On September 5, 2014, the Prudential Regulation Authority (PRA) published a supervisory statement1 (Supervisory Statement) setting out in detail the PRA’s approach to the authorization and supervision of existing and prospective international banks in the United Kingdom (UK). The Supervisory Statement is directed at PRA supervised deposit-takers and designated investment firms incorporated elsewhere in, and outside of, the European Economic Area (EEA).
Whilst the Supervisory Statement applies to all foreign banks operating in the UK, there is a particular focus on non-EEA bank branches (Foreign Branches) which, over the coming months, will need to assess their business models, the sufficiency of their senior management arrangements, systems and controls, resolution plans and how adequately the plans cover the UK branch operations in preparation for:
- branch returns to be submitted to the PRA by November 14, 2014;
- the UK’s implementation of the Bank Recovery and Resolution Directive2 on January 1, 2015; and
- the attestation on compliance with rules pertaining to senior management arrangements, systems and controls, due on March 31, 2015.
This Update examines some of the key factors detailed in the Supervisory Statement with respect to Foreign Branches and outlines related areas of consideration.
The PRA was formed in April 2013 following the abolition of the Financial Services Authority and the transfer of its powers and functions to the PRA and the Financial Conduct Authority (FCA). The PRA is responsible for the prudential supervision of deposit-takers, insurance companies and designated investment firms. The Supervisory Statement expands on the general approach of the PRA to supervision as set out in its banking approach document3with fuller details on its approach to the supervision of international banks. Whilst the Supervisory Statement is not intended to change the UK’s historic approach to the supervision of international banks, it does clarify this approach and provides a transparent platform for the way in which the PRA authorizes and supervises branches.
The Supervisory Statement follows the PRA’s consultation paper on its proposed approach to the supervision of international banks that was published in February 2014.4 The supervisory structure is framed on the PRA’s policy objective of maintaining an open financial market, but balanced against its statutory objective of promoting the safety and soundness of the Foreign Branches it supervises.
Key features of the PRA’s supervisory approach
As a general matter, given that a Foreign Branch is not a separate entity from the bank of which it is a part, it is primarily supervised by its home state supervisor (HSS) as part of the supervision of the banking group as a whole. In contrast, the UK subsidiaries of international banks (as separate legal entities from their parents) are authorized and regulated in the UK on a standalone basis and are required to be separately capitalized.
The focus of the PRA’s supervision of Foreign Branches will be assessed on the basis of the following three factors:
- the extent to which the supervision of the Foreign Branch by its HSS is equivalent to that of the PRA;
- the Foreign Branch’s activities and the extent to which it performs a critical economic function in the UK; and
- the level of assurance that a HSS can give the PRA that the home state resolution regime will deliver appropriate outcomes for the PRA’s objectives, as well as the credibility of the Foreign Branch’s own resolution plan, if things were to go wrong.
While the Supervisory Statement provides an element of uniformity in the PRA’s approach, these factors will be considered in the round, which means the PRA’s determination on acceptable standards will vary from bank to bank even from the same jurisdictions. This means that the existence of another branch from the same home state will not automatically mean that other branches of other banks from that jurisdiction can operate as branches in the UK. Therefore, each Foreign Branch will need to assess the PRA’s supervisory criteria within the context of not only its home state regulatory regime, but also its business model, systems and controls, and group resolution plans.
In circumstances where the PRA is satisfied in respect of such matters, the PRA will seek to agree a split of prudential supervisory responsibilities between itself and the HSS. The agreement will be tailored to each Foreign Branch and will set out the allocation of supervisory responsibilities on matters such as business risks, capital and liquidity, risk management and management governance. In other cases, the PRA will consider the most appropriate course of action with respect to the Foreign Branch which may, in some cases, include (i) refusing the authorization of a new Foreign Branch or cancelling the authorization of an existing Foreign Branch; or (ii) imposing limitations on the nature and scale of activities performed by the Foreign Branch.
Key considerations and challenges that lie ahead
HSS Equivalence Test
The Supervisory Statement sets out broad principles on which the PRA will assess HSS equivalence. The list is not intended to be exhaustive but includes:
- the HSS’s rules, powers, consolidated supervision, information sharing, confidentiality, and the competence and independence of supervision;
- the capital, liquidity and resolution regimes for consistency with international standards; and
- the PRA’s previous experiences in its interactions with the HSS.
This process is outside the control of Foreign Branches or even the HSS and therefore, there may be little transparency whilst the review process is underway. Furthermore, equivalence assessments will be reviewed periodically as determined by the number and size of Foreign Branches in a particular home state. Whilst Foreign Branches can derive some comfort from the fact that this is not a new process, and therefore, they will have a good sense of the PRA’s assessment of, and relations with, their HSS to date, given that the global regulatory regime is constantly evolving, the PRA’s approach to HSS equivalence will consequently develop and change over time. This, in turn, may impact the ability of Foreign Branches to plan business strategies going forward. In this regard, Foreign Branches should keep abreast of any reports published on their home states by international bodies such as the International Monetary Fund and Financial Stability Board, which the PRA will include in its analysis of HSS.
Critical Economic Function
In addition to the HSS assessment, the PRA will also evaluate the UK activities of a Foreign Branch to determine whether it undertakes a critical economic function (CEF). Those Foreign Branches that are engaged in a CEF will be subject to a closer review and the PRA will be seeking a higher level of assurance with respect to resolution from them.
