The UK Prudential Regulation Authority (PRA) has issued new proposals in Consultation Paper 29/16 (CP 29/16) that would make some fairly technical amendments to the UK rules which set out the internal ratings-based (IRB) approaches to measuring capital requirements for residential mortgage portfolios. The rules are currently contained in the PRA's Supervisory Statement 11/13 which would be amended with new text as set out in CP 29/16. The proposals do not represent a blanket change in capital requirements for residential mortgages, rather they are intended to reduce variability in risk-weights as between banks using the IRB approach for mortgage lending exposures and improve risk capture. In any event, the IRB approach - which banks may only use with permission from their supervisor - is one of the formulaic approaches that requires banks to calculate several "inputs" to the overall capital calculation, and so the resulting capital requirements are different for each bank. Specifically proposing amendments to the "loss given default" (LGD) and "probability of default" (PD) inputs to IRB calculations for residential mortgages, the PRA proposes that:
- LGD models should involve banks applying a house price fall assumption - in an economic downturn - of no less than 25% (instead of using current assumptions which the PRA has found vary widely between banks); and
- PD inputs should move away from using "point-in-time" and "through-the-cycle" models, as these have shown insufficient risk capture (given that mortgages are long-term and cyclical while these models reflect recent experience and do not fully take account of cyclicality). Banks should instead apply a modelling methodology that falls between the two ends of the spectrum.
The new rules would come into effect by 31 March 2019 (with banks to be given until 31 May 2018 to submit alternative models for approval by the PRA), but notes that it will monitor intervening changes in the UK regulatory framework between now and that date, including the impact of the Brexit vote (see our Client Alert on the implications of Brexit for structured capital markets transactions). Changes to mortgage risk-weights could have an impact on banks' appetite for both mortgage origination and, in turn, securitisation, although the PRA expects the overall effects on capital requirements to be generally neutral. The PRA acknowledges that recent stress tests have shown that some banks' mortgage risk-weights can increase significantly in stressed conditions. Recalibration of these models presents an opportunity to better capture the risks arising from mortgage exposures and prevent wide swings in banks' capital requirements for residential mortgages in future. Responses to CP 29/16 are requested by 31 October 2016 and the PRA is expected to issue its final rules later in 2016 or early 2017.
Prudential Regulation Authority Consultation Paper 29/16