Since Sam Woods’ speech last November, we have been expecting proposals for a new prudential regime for smaller banks and building societies. Last week, the Prudential Regulation Authority (PRA) published its discussion paper setting out the various options for designing a ‘strong and simple’ prudential framework for banks and building societies which it considers to be neither systemically important nor internationally active.
The proposals signify a major shift in prudential policy for UK banks and building societies, and are the latest step in a long-standing effort by UK policy makers to increase competition in the retail banking sector and encourage new entrants to the market. They build on other recent policy action, such as the PRA’s policy statement on its approach to new and growing banks and its introduction of a simplified prudential regime for certain UK credit unions.
The financial sector has seen significant development in recent years, with increased competition and an influx of new so-called challenger banks, payment service providers and e-money issuers into the market.
This has led UK regulators to question whether the existing onshored EU Capital Requirements regime should be simplified in recognition of the fact that these types of firms typically face different risks and have different strategies to those of their larger, international competitors. The EU Capital Requirements regime implements in the EU the global standards of the Basel Capital Accord. The Accord is designed for complex and international banks, but the EU Capital Requirements regime broadly applies to all banks in a similar way.
The complexity problem
The PRA recognises that the current UK prudential regime poses particular challenges to smaller firms, most notably the “complexity problem”. The complexity problem arises where the cost to firms of “understanding, interpreting and operationalising a prudential requirement, or set of requirements, are higher relative to the associated public policy benefits for smaller firms than for larger firms”. This cost is proportionately greater for these entities than for larger firms, which typically have bigger regulatory budgets and more in-house expertise and experience.
This also recognises that the factors affecting smaller banks are different from those impacting larger, established, international firms. Our recent blog post on The Outlook for Challenger Banks notes that smaller banks have different business plans and strategies, face different risks and have to overcome additional challenges compared to the incumbents with which they are in direct competition.
Requiring smaller firms to comply with the existing regime may in fact make them less resilient and therefore run counter to the public policy objectives of the regime. The economic impact of compliance costs may result in some firms being induced to increase their risk taking, which in turn reduces their soundness. It may also deter new entrants to the market, hindering competition.
Who is the new regime aimed at?
The PRA’s discussion paper makes clear that the proposals for a new prudential framework are aimed at “non-systemic and non-internationally active firms”. Internationally active firms are, and will remain, subject to international Basel standards.
The pool of non-systemic, domestic banks and building societies covers a broad spectrum of PRA-regulated entities, carrying out a wide range of activities and having varying levels of total assets. Although the PRA expects to introduce a graduated approach in time, with a regime that becomes gradually more sophisticated as firms increase in size or engage in more complex activities, or both, its focus for now is on the smallest of such firms.
But which of those firms will be caught by the new “simple” regime? If size is taken to be the defining criterion, should it be judged on the basis of total assets or total retail deposits, or a different metric altogether? Would small firms which conduct complex activities be included in the scope? What about firms engaging in trading activity, or riskier activities such as lending to high risk borrowers? How will subsidiaries of foreign banks, which may pose different prudential risks to the UK market, be treated? And how will the framework take into account the fact that some firms may individually be small in size and undertake simple activities, but become systemic as a herd?
The PRA will also need to consider how any new regime interacts with existing rules applicable to banks, such as the ring-fencing regime. Whether or not a ring-fenced bank could fall within the scope of the proposals is not yet clear, but given that the ring-fencing regime aims to protect the provision of core retail services from risks originating from outside the ring-fence and to improve the resilience of banking groups, including smaller ring-fenced banks within the scope of the regime would not be inconsistent with the objectives underpinning the proposals.
These are just a few of the many factors that will need to be considered during the course of designing the regime. It is clear that defining its parameters, and identifying those small firms which should be caught, will not be a simple exercise.
Those firms that do fall within the regime may benefit from reduced prudential implementation and compliance costs, and could find that their capital requirements fall as a result. This could lower some of the existing barriers to entry into the market and positively impact competition.
However, firms falling just outside the scope of any new regime could find themselves in a difficult position. They would face the “complexity problem” while at the same time having to compete with both larger, established firms, which have the benefit of economies of scale and experience in prudential compliance costs, and smaller firms, which are able to take advantage of lower costs under the new framework. A graduated approach would mitigate this “cliff-edge” effect. Also, mid-tier firms may find that these issues are mitigated to some extent by other measures currently considered by the regulators, including the Bank of England’s review of its approach to minimum requirement for own funds and eligible liabilities (MREL), and the Financial Policy Committee and the Prudential Regulation Committee review of the UK leverage ratio framework. However, this remains to be seen.
What form might the new regime take?
The PRA is clear that any simplification of the regime must not come at the expense of firms’ resilience or the UK’s broader financial stability. Areas that might be simplified include capital requirements, the Senior Managers and Certification Regime, remuneration rules and regulatory reporting. On the other hand, prudential governance requirements and operational resilience rules are not viewed as contributing to the complexity problem so are more likely to continue to apply in their current form, and recovery and resolution planning will also continue to be required.
As discussions are still at an early stage, the detail of any new regime is not yet known. At this time, the PRA is considering two approaches: (i) a streamlined approach and (ii) a focused approach. The former would take the current regime as its starting point, simplifying certain rules to fit smaller firms better; the latter starts with a blank page, imposing a more narrow but more stringent set of prudential rules. The discussion paper draws out a number of examples, but there are benefits and disadvantages to each, so the challenge for the PRA will be in drawing the regime in a way that works well (and better than the existing regime) for the firms falling within it.
Care will need to be taken in designing the new regime to ensure that it does not inadvertently create barriers to growth. This could happen if, for example, large jumps between layers of the regime are introduced, incentivising firms to stay below applicable thresholds and in turn stifling competition in the sector. Such risks could be mitigated by avoiding cliff-edges in the application of the rules, but also by introducing optionality to allow smaller firms who expect to grow quickly to opt into the full prudential regime at an early stage instead of the ‘strong and simple’ framework. Other measures, such as intermediate requirements, could help further to smooth transitions.
It will also be important to ensure that any new approach, and the end-goal of introducing a graduated regime, does not introduce additional complexity or require firms to implement new rules and procedures too frequently, particularly if they move through the layers quickly.
Designing a new strong and simple prudential regime for a subset of smaller banks will not be an easy task, and as with any significant change in regulatory approach, the design and implementation of the new regime will likely take some time to complete. While we are unlikely to know the full detail for some time, these proposals are likely to be welcomed and seen as an opportunity to help facilitate smaller firms in what has been a challenging market.
We do not think that we have made any part of the banking system too safe. Nor do we think that a simpler regime should lead to any change in the level of resilience of the firms we supervise. What we aim at is a simpler regime which delivers the same level of resilience for small firms in a more efficient way.