The long road to proportionality in prudential regulation and supervision

Wed 02 Feb 2022

The great financial crisis triggered a massive wave of bankruptcies in the worldwide banking sector, affected not only large international banks such as Lehman Brothers but also local ones such as Northern Rock in the UK.

Basel prudential standards are designed to cope with financial risks stemming from the global banking system without taking into account local specificities. When it comes to risks posed by smaller banks on the financial stability, the Basel Committee leaves local regulators the ability to adopt local rules to that respect, either in designing their own approaches or in adopting international standards to their local banking system.

The EU privileged a comprehensive transposition of agreed international standards with exemptions options and national discretions

With the entry into force of the so-called “CRR – CRD IV” legislative package in the EU in 2013, the EU co-legislators adopted a comprehensive approach when submitting all EU institutions, e.g. credit institutions and investment firms, to Basel III standards. One of the most controversial rules was the new binding requirement of a short-term liquidity ratio, the LCR for short, that has been applied to all kinds of institutions with no differentiation. Investment firms were particularly affected by the LCR and voiced against it to the European Commission (EC). This was followed by smaller banks, especially on the prudential reporting issue, considering they were too much constrained by the new rules introduced by the Regulation on capital requirements (CRR) as opposed to larger banks, who may benefit from economies of scale to comply with improved reporting requirements.

The 2015 EC “call for advice” was the first occasion for financial stakeholders to report to the Commission the areas of regulation where more proportionality would be beneficial and very welcomed. The consultation process led, among other things, to two conclusions: investment firms must have a dedicated prudential regulation, distinct from the CRR banking rules; smaller banks that entail no systemic risks should be subject to lesser costs of regulatory compliance, particularly when it comes to reporting and disclosure requirements, and the way to compute capital ratios.

The IFR/IFD legislative package was adopted in November 2019 with the aim of designing specific prudential rules for investment firms, while the CRR2 – CRD5 banking package, adopted in the same year, covered specific aspects with respect to proportionality for smaller banks. All these rules are from now being implemented or are about to be.

More importantly, the recent new banking package unveiled by the Commission in October 2021 enhances the proportionality principle with respect to disclosure. The EBA, in cooperation with the ECB, has been working on the creation of the European Centralised Infrastructure for Supervisory Data (EUCLID) to aggregate in a centralised integrated system the reporting information shared by supervisors on the largest EU banks. This system is particularly useful to feed public reports and analysis with aggregated data and risk indicators on the overall EU banking sector. However, the EBA is not allowed to disclose individual bank data that is reported to supervisors. It is therefore contemplated in the CRR3 – CRD6 package to introduce powers that would allow banks to only report information to their supervisors and the EBA would then proceed to disclose the required parts of that information on behalf of banks. This would be particularly beneficial for small and non-complex ones.

What about supervision?

The launch of the Single Supervisory Mechanism (SSM) in 2014 encompasses the proportionality principle in prudential supervision. This is one of the outcomes of the negotiations between Member States when they were discussing the Banking Union project. In particular, some members voiced for less intrusion from the ECB as a single supervisor especially on domestic banks whose failure would have only local consequences manageable by the national competent authority (NCA). Accordingly, banks considered significant (SI) were positioned under European Central Bank’s (ECB) direct supervision, while non-significant or LSI under NCA’s remit. Thus, the proportionality principle in supervision has been linked to the degree of intrusiveness of the oversight depending on the size of the institution.

Across the channel

For many years, the PRA has been applying a proportional approach to regulation as well as supervision to smaller banks, but the difference has been more pronounced for the latter. Over the last year or so, the PRA has published a discussion paper on their plans to implement a “strong and simple” regime for less systematically important banks. More recently they have published a feedback statement on the responses that they have received on the discussion paper. From our study of the feedback statement, we have outlined below some of the PRA’s key proposals that we believe could be implemented in the future. This is a very important area for EU banks with UK operations to consider in the context of supervisory equivalence and regulatory divergence.

The diversity of PRA-regulated firms that are not considered systemically important suggests it may not be feasible to have a single set of strong and simple prudential rules applying to them all. Therefore, it is more appropriate to have requirements that expand and become more sophisticated as the size and/or complexity of firms increase. The PRA is therefore working to have a layered framework in the future – meaning that additional layers of regulation and supervision will apply as banks increase in size and/or become more complex. Whilst this is structurally similar to the ECB regime, the PRA framework can be expected to be significantly more defined than what the ECB currently has in place.

The PRA can be expected to keep the components of its eligible capital intact. This means, that CET1, AT1 and T2 capital instruments can continue to be counted for as eligible capital even for the bottom-most regulatory and/or supervisory layer. This is equivalent to the ECB’s current regime.

The PRA plans to use firms’ balance sheet size to determine the aforementioned layers. This is consistent with the ECB regime. Where there could be divergence is around the PRA’s plans to apply exceptional treatment to those banks that use IRBs, has a trading book (no matter how small), and has multiple critical functions. Although, such a divergence is likely to be favourable for EU entities in the context of equivalence – of course, subject to the actual extent of regulation and supervision that apply.

In the context of capital adequacy, the PRA can be expected to implement the Basel 3.1 Standardized approach in its new regime, which is positive in the context of equivalence. However, Pillar 2A requirements under the PRA regime is expected to be simpler than the EU regime. The PRA can be expected to introduce defined calculations and templates on this topic. There is also a possibility that Pillar 2 add-ons could be set as fixed, nominal amounts, rather than as percentages of risk weighted assets, to improve clarity and reduce variability. Similarly, for Liquidity, the PRA can be expected to retain LCR and NSFR but amend Pillar 2 requirements.

We would reasonably expect the PRA to simplify the ICAAP and ILAAP documents. It is also possible that the PRA might be pushed towards combining the two documents into one. This is not entirely impossible given the extent of overlap between the two documents. In fact, UK’s Financial Conduct Authority has already implemented a combined approach to ICAAPs and ILAAPs through the ICARA process. This could be a significant point of divergence between the EU and UK regimes.

We believe that it is too early to make a call on what we might expect the PRA to change in the context of solvent wind down, recovery and resolution planning; as well as on the matter of governance, remuneration and risk management. But we can reasonably expect the PRA to provide more guidance on these matters.

The feedback statement suggests that there is overwhelming support for Pillar 3 disclosure requirements to be dropped, and such disclosures being combined with annual audited accounts. Again, this would be a major point of divergence between the UK and EU. However, there could be a number of issues with implementing this regime – not least the absence of subject-matter expertise on regulatory matters in external auditors. We, therefore, expect the UK’s Pillar 3 disclosure regime to be simplified.