Authors: Jenny Stainsby, Vicky Man and Cat Dankos
While there have been other reviews1 into the near failure of the Co-operative Bank (“Co-op Bank”), on 6 March 2018, HM Treasury announced that it had directed the Prudential Regulation Authority (“PRA”) to conduct a further investigation, specifically focused on the prudential supervision of Co-op Bank between 2008 and 2013 with a view to reporting on any lessons learned and making appropriate recommendations (“the Review”). The review period covers a significant period for the Co-op Bank, including its merger with Britannia Building Society (“Britannia”) in 2009 and its withdrawal from the bidding process to purchase 632 bank branches from Lloyds Banking Group in 2013.
This is the first example of the use of a statutory power enacted in 2012 whereby the Treasury may require the PRA (or Financial Conduct Authority (“FCA”)) to investigate where it considers that it is in the public interest that the PRA (or FCA) should carry out an investigation into ‘relevant events’ and it does not appear to the Treasury that such an investigation has been or is being undertaken2. The Government had announced its intention to invoke this power in 2013, stating at that time that the review would not commence until the conclusion of all regulatory enforcement action relating to Co-op Bank.
With Treasury’s approval, the PRA appointed Mark Zelmer as independent reviewer to conduct the Review. Mr Zelmer’s report was published on 27 March 2019. In it, Mr Zelmer addresses the eight areas of investigation which were set out by HM Treasury; and provides eight recommendations. The PRA and the Bank of England’s (“BoE”) Joint Response was published on the same day and welcomed the report.
Many of the observations made in the report are unsurprising, and to a considerable degree, as acknowledged in the report itself, the shortcomings in supervision during the period of the review will have been addressed during the restructure of the UK regulatory regime in 2013. While a clear theme coming from the Review is the need to ensure ongoing compliance with regulatory and statutory requirements, there are a handful of forward-looking points from the Review and Joint Response of particular note:
- the Review draws particular attention to the importance of stress testing, and it seems likely that as stress testing methodology continues to evolve, it will do so with a particular eye to incorporating “the inherent uncertainty that would prevail as a stress scenario unfolds in real life”, the most recent ‘real life’ example to be included in stress tests being cyber stress tests;
- the Review considers various threats to the safety and soundness arising from technology, (for example, cyber-attacks), but notably draws out the potential impact of Open Banking on bank runs which may highlight for some firms the need to review both “early warning” detection strategies and crisis management preparedness;
- in the joint response, the PRA explains that it is considering whether to set either formal or informal asset encumbrance limits; should the PRA proceed with limits, this will have an impact on balance sheet calculations; and
- the Review also notes that the PRA said that it intends to assign firms’ senior managers (as designated under the Senior Managers and Certification Regime or “SMCR”) to be accountable for actions in letters to the largest UK deposit takers; the September 2018 letter on LIBOR transition is an illustration of this.
Below we consider in more detail some of the key recommendations, the BoE and PRA response, and implications for firms.
- Stress testing
- Recommendation: The PRA and BoE should continue to evolve their stress test exercises so that they encompass a broad range of risks to which firms are exposed, and consider how best to incorporate the inherent uncertainty that would prevail as a stress scenario unfolds in real life.
- Joint Response: In collaboration with the Financial Policy Committee (“FPC”), the PRA and BoE run various stress tests, including an annual cyclical scenario (“ACS”) and biennial exploratory scenario (“BES”). The ACS tests in particular have been quite severe; testing firms’ resilience and ensuring they had sufficient capital to withstand shocks and to support the economy if stress does materialise. These tests also reflected a broad range of “real life” experiences, including uncertainty, panic selling and other asset price stresses observed in historical crises. For example, in September 2018 (and most recently in its 15 April 2019 statement), the BoE announced it would explore whether climate related factors should be included in a future BES and this year, the PRA and BoE plan to start piloting cyber stress tests.
- Key takeaways: In light of regulators’ intention to stress test firms’ resilience against cyber and other risks, firms may wish to expand the range of scenarios they consider and also evaluate their risk profiles more holistically, incorporating cyber risks, and climate-related factors, in addition to prudential risks. In general, firms should ensure their relevant policies and guidelines remain up-to-date and that staff receive regular training, such as their operational risk policy, business continuity plan and company resolution plan.
- Using new resolution tools in systemic situations
- Recommendation: The PRA and the BoE should continue to study how best to use new resolution tools under the Banking Act 2009 in systemic situations.
- Joint Response: The PRA and BoE acknowledge that more progress is needed where failures occur in systemic situations and it is important to ensure that the tools can be effectively used as intended in such situations. The Joint Response noted the transparency of regulatory expectations around resolvability, including, in the BoE’s resolvability assessment framework (“RAF”) and guidance on resolution, particularly in relation to capital and loss absorbency requirements. It also commented that the UK banks are “well on the way” to meeting loss absorbency requirements. Other measures which the Joint Response flagged as helpful in systemic situations included: statutory safeguards within the resolution regime (e.g. those capping losses) and introduction of a resolution liquidity framework. The Joint Response also flagged the possibility of imposing requirements to restrict cross-holdings of minimum requirement for own funds and eligible liabilities (“MREL”) between globally systemic firms in order to reduce contagion risk, as currently proposed in the Capital Requirements Regulation II (“CRR II”).
