as an IRB bank would be required to hold, albeit that there is considerable variation in the range of banks risk weights under IRB for UK mortgages. Of course this reduction is welcome but IRB banks will still be able to lend in the mortgage market more capital-effectively than SA ones which comprise about 70% of all bank mortgage lending in the UK. However, we do recognise that the UK s largest banks also have to comply with G or D-SIB buffers, leverage ratio constraints and UK bank stress testing impacts. In our view it is likely that SA banks will continue to focus their lending on the higher LTV ranges where margins and returns on capital are higher, reflecting the perceived higher risk associated with higher LTV exposures. Pillar 1 remediation should remain a priority Even if the capital benefits are greater than we expect, there are disadvantages to this adjustment being made through Pillar 2A rather than Pillar 1 as this will not impact the CET 1 ratio, the primary measure against which banks are assessed. We recognise that the PRA cannot adjust Pillar 1 requirements determined under the current CRD IV capital regime, but we strongly encourage the PRA, along with the Bank of England, to ensure that a more risk sensitive SA is established by the Basel Committee on Banking Supervision (BCBS) as part of the finalisation of the Basel III framework. This is important both to exclusively SA banks and banks using a mixture of approaches, particularly if a capital floor based on the standardised approach does materialise, something our members continue to fundamentally disagree with. Only by refining Pillar 1 can a fairer, more level playing field, appropriate for the risks being borne be created. There are other regulatory impediments hindering standardised bank competiveness The PRA will be aware that higher capital requirements for SA banks will also have implications for minimum requirement for own funds and eligible liabilities (MREL) that they are required to hold. The Bank of England s approach to setting MREL requires banks that are subject to bail-in or partial transfer to hold MREL of up to twice their Pillar 1 plus Pillar 2A requirement, depending on the proportion of their business that would be transferred under the bank s particular resolution strategy.

3 3 During the transitional implementation stage from 2020 to 2022, MREL is to be established for such banks up to two times Pillar 1 plus one times Pillar 2A. As Pillar 1 represents a greater proportion of this total MREL requirement compared to the Capital requirement, the Pillar 2A reductions achieved under the consultation proposals will be less effective for MREL in offsetting excess Pillar 1 levels. Banks with between 40,000 to 80,000 transactional accounts would be considered as candidates for partial transfer which may, as business models evolve, catch an increasing number of banks, including those that are on the SA. As we noted in our response to the Bank of England s 2015 MREL consultation, we do not support a numerical threshold for partial transfer and recommend greater supervisory and resolution authority discretion. Indeed with seven day account switching in place it is debatable whether banks that are neither D-SIBs nor G-SIBs should hold any MREL at all. PD matters In order to fully understand the differences between SA and IRB risk weightings, tables 1 & 2 should be further enhanced by providing data on PD and LGD for the different asset classes, although we recognise that there will be challenges related to the distribution of individual exposures by bank within the average range of the total population of banks as well as the ratings philosophy adopted by individual banks. It would be very difficult for a SA bank to cross-refer to the RWA since its experience of LGD for each PD would be the real comparator. This would also allow for the better use of the PRA data to identify the correction to the Pillar 1 risk weight on an evidence-base more specific to the bank, enabling it to understand where it sits in the range of comparable IRB risk weights that have been provided by the PRA. Access to this data would also help banks to monitor their portfolios performances and better understand how internal models perform and how conservative they are before applying for IRB. To use the data points as a guideline for RWA calculation, a bank would need to take into account the position in the macroeconomic cycle and its likely effects. So clarity as to whether the data points are on a Point in Time (PiT) or Through the Cycle (TtC) downturn basis would be helpful. IFRS 9 We welcome the PRA s acknowledgement that the interactions between IFRS 9 expected credit losses and the SA are inappropriate and support its proposals to introduce a separate benchmark based on unexpected losses to remove expected loss from the calculation of average IRB risk weights. However, while we understand that the PRA s methodology of using IRB benchmarks cannot be easily adapted to apply to the full range of exposure types of IRB banks with international standardised portfolios, finding an analogous approach suitable in this situation is imperative. It cannot be correct to adjust for known errors in the capital framework only for a subset of banks. This issue will not be immaterial for IRB banks, given their significant use of the SA. We comment below on each of the three elements of CP3/17.