Definition of CEF and Thresholds
The Supervisory Statement defines a CEF as a “function whose disruption or withdrawal could have an adverse material impact on financial stability in the UK”. The materiality of a Foreign Branch’s activities in the following categories will determine whether the PRA regards it as performing a CEF:
- retail banking;
- corporate banking;
- payments, clearing, settlement;
- intra-financial system borrowing and lending; or
- investment banking.
The PRA’s determination will turn on a quantitative assessment of each Foreign Branch, taking account of the overall level of deposits covered by the Financial Services Compensation Scheme, the value and type of accounts the Foreign Branch holds, number of customers, substitutability of services and planned growth. Whilst not a defined threshold, the PRA (i) expects Foreign Branches to have under £100 million of retail/small and medium-sized enterprises covered transactions or instant access account balances; and (ii) considers that retail and small and medium-sized enterprise accounts in excess of 5,000 may be of concern. As such, any Foreign Branch that is currently engaged in (or will, going forward be looking to undertake) activities beyond the de minimis threshold will only be able to do so insofar as the PRA receives a high enough level of assurance from the HSS over resolution.
The PRA is introducing a twice yearly return (Branch Return) to enable the PRA to assess the potential impact that Foreign Branches would have on UK stability. The final form of the Branch Return and accompanying notes are to be published by September 30, 2014 and must be returned to the PRA by November 14, 2014.
The Branch Return will require the introduction of an internal reporting process tailored to the prescribed form of return. While this in and of itself should not be too burdensome, the concept of CEF and related thresholds may somewhat curtail the growth plans of a Foreign Branch and, ultimately, banks may find it more appropriate to plan economic expansion through a UK subsidiary, as opposed to a Foreign Branch.
Arrangements for resolution will be key to the PRA’s risk assessment of a Foreign Branch and “is ultimately where it will place most emphasis”.5 The assessment will include seeking the appropriate assurances from the HSS (relative to the scale of the Foreign Branch’s UK activities) and understanding the bank’s group resolution plan in detail. A key consideration for Foreign Branches will be the wide-ranging powers the PRA will acquire under the UK’s implementation of the EU Bank Recovery and Resolution Directive from January 1, 2015, whereby the PRA will have the ability to resolve Foreign Branches on a standalone basis in certain circumstances. Therefore, ensuring the appropriate outcome with respect to the assurances the PRA will be seeking from the HSS and bank itself will be paramount.
A Foreign Branch with a CEF which requires continuity of service or a significant amount of time to wind down will attract greater scrutiny from the PRA and will need to demonstrate:
- a clear rationale for why the CEF is part of the business model for the bank and why it is appropriate to be carried out in a branch;
- a resolution plan for the whole bank and how the branch links to the plan;
- a clear functional and operational plan for continuity of service for the CEF;
- how the branch will access critical systems; and
- how data managed in the home state will be maintained.
While a Foreign Branch may ultimately be able to get the PRA comfortable with comprehensive and credible resolution plans, it will have no control over the PRA’s assessment of the home state regime. The Supervisory Statement provides little detail on how the PRA will embark on this assessment, but ultimately it will be seeking assurance that at a minimum the Foreign Branch’s UK depositors and creditors will rank equally with their home state counterparts. In this regard, the PRA recognizes the risks of short notice legislative changes during a crisis intended to favor domestic administrative discrimination against foreign creditors or depositors and is expected to publish further information on its related policy before the end of 2014.
The Supervisory Statement also places emphasis on a Foreign Branch’s risk management, and systems and controls, and is introducing a regime whereby a senior individual within the UK management team will be required to annually attest compliance with the FCA/PRA Senior Management Arrangements, Systems and Control Sourcebook (SYSC);6 the first is to be submitted by March 31, 2015.
This reinforces the PRA and FCA focus on improving individual responsibility and accountability in the banking sector. The attestation regime may eventually be replaced by a senior manager regime whereby at least one individual per Foreign Branch will need to be approved by the PRA as an Overseas Branch Senior Executive Manager with responsibility for the activities of the UK branch.7 Full details of the PRA’s proposals are expected to be published in a future consultation paper.
In the meantime, Foreign Branches should not only identify the appropriate senior individual to provide the attestation but also review their policies and procedures around their SYSC requirements, and ensure that any discrepancies and gaps are addressed in time for their first attestation or notified to the PRA in a timely manner prior to March 31, 2015.
The Supervisory Statement is intended to provide clarity over the PRA’s supervision of Foreign Branches. The PRA’s approach and key considerations are as expected, but there remains uncertainty as to the PRA’s process and methodology for assessing HSS equivalence and resolution regimes. Nonetheless, there are some key points to take away from the Supervisory Statement:
- The PRA’s supervision of Foreign Branches will not be homogenous:
a) Foreign Branches conducting a CEF will be subject to closer review and supervision, and restricted in terms of their business development and growth. Ultimately, they may be forced to set up a subsidiary; and
b) Foreign Branches not engaged in a CEF and subject to international regulatory standards in their HSS should still find it relatively straightforward to obtain and maintain PRA authorization.
- It is the whole bank and not just the Foreign Branch that will be under the PRA’s review. Furthermore, the PRA’s assessment is not static and will evolve over time. Therefore, while the PRA may be content with a bank’s risk assessment in the short term, the assessment will always be at risk of change and will be influenced by matters beyond the bank’s control (e.g., changes in its home state resolution regime).
- The PRA’s supervisory regime will not be limited to the banking institution, but the PRA is also looking to develop a framework whereby specific individuals will be more explicitly accountable for the activities of the Foreign Branch.