Prudential regulationi Regulatory capital
Many of the detailed rules regarding the application of prudential supervision by competent authorities and in relation to regulatory capital adequacy are contained within the EU Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD), together referred to as CRD IV (for further information, see the European Union chapter). The CRR is, at present, directly applicable in the United Kingdom and, accordingly, the PRA has not made rules to implement its provisions, except in relation to certain discretions afforded. The CRD, as an EU directive, is not directly applicable and has been implemented by means of legislation and regulatory rules adopted in the UK. It should be noted that the European Parliament has adopted, and the Council of the EU is (at the time of writing) soon expected to adopt, a directive amending the CRD and a regulation amending the CRR, a package commonly referred to as CRD V, later in 2019. If adopted in its current form, CRD V would entail significant changes to the regulatory capital and liquidity requirements that apply to UK banks. For the reasons set out in subsection i of Section VIII of this chapter, it is anticipated that once adopted by both the European Parliament and the Council of the EU, CRD V will be adopted or implemented (as applicable) in the UK regardless of the outcome of Brexit.
Under the CRR, UK banks are required to hold capital in respect of credit risk, market risk and operational risk. Credit risk is, broadly, the risk that a debtor will not repay a loan at maturity or that a counterparty will not perform an obligation due to the bank. Market risk measures the risk of a bank suffering losses as a result of changes in market prices where it has invested in debt or equity securities, or in derivatives or physical commodities. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
The rules on market risk apply to trading activity where the bank's purpose is to make a profit, or avoid a loss, from short-term changes in market prices (i.e., proprietary trading). Such trading positions constitute the bank's trading book. A building block approach applies, whereby capital must be held against specific risks (e.g., position risk, counterparty risk, foreign exchange risk and commodities risk). Transactions giving rise to more than one risk category may trigger several different capital charges. Banks can (with PRA approval) use a market risk internal model to calculate their capital requirements for market risk.
The credit risk capital charge will depend on the bank's risk-weighted assets, calculated using either the standardised approach or an internal ratings-based approach. The standardised approach sets capital charges for exposure to particular classes of counterparty (e.g., corporates, interbank, retail, residential mortgages), generally based on external credit ratings. Internal ratings-based (IRB) approaches, which are based on internal models for credit risk, can be used only if approval is given by the PRA. The PRA recognises two IRB approaches: the foundation IRB and the advanced IRB. Under the foundation IRB, banks are required to determine the probability of default of exposures; the other risk factors are determined based on supervisory estimates, which are then fed into a formula to determine the capital charge for such exposures. Under the advanced IRB, the bank determines all the risk factors based on its own internal estimates.
The PRA would typically require a new bank to use the standardised approach and, if the bank can demonstrate to the PRA that it has sufficiently sophisticated risk-modelling methods, the PRA may grant permission to apply an IRB approach (although, under the CRR, this is not allowed within the first three years of the bank's existence).
The PRA imposes restrictions on large exposures incurred by banks, and requires capital deductions for funding arrangements (including loans and guarantees) entered into with connected parties where those arrangements are of a capital nature.ii Types of capital
Under the CRR, bank regulatory capital is classified according to the scheme promulgated by the Basel Committee on Banking Supervision. In summary:
- UK banks are required under the CRR to hold base regulatory capital of at least 8 per cent of the total risk exposure amount (which takes account of exposures arising in respect of credit risk, market risk and operational risk) plus additional capital in respect of various regulatory capital buffers. The capital buffers include the CRD IV combined capital buffer (which is formed of a capital conservation buffer of 2.5 per cent of a bank's total risk exposure amount, plus a countercyclical buffer that the Bank of England calibrates on advice from the FPC), certain sector-specific capital buffers calibrated by the FPC, Pillar 2 capital buffers (which the PRA has split into Pillar 2A, a capital buffer to address risks that are not adequately captured by the CRR capital requirements, and Pillar 2B, an additional capital buffer to address risks to which the bank may become exposed over a forward-looking planning horizon) and systemic capital buffers (reflecting the global or domestic systemic importance of a bank). Ultimately, the effect of the buffers is that UK banks are required to hold regulatory capital of an amount that is significantly in excess of 10.5 per cent of the applicable total risk exposure amount (being the 8 per cent base requirement plus the 2.5 per cent capital conservation buffer).
- The base capital requirement relating to the highest quality of capital (Common Equity Tier 1 (CET1) capital, which is broadly ordinary share capital and reserves) is at least 4.5 per cent of the total risk exposure amount. Banks are required to satisfy the regulatory capital buffers referred to in (a) using CET1 capital and will, accordingly, need to maintain a CET1 capital ratio significantly in excess of 4.5 per cent of the total risk exposure amount. The PRA has the power to restrict the payment of distributions (in the form of dividends or staff bonuses) by UK banks unless this and certain other capital buffers are satisfied (further details of these measures are set out in the European Union and International Initiatives chapters).