4 Adjustments to the PRA s Pillar 2A approach for firms using the SA for credit risk 4 We support the proposal that SA banks should be able to offset Pillar 2A capital against the more conservative Pillar 1 capital requirements when compared to IRB Pillar 1 requirements. Our expectation is that capital reductions on mortgages can be spread over all asset classes, if the mortgage assessment results in a negative Pillar 2A outcome, but we would appreciate the PRA confirming this. But as we note above it is not clear that the reduction in Pillar 2A capital will be substantial enough to fully rebalance the capital discrepancies between SA and IRB banks. We offer below a number of suggestions that could reduce the discrepancy. Recalibrating Pillar 1 matters CP 3/17 s proposals do not fundamentally alter a SA bank s RWAs but reduce the buffer above the Pillar 1 minimum. It is recognised that the current Pillar 1 calibrations for some asset classes are overly conservative so we fully support the current BCBS work to finalise the Basel III framework. We understand this will align more closely the RWAs calculated by the SA and IRB approaches for lower LTV mortgages, which we fully support. We know that the PRA and Bank of England have been strong proponents of this recalibration and encourage them to work with the BCBS secretariat to finalise the Basel III framework quickly, in order that banks can appropriately adjust their business models and engage with potential investors about appropriate levels of capital. We note however that BCBS proposals, as we currently understand them, in relation to lending to commercial real estate (CRE) development and buy-to-let (BTL) are likely to require additional levels of capital that are, in our view, not commensurate with the levels of risk associated with these asset classes. In addition, for the 80% - 90% prime mortgages LTV band the discrepancy between the upper range of the IRB benchmark and the proposed standardised risk weight will in fact increase. We look forward to engaging with the PRA about this concern should the BCBS s revised framework be unduly penal in light of the importance of CRE and BTL lending to increasing the supply of housing in the UK. Offsetting conservatism against all elements of Pillar 2A We believe the restriction on the components of Pillar 2A that can be offset may limit the benefit of the PRA s proposed approach, while also continuing the distortions in the mortgage market, particularly as any adjustment to Pillar 2A capital will be discretionary. Our position is that if a bank can demonstrate that there is an undue difference between the IRB and SA Pillar 1 capital requirements then the correcting adjustment should be made against the totality of the Pillar 2A buffer and any discretion should be suitably constrained. A discretionary approach provides insufficient opportunity for banks to challenge overly prudent capital determinations once their ICG has been set. For example, the current concentration risk approach provides clear guidance, setting a number of arguments that banks can make to seek to limit the concentration risk add-on, including that their credit risk Pillar 1 is over-stated compared to Pillar 2A. The experience of banks is that PRA does not always place reliance on these arguments, negating the value of the PRA s proposed approach.

5 5 The current approach to credit concentration referred to above treats banks with a UK based business model as being concentrated, (and limits diversification by excluding mortgages from the assessment of concentration) and does not attempt to reflect the diversification that exists across UK regions. These banks cannot offset credit risk components against the credit-related concentration risk add-on. This penalises banks with a simplified UK-only business models as the concentration risk add-on can comprise the majority of Pillar 2A so is the only meaningful Pillar 2A requirement against which conservatism in the SA Pillar 1 could be offset. So concentration risk should be available to offset against conservative Pillar 1 credit risks, particularly as the combination of the excessive concentration risk add-on, with lack of genuine offset, together with the capital conservation buffer and countercyclical capital buffer (when applied), means that their overall minimum capital requirements are significantly overstated compared to their risk profile. Could Pillar 2 capital increase? The stylised example below is based on a portfolio comprising equal amounts of mortgages and credit cards. It demonstrates that the PRA s approach will not generate an automatic decrease in P2 (as stated in Par 3.5/3.9) and even less so if the upper floor were to be applied. There is a need to ensure that this aligns with steady-state expected levels of Pillar 2A (2.4% Tier 1) stated by the FPC as being appropriate Tier 1 equity requirement for the banking system 2. SA IRB-Old IRB-New IRB-New (Average) (Average) (Upper) Mortgage Credit Card Pillar 2A proxy Replicating methodologies CP3/17 warns that a bank must not merely replicate the PRA methodologies as it must carry out its own assessment. However for smaller banks with more limited data or less detailed models for some portfolios, it is common to be guided by the PRA published methodologies. In the credit concentration risk assessment, Herfindahl-Hirschman index (HHI) benchmarks are considered as a basis of the internal assessment, even though for UK only banks the HHI methodology is not really appropriate as it produces a 100% weighting for such business models which is correspondingly heavily weighted for Pillar 2A purposes. An alternative could be to use the IRB benchmark risk weights for the HHI calculation for SA banks. Banks may now feel required to develop more sophisticated approaches, which would appear to be contrary to the welcome proportionate spirit of the consultation. We do not support such an outcome and would welcome an early statement from the PRA that this is not its expectation. 2.