- Key takeaways: The independent reviewer raises concerns about how Open Banking may affect the use of the resolution tools. He warns that the advent of third party service provider access to bank account data presents a risk that funds will be automatically transferred away from a potentially troubled institution, regardless of the strength and efficiency of deposit protection scheme or the resolution arrangements. In response, firms should consider reviewing both “early warning” detection strategies and crisis management preparedness to ascertain whether they have sufficient response mechanisms in place.
- Setting asset encumbrance limits
- Recommendation: The PRA and BoE should consider whether to impose formal or informal constraints on the extent to which firms and other deposit-taking institutions could encumber their assets in normal circumstances and how best to factor encumbrances into the recovery and resolution plans for these institutions.
- Joint Response: In view of this recommendation, the PRA said that it would consider whether to set formal or informal asset encumbrance limits. The BoE noted that the RAF would place greater responsibility on firms to demonstrate how they would meet their liquidity needs in resolution. This would involve having the capability to estimate, anticipate, and monitor potential liquidity resources and needs, and to mobilise liquidity resources; firms would need to take into account encumbrance levels as part of that analysis.
- Key takeaways: Although it is unclear whether the PRA will set asset encumbrance limits and how informal limits would operate in practice, firms may want to consider how the imposition of formal or informal asset encumbrance limits would impact their current operations and whether they are able to demonstrate they would be able to meet liquidity needs in resolution.
- Prevent circumvention of regulatory requirements
- Recommendation: The PRA should continue to pay close attention to any attempts by firms to circumvent regulatory and supervisory requirements and focus on the economic substance of transactions, not their accounting treatment or how they are funded.
- Joint Response: The PRA noted that one of its current strategic goals was to adapt to changes in the external market, and said that it planned to re-examine the processes and procedures it currently has in place to deal with firms’ attempts to circumvent regulatory and supervisory requirements. The PRA also said that it intended to introduce a specific focus in its horizon-scanning on how IT expenditure was being accounted for by firms. However, the PRA said that it did not intend to review every transaction and would hold firms to account for their compliance with the Senior Managers Regime, noting that Senior Managers and the boards of regulated firms are responsible for identifying and mitigating the risk that their firms were engaged in regulatory arbitrage.
- Key takeaways: Firms may wish to review the accounting treatment of various costs, particularly IT expenditure given the comments in the Joint Response. In particular, Senior Managers and the board should be vigilant in ensuring that the firm has adequate systems and controls in place to identify and mitigate the risk that of engaging, or being seen to engage, in regulatory arbitrage.
- Introducing third party reviews
- Recommendation: The PRA should consider whether to introduce more formal third-party reviews of key prudential information supplied by banking groups through their regulatory data returns.
- Joint Response: The PRA will consider how to ensure the regulatory data is accurate, including by way of introduction of more formal third party reviews. In this regard, the PRA would consider the following:
- whether the benefits of any such reviews would outweigh the costs;
- to which types or sizes of firms they might apply;
- which data might be within scope;
- whether reviews would be targeted or regular;
- whether the results of the review would be private or public;
- the significant amount of work some regulated firms will have to carry out in coming years as a result of Brexit; and
- other supervisory tools available (e.g., a firm’s responsibility to provide accurate regulatory returns, responsibility of individuals under the Senior Managers Regime, validation and plausibility checks run as part of the PRA’s day-to-day supervision and requiring firms to conduct an internal audit review/ commission an independent review, potentially under a section 166 investigation notice).
- Key takeaways: While the PRA has agreed to consider this recommendation, it appears unlikely that it will require more formal third party reviews at the present stage. However, firms should nevertheless ensure that their regulatory returns are accurate and not misleading, given the firm-wide and individual implications. For example, inaccurate returns may be viewed as breaching one or more of the PRA Fundamental Rules (e.g., Fundamental Rule 2: Due skill, care and diligence, Fundamental Rule 5: Effective risk strategies and risk management systems, etc.) which can, in turn, lead to supervisory intervention or enforcement action. At the individual level, there are corresponding expectations under the SMCR.
- Giving more guidance to PRA supervisors
- Recommendation: PRA supervisors would benefit from more detailed internal guidance on how to assess the risks to which regulated financial institutions are exposed and the associated mitigants, as well as how to assess significant transactions.
- Joint Response: The PRA will develop further material to convey key principles which supervisors can apply.
- Key takeaways: The acknowledgement of the need for further guidance for PRA supervisors may underscore for firms the need to fully engage with their supervisory team to ensure the team understands the business and/or any significant transactions.
1Please see the reports by Sir Christopher Kelly “Failings in management and governance – Report of the independent review into the events leading to the Co-operative Bank’s capital shortfall”, 30 April 2014, Lord Myners, “The Co-operative Group – Report of the Independent Governance Review”, 7 May 2014 (the Myners Review) and the House of Commons Treasury Committee, “Project Verde”, Sixth Report of Session 2014-15, Vol.I, HC 728-I (TSC Verde Report).
2Financial Services Act 2012, section 77