- Subject to specified limits on eligibility, banks are permitted to hold other types of capital instrument to satisfy their total capital requirement, with these instruments categorised as Additional Tier 1 (broadly, perpetual subordinated debt instruments or preference shares with no incentive to redeem and that will automatically be written down or converted into CET1 upon the bank's CET1 ratio falling below a specified level, which the PRA expects to be at least 7 per cent) and Tier 2 (broadly, subordinated debt instruments with an original maturity of at least five years).
- In addition to the regulatory capital requirements under CRD IV, the Banking Reform Act introduced a framework for regulators to impose non-capital primary loss-absorbing capacity requirements on ring-fenced banks and banks that are systemically important. This requirement to hold additional loss-absorbing capacity, the amount of which is calibrated according to the minimum requirement for own funds and eligible liabilities (MREL) framework under the EU Bank Recovery and Resolution Directive (BRRD) and, for UK global systemically important banks (G-SIBs), the Financial Stability Board's total loss-absorbing capacity requirement (see subsection vii), will be fully implemented by 1 January 2022.
Regulatory capital requirements apply to individual banks on a stand-alone (solo) basis and to their groups on a consolidated basis. The PRA also supervises banking groups on a consolidated basis. The relevant requirements can be complex, but the basic principle is that banking groups must hold prescribed minimum amounts of capital, on a group-wide basis, to cover the risk-weighted assets and off-balance sheet liabilities of members of the group, whether they are regulated or not.
Under the CRR, consolidated supervision generally applies at the level of the highest parent undertaking incorporated in the European Economic Area (EEA) with its subsidiary undertakings that are banks or investment firms or that carry on broadly defined financial activities. Subsidiary undertakings are required to be consolidated in full, although proportionate consolidation for non-wholly owned subsidiaries is permitted in certain circumstances, subject to supervisory permission. Banking groups are permitted, subject to the satisfaction of certain prescribed conditions and haircuts, to recognise on a consolidated basis the minority interest that arises in respect of non-wholly owned subsidiaries that are fully included within the consolidation. Participations are also included within the scope of consolidated supervision on a proportionate basis. A participation is presumed to be held where there is a holding of 20 per cent or more of the share capital in another undertaking.iv Liquidity
The PRA's liquidity regime broadly requires UK banks to be self-sufficient for liquidity purposes: banks may only rely on other members of their group if they obtain a rule modification from the PRA and comply with stringent requirements. The PRA is unlikely to grant this modification to a UK bank that is seeking to rely on liquidity from non-UK subsidiaries. The liquidity standards require banks to have adequate liquidity resources in certain specified stressed scenarios.
The CRR introduced a binding liquidity coverage ratio (LCR) and also contemplates the introduction of a net stable funding ratio (NSFR) requirement, measuring liquidity over a longer period of time than the LCR. The CRD V proposals include the implementation of a binding NSFR requirement which, if CRD V is adopted in its current form, would take effect during 2021.v Leverage ratio
Given the number of systemically important banks in the UK and the relative size of the UK banking system, the FPC directed the PRA in 2015 to introduce a leverage ratio in the UK ahead of any internationally agreed standard. The PRA has implemented the FPC's proposals in relation to UK banks and building societies that have retail deposits equal to or greater than £50 billion, which include a minimum leverage ratio requirement of 3.25 per cent; a countercyclical leverage ratio buffer set at 35 per cent of the firm's countercyclical buffer; and for UK G-SIBs (and, from 2019, domestic systemically important banks (D-SIBs)), an institution-specific supplementary leverage ratio buffer.
If implemented in its current form, CRD V will introduce a binding leverage ratio requirement of 3 per cent of Tier 1 capital that firms must meet in addition to their risk-based requirements. This would apply from the date on which the regulation amending the CRR enters into force.vi Ring-fencing
The Banking Reform Act introduced the legal framework for the ring-fencing of core banking services that are critical to retail and small amd medium-sized enterprise (SME) clients. Affected banks were required to organise themselves to comply with the requirements by 1 January 2019. As a result, the core deposit-taking business of affected banks is now carried out through entities that are legally and financially independent of other group entities that carry on various wholesale or investment banking activities. Key details on the scope of the ring-fencing requirements and the restrictions applying to ring-fenced entities are set out in a combination of relevant secondary legislation and regulatory rules.
