On 10 January 2019, the Prudential Regulation Authority released Consultation Paper (CP) 1/19, setting out certain proposed changes to Supervisory Statement (SS) 17/13 “Credit risk mitigation”.

SS 17/13 was produced to provide clarification on the PRA’s expectations with respect to the recognition of credit risk mitigation in the calculation of certain risk-weighted exposure amounts. The PRA has been reviewing firm practice in the capitalisation of certain secured financing transactions including non-recourse loans (that is, where the lender does not have full recourse to the assets of the beneficial borrower) and CP 1/19 aims to clarify the eligibility of financial collateral as funded credit protection under Part Three, Title II, Chapter 4 of the Capital Requirements Regulation 575/2013 (CRR).

Article 207(2) CRR states that where the collateral is financial collateral, “the credit quality of the obligor and the value of the collateral shall not have a material positive correlation”. However, as the PRA notes, for non-recourse loans the creditworthiness of the obligor can depend materially on the value of the financial collateral.

The PRA has noticed inconsistencies in how firms have interpreted the Article 207(2) requirement and as such, proposes a new chapter to SS 17/13 to clarify how firms should treat collateral with a material positive correlation for the purposes of credit risk mitigation.The PRA has made the following proposals:

  • Any financial collateral asset whose value is materially positively correlated with the obligor’s credit quality is not eligible, as it cannot be relied upon to mitigate loss at the point of default.
  • In determining whether a financial collateral asset satisfies the requirement in Article 207(2), firms must consider the characteristics of the obligor, the transaction and the collateral e.g. legal connectedness and business model dependencies. The absence of a legal connection between the issuer of the collateral and the obligor does not preclude the possibility of material positive correlation.
  • In relation to non-recourse loans, the PRA considers any financial collateral asset whose value has a material positive correlation with the total value of all the assets to which the lender has legal recourse as meeting the definition in Article 207(2).Of further note, the PRA is yet to feed back on the February 2018 consultation CP 6/18 “Credit risk mitigation: Eligibility of guarantees as unfunded credit protection” that proposed adding a Chapter 7 to SS17/13. This proposal has caused great uncertainty in the credit insurance market and will require detailed analysis upon its publication.
  • This CP is relevant to UK banks, building societies and PRA-designated UK investment firms subject to the CRR. The consultation closes on Wednesday 10 April 2019. The PRA will keep the policy under review to assess whether any changes would be required once any new arrangement with the European Union takes effect.