6 6 Treatment of sovereigns We note footnote (b) of Table B states that SA risk weights would not apply to EU sovereign exposures, irrespective of their external credit rating or Credit Quality Step (CQS). Does this mean that no benchmarks should be applied for such exposures or should our members use the CQS1 benchmark? Revisions to the IRB benchmark Why use upper range? The PRA proposes that the starting point for assessments will be the upper range of IRB benchmarks, which may then be subject to reduction based on sound risk management practices. The PRA should reconsider its commitment to using the upper range as the starting point, which we do not support. In our view it would be more objective to begin with the mid-point, or alternatively and more accurately, a volume measure weighted by EaD. Potential additions or deductions in relation to the specificities of the bank s portfolio set would then be taken into account. As the example above demonstrates, using the upper limit would particularly disadvantage banks with large credit card portfolios. We note it is proposed that the extent of any reduction would be dependent on the PRA s assessment of the bank s risk management practices but would not expect there to be any overlap between this assessment and any risk management and governance scalar included in the PRA buffer. Such potential double counting should be avoided. Commercial Real Estate We believe the PRA should introduce more granularity into the tables, based on the slotting approach, to avoid over-conservatism which will in turn impact the availability of finance needed to overcome the current lack of supply in the UK housing market. We note that tables 1 and 2 do not incorporate the requirements in the EBA s final RTS on the slotting approach in relation to the development or acquisition of real estate, but instead uses, in our view, an unduly penal risk weight of 350%, or 250% after adjustment, for IFRS 9 effects. It would also be helpful to make a clear distinction between residential property development and commercial property development by splitting this category into its two component parts. As currently drafted, footnote (c) to Table A in Appendix 1 could be read as including residential development within the scope of commercial real estate development. We do not believe this is the intention given the different risk profiles of these two distinct portfolios. We would appreciate clarification of whether or not banks should present an analysis of their Commercial Real Estate (CRE) portfolio and slotting approach as part of its ICAAP. Our expectation is that the PRA would not require a SA bank to implement the slotting approach to perform the ICAAP and assess Pillar 2A and any offset.

7 7 We note that the PRA s approach to CRE will be dependent on the materiality of a banks CRE portfolio. It would be helpful to have more clarity about how materiality should be considered. Standardised and IRB risk weights are not comparable We believe the only way in which banks can truly compare SA and IRB risk weights, to identify margins of conservatism, is by decomposing risk weights into their component PD and LGDs, as a bank s experience of LGD for each PD would be the real comparator, although as we note above there would be challenges to be overcome in adopting this approach. This would also allow for the better use of the PRA data to identify the correction to the Pillar 1 risk weight on an evidence basis more specific to the bank and enable it to understand where it sits in the range of comparable IRB risk weights that have been provided by the PRA. Clarification as to whether the PD is on a PiT or TtC downturn basis is needed so that a bank could take into account the position in the macroeconomic cycle and its likely effects. Since some of our members are moving towards the IRB approach, it would be helpful to provide the PD and LGD used to calculate the upper limit RWA. This will help banks to monitor their portfolios performances and better understand how internal models perform and their conservativism before applying for IRB permission. We note that there is an inherent time-lag arising from the fact that 2015 data will be published at the end of 2017 to be used in banks 2018 SREPs. What about other asset classes? We hope that the PRA s welcome approach can in due course be applied to all asset classes such as auto loans and unsecured lending. For example, for unsecured lending the customer s debt to income at origination (DTI), and for commercial lending the debt service coverage ratio (DSCR) or the LTV could be a good indication of the risk. SME supporting factor There is no indication of how the SME discount should be applied. The table implies that under IRB the SME RWA is higher than the standardised, but we are not certain that this is the case. Should banks apply the SME discount over the IRB RWA? Again details of underlying PD and LGD would help understanding the benchmark. Additional considerations, as part of the SREP, for SA firms using IFRS as their accounting framework Double counting Under both SA and IRB approaches there is in our view an overlap with ECL methodologies. We ask the PRA to review and appropriately revise the consultation to address the overlap. We would like to emphasise that such a review is not only necessary for the SA but also for the IRB where the interaction between the maturity adjustment and lifetime ECL is unclear and depending on the interpretation could result in double-counting.

8 We look forward to engaging with the PRA about this important issue. Pillar 2 methodologies 8 It would be helpful if the PRA could clarify how it intends to address forthcoming changes to the EBA and FINMA/ regulatory rules and guidelines on Pillar 2 in order to maintain a level playing field (and equivalence) with other jurisdictions and how it anticipates home and host regulators reaching joint decisions. We believe it will be necessary for the PRA to review these proposed changes to Pillar 2A once the revisions to the current Basel III framework are completed to ensure appropriate results are achieved when the revised framework is implemented. An issue that may arise is whether IRB risk weights are still a valid benchmark when an output floor is applied. The BBA and its members would be delighted to discuss this response to the PRA s very welcome consultation on refining its approach to the Pillar 2A capital framework. Responsible Executive Simon Hills simon.hills@bba.org.uk