Broadly speaking, the ring-fencing requirements apply to banks that carry out the activity of accepting core deposits. For these purposes, core deposits include all deposits except those:
- made by large organisations (undertakings that are not SMEs) and their group members;
- made by relevant financial institutions;
- made by certified, consenting high-net-worth individuals and closely related persons; and
- taken by branches of an affected UK bank outside the EEA.
Banks whose core deposits do not exceed £25 billion are exempt from the ring-fencing requirements. This threshold is calculated taking into account all UK banks in a group. Building societies, insurance firms, credit unions, cooperative societies, community benefit societies, and Northern Ireland industrial and provident societies are also exempt.
Ring-fenced banks are subject to significant restrictions on their banking activities, including a prohibition (subject to exceptions) on incurring exposures to relevant financial institutions (e.g., non-ring-fenced banks, global systemically important insurers and investment firms) and limitations on the types of financial products and services that ring-fenced banks may provide. Ring-fenced banks are also prohibited from having branches outside the EEA and, subject to exceptions, participating interests (presumed to exist at a holding of 20 per cent or more of issued share capital) in undertakings incorporated or formed under the law of a jurisdiction outside the EEA. The scope of application of this requirement following Brexit is not yet clear.
A fundamental principle of the regime is that ring-fenced banks may not deal in investments as principal, except where narrowly drawn exceptions apply relating to matters including risk management, debt-for-equity swaps, securitisation of assets originated by the ring-fenced bank, certain simple derivative products, security over shares or other investments and entering into transactions with central banks.The role of the PRA
The Banking Reform Act amended the PRA's general objective under the FSMA with effect from 1 January 2019 to provide that it must discharge its general functions in relation to ring-fenced bodies and ring-fencing requirements to ensure the continuity of the provision of core services in the UK. These core services are broader than the core activity of accepting deposits and extend to facilities for making payments from, and overdrafts in connection with, deposit accounts.
The PRA rules on ring-fenced banks are designed to ensure that:
- core activities of ring-fenced banks are not adversely affected by other group members;
- ring-fenced banks make commercially independent decisions;
- ring-fenced banks are not unduly reliant on resources from other group members that would not be available if those members failed; and
- ring-fenced banks are sufficiently resilient, including upon failure of a group member.
The Banking Reform Act also provides the PRA with powers to require the restructuring or break-up of a group that, in the PRA's view, is failing to meet the ring-fencing objectives.vii Recovery and resolution regime
The PRA requires UK banks to produce and maintain a recovery plan, describing actions that could be taken by the bank to ensure the continuity of all or part of its (or of a group member's) business in prescribed stress scenarios; and a resolution pack containing information and analysis that would assist the regulator with any action it needs to take in the event that the bank is likely to, or does in fact, fail. The PRA has issued supervisory statements prescribing the information and analysis that must be set out in recovery plans and resolution packs, which take into account the requirements of the BRRD.
The Banking Act 2009 introduced a special resolution regime for UK banks, which is intended to facilitate the orderly resolution of banks in financial difficulties. The Banking Act 2009 also established two new insolvency proceedings for banks that are available in respect of failed banks or residual parts of banks that are in wind-down (referred to as the modified insolvency processes). Failure for these purposes includes insolvency, bankruptcy or administration of the bank concerned or the exercise of resolution powers under Part I of the Banking Act 2009 (the latter are referred to as the stabilisation options) in relation to that bank. The stabilisation options comprise methods for addressing the situation if a bank has encountered or is likely to encounter financial difficulties and can be summarised as the transfer of all or part of the business of the bank to a private sector purchaser, a bridge bank wholly owned by the Bank of England or an asset management vehicle; the bail-in option (see below); and taking the bank into temporary public ownership.
Exercise of the stabilisation options is subject to certain strict conditions prescribed under the Banking Act 2009. The PRA (having consulted with the Bank of England) must be satisfied that the relevant bank is failing, or is likely to fail, and the Bank of England (having consulted with HM Treasury, the PRA and the FCA) must be satisfied that, having regard to timing and other relevant circumstances, it is not reasonably likely that (aside from the stabilisation options) actions will be taken by or in respect of the bank that will enable the bank to cease to be failing or likely to fail. The Bank of England must have regard to certain special resolution objectives, and must be satisfied that the stabilisation option is necessary having regard to the public interest in the advancement of one or more of these objectives; and that one or more of the objectives would not be met to the same extent by the winding up of the bank. Each stabilisation option is subject to additional specific controls to ensure it is used only where the relevant authority considers it necessary having regard to relevant circumstances, such as the public interest in the stability of the UK financial system.
