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Building the pillars

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  • Publish date: 05 June 2017
  • Archived on: 05 June 2018

As the PRA releases a new consultation paper on adjustments to Pillar 2A, Neeraj Kapur, chairman of the Financial Services Faculty, assesses their potential impact and implications.

The February consultation paper (CP) 3/17 from the Prudential Regulation Authority (PRA) sets out proposed adjustments to the bank Pillar 2A capital framework. Through Pillar 2 the PRA sets capital add-ons for risks for each firm individually which are either not captured (such as pension risk not captured in the credit risk weights), or risks that are not fully captured (credit risk for especially high risk credit books).

Fair game

The CP is part of the PRA’s response under its secondary objective to foster competition in the financial services markets. It responds to calls from smaller banks and building societies for a more level playing field, when comparing capital requirements under the Internal Ratings Based (IRB) approach with the Standardised Approach (SA) most of the smaller players use.

The starkest contrast is when the two approaches are compared for capital requirements on low Loan to Value (LTV) mortgages. The difference in approach can lead to up to c1,000% more capital required by the SA firms compared to the IRB firms for the exact same mortgage exposure.

For example, for every £100 of less than 50% LTV mortgages a SA lender has to hold £2.80 of capital, whilst an IRB bank need only hold 26p! The mortgage sector is important since it represents more than £1.3tn of lending in the UK. This leads to the potential for increasing “dead capital”, as both Mark Carney and Sam Woods describe it, which means that excess capital is set aside and is no longer available to the bank to lend against. This takes lending away from the economy, which could lead to less growth.

Recalibration

When setting add-ons the PRA compares firms’ SA risk weights to the upper range risk weights derived from IRB models (the ‘IRB benchmark’). In this CP the PRA is suggesting two things. Firstly, that they use Pillar 2A offsets to try and correct as far as is possible the difference in capital requirements identified above. Secondly, to revise the IRB benchmarks for the latest data (end-2015). This would all seem very sensible, however there are some issues. Firstly Pillar 2A is used to balance more than just credit risks in a bank or building society. So if a bank is poorly managed or has poor IT systems thus increasing its risk, the Pillar 2A add on could be high. Where a bank or building society has very limited Pillar 2A add-ons, due to being better managed, it will have less scope to reduce this, unless the PRA considers adjusting the Pillar 2A such that it allows it to become negative.

This is highly unlikely. The real issue that comes out in the CP is that the Pillar 1 under SA is too conservative, especially for low LTV consumer mortgages.

Defeating concentration

It is interesting when I look at the consumers’ point of view through the Competition and Markets Authority’s retail banking market investigation concluded in August 2016, which did not propose any material changes. This, in essence, perpetuates the same large “too big to fail” banks to swap current account customers between themselves and enjoy the lower risk weightings under IRB as well as benefiting from the implicit UK government guarantee. The real issue is that the high street has seen more than 20 banks and building societies reduce to five effectively. This is the competition issue and as long as the capital requirements, especially on mortgages, remain so far apart between small and large banks and building societies the only losers are the UK consumers. So the Bank of England and PRA’s attempts to re-balance this situation are very welcome to us all.

Double counting

The CP also proposes to take into account the impact of IFRS 9 on SA firms using IFRS when setting Pillar 2A. This is because elements of expected credit losses in IFRS may already be covered by the SA Pillar 1 capital requirements. IRB risk weights, for comparison, only take account of unexpected losses.

Too little too late?

The big question is “Is this enough?” I would say quite frankly “no, but…” The “but” is that this is a welcome move in the right direction and within the confines of the current regulations under the CRR and what latitude the PRA currently perceives it has. However, currently, there are many other exogenous forces at play on this subject.

One of the biggest impacts is the effect of the current Basel committee deliberations on Capital Floors. This would see, if the US has its way, the minimum risk weight under IRB set at 75% of the SA. This has, perversely, led to many IRB firms calling for SA Pillar 1 risk weights to be reduced! The Basel committee has not been able to meet since last year because the EBA does not agree with the US call for a 75% floor to be phased in over 10 years. So in the short term the PRA is indeed working, as part of its competition objective, to, as it has said: “Harrow the ploughed field”, which is both encouraging and commendable, but it still feels like the whole field sits on the side of a hill. One thing is for sure – there are no quick fixes or silver bullets.