Prudential Regulation Authority Rulebook

4.1

Poor capital management is a common theme across new and growing banks, with such banks often leaving it to the last minute before securing the investment needed to continue operating without entering capital buffers. This can result in banks entering their capital buffers in the usual course of business, which is not in line with PRA policy, or the need to seek additional capital investment under challenging circumstances, which can act as a significant distraction for management.

4.2

The PRA’s expectations in relation to all UK incorporated firms, including new and growing banks, are that firms should maintain appropriate capital resources, both in terms of quantity and quality, consistent with their safety and soundness and taking into account the risks to which they are exposed. Having enough capital of sufficiently high quality reduces the risk of a firm becoming unable to meet the claims of its creditors, and is crucial for maintaining depositor confidence.

4.3

The PRA recognises that new and growing banks need time to become profitable and that, consequently, new banks are typically dependent on external capital support to meet required growth targets and to help absorb early losses. A bank should prudently consider potential headwinds and ensure that it has sufficient capital to withstand these, including the possibility that profitability takes longer to achieve than expected. The loss or delay of external capital support is a frequent contributor to new bank business models becoming distressed and growth targets being missed.

4.4

As first articulated in the 2013 report, new banks should also hold sufficient capital resources to meet Pillar 1 (P1), Pillar 2A (P2A), and buffers for at least the 12 months following exit from mobilisation (or upon authorisation if a firm does not follow the mobilisation route). This is in addition to meeting actual capital requirements, buffers and, if applicable (subject to the resolution strategy) any MREL above TCR. This is intended to avoid the significant management distraction involved in seeking external capital support in a bank’s first year of operation, recognising these banks are likely to have few recovery options and a high rate of capital erosion.

4.5

Beyond this, banks should continue to manage their capital position on a sufficiently forward looking basis to avoid the need for emergency actions in order to prevent capital requirements plus buffers