The Banking Reform Act amended the Banking Act 2009 to introduce bail-in as a stabilisation option. This came into effect on 1 January 2015. Broadly speaking, the bail-in tool enables the Bank of England, during the stabilisation period of a failing bank, to impose losses on shareholders and, subject to limited exceptions, unsecured creditors of a bank as if that bank were insolvent, through write-down or conversion into different forms of liability (e.g., equity). The bail-in tool, as implemented, is intended to reflect the powers required under the BRRD, and its use would be subject to the no creditor worse off principle (i.e., affected creditors must not be left worse off under bail-in than they would otherwise have been under ordinary insolvency proceedings).
Certain liabilities (such as deposits protected under the Financial Services Compensation Scheme (FSCS), the UK deposit guarantee scheme) are excluded from the scope of the bail-in tool.
As the UK resolution authority under the BRRD, the Bank of England is also required to set MREL requirements for UK banks, building societies and investment firms within the scope of the BRRD. MREL supports the bail-in tool and is intended to ensure that firms within the scope of the BRRD have sufficient own funds and other eligible liabilities to facilitate the effective application of bail-in on resolution. The Bank of England sets MREL requirements on an institution-specific basis and according to the preferred resolution strategy applicable to that institution and its group. For UK G-SIBs, the Bank of England also sets MREL as necessary to implement the Financial Stability Board's total loss-absorbing capacity (TLAC) standard.
Different requirements apply in relation to external MREL (which applies to resolution entities, i.e., the entity or entities in respect of which a group's preferred resolution strategy envisages that resolution action would be taken) and internal MREL (which applies to legal entities within a group that are not themselves resolution entities).
For resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy, the MREL requirements are to be phased in as follows:
- since 1 January 2016, all resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy have been required to maintain MREL resources at least equal to their capital requirements;
- since 1 January 2019, G-SIBs with a resolution entity incorporated in the UK have been required to meet an MREL requirement equal to the TLAC standard, being the higher of 16 per cent of risk-weighted assets or 6 per cent of leverage exposures;
- from 1 January 2020, G-SIBs and D-SIBs with a resolution entity incorporated in the UK will be required to meet an MREL requirement equal to the higher of two times their Pillar 1 capital requirement plus their Pillar 2A capital requirement, or two times the leverage requirement (to the extent applicable). Other institutions in respect of which bail-in or partial transfer is the preferred resolution strategy will be required to meet an MREL requirement of 18 per cent of their risk-weighted assets; and
- from 1 January 2022, all resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy will be subject to an MREL requirement equivalent to the higher of two times their regulatory capital requirement (plus any relevant buffers), two times the leverage requirement (to the extent applicable) or, in the case of G-SIBs only, 6.75 per cent of leverage exposures.
The Bank of England generally expects to set internal MREL requirements as equal to an institution's capital requirements for those institutions that are not material in a group context. Material subsidiaries, however, are subject to an internal MREL requirement that is calibrated at 75 to 90 per cent of the external MREL requirement that would apply to that entity if it were itself a UK resolution entity. Material subsidiaries for these purposes are those that have more than five per cent of the consolidated risk-weighted assets of a group, generate more than five per cent of the total operating income of the group, have a leverage exposure measure larger than five per cent of the group's consolidated leverage exposure measure, or are otherwise material to the delivery of a group's critical functions.
The Bank of England intends to review its calibration of MREL by the end of 2020 before setting the end-state MRELs that will apply to institutions from 1 January 2022. Institutions that have adopted a modified insolvency process (rather than bail-in) as their preferred resolution strategy will be required to meet an MREL equal to their regulatory capital requirements; no separate requirement will apply.
If CRD V is adopted in its current form, it would introduce further requirements relating to internal MREL for G-SIBs, as well as detailed requirements relating to the eligibility of liabilities as MREL resources. These are expected to apply from the date that CRD V enters into force.viii FSCS
Certain deposits held at UK-authorised banks are covered by the FSCS. The FSCS is managed and administered by the Financial Services Compensation Scheme Limited, a limited company established under the FSMA. This body is accountable to the PRA and the FCA for the effective operation of the FSCS, but is independent from those regulators. Pursuant to the FSMA, the PRA and the FCA are jointly responsible for ensuring that the FSCS is capable of discharging its functions.
The FSCS, which is funded by levies on regulated firms imposed on different sectors (and is therefore free to consumers), protects certain retail deposits (primarily those of private individuals and small businesses), and claims relating to certain investment products and certain types of insurance policies. The maximum current level of protection for bank deposits is £85,000 per depositor in respect of all the depositor's accounts held at a bank.
Deposits protected by the FSCS are regarded as preferential debts in the event of a UK bank's insolvency, and therefore rank ahead of the claims of most other unsecured creditors.