PRA dis-incentivising high risk mortgage lending

1 March 2017

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Both the PRA and Competition and Markets Authority (CMA) are concerned that mortgage lenders operating under the Standardised Approach (SA) for credit risk are being incentivised to specialise in riskier exposures, thereby undermining the safety and soundness of these firms. This is due to the conservative nature of the SA, which remains insensitive to the reduced risk of lower LTV exposures.

This situation is exacerbated for SA firms operating under International Financial Reporting Standards (IFRS) who will be hit hardest by the impending introduction of IFRS 9, which moves the basis of provisions from an incurred loss measure to an Expected Credit Loss measure.

The PRA are therefore consulting on refining the Pillar 2A capital framework from 1st January 2018. This impacts all banks, building societies and PRA-designated investment firms operating under the SA.

A fly in the ointment

The Internal Capital Adequacy Assessment Process (ICAAP) is used to inform the level of additional Pillar 2A capital requirements for risks either not captured or not fully captured under Pillar 1. A crucial element of this is a comparison of SA and Internal Ratings Based (IRB) risk weights using the PRA’s IRB benchmarking. Whilst some steps have already been taken by the PRA to reduce the discrepancy in capital requirements between SA and IRB firms, the regulator does not feel this necessarily goes far enough to address their concerns.

A further fly in the ointment is the introduction of IFRS 9 since impacted firms should expect to see an increase in credit loss provisioning, which could be significant for mortgage lenders. This hurts SA firms in two distinct ways, firstly, by not benefitting from IRB Expected Loss (EL) effectively absorbing some of the increased provisioning, SA firms are also hampered by an element of EL being reflected in Pillar 1 risk weights. As such SA firms will see their Common Equity Tier 1 capital adversely impacted through a reduction in retained earnings and the disparity between SA and IRB firms will widen further.

Leveling the playing field

The PRA are therefore proposing that, rather than mechanically linking Pillar 2A assessments to the IRB benchmark, a more judgemental approach based on other factors should be used. These factors would include a firm’s business model and overall risk profile as well as peer reviews and the appropriateness of the IRB benchmark to the specific firm. The fundamental consideration will be the PRA’s estimation of the amount of capital necessary to ensure a sound management and coverage of risk. In order to facilitate this assessment, all firms will be expected to submit regular credit risk exposure returns alongside every ICAAP submission rather than on a more ad-hoc basis as is currently the case.

The PRA is also proposing the introduction of a secondary IRB benchmark based entirely on unexpected losses, whereby EL is removed from the benchmark calculations. This would be more representative for SA firms currently under IFRS.

The PRA is hoping that these measures will help level the playing field for well managed and risk sensitive SA firms by enabling access to the capital benefits of low LTV exposures normally reserved for IRB mortgage lenders. Additionally, the Minimum Requirements for own funds Eligible Liabilities (MREL) as required in accordance with the EU Bank Recovery and Resolution Directive may also be reduced since the Bank of England links MREL directly with Pillar 2A requirements.

What should you do now?

The consequences of the PRA’s steps to both ensure the safety and soundness of the firms it regulates and also encourage effective competition from the well run, low risk mortgage lenders leads to certain expectations on you.

In order to make the most of the opportunities presented by the PRA’s proposal you will need to establish the potential impacts and consider what capital benefits may be available to you. You may also wish to reassess your risk appetite in light of the regulators concerns about high LTV mortgage lending. Alternatively you may even consider moving to the IRB approach.

You will also need to demonstrate that your ICAAP encapsulates a true and fair assessment of your firm’s specific risks rather than merely replicating the PRA’s own methodology and you will be expected to have the necessary systems in place to cope with the increased reporting burden. It’s never too soon to give your ICAAP a health-check and the competitive advantage of doing so should not be under-estimated.

Bovill has expertise in prudential regulation and can provide you with tailored support and guidance to enable you to maximise the benefits presented by the PRA’s proposals. We can also carry out a full review of your ICAAP and related disclosures and advise you on any further action you may need to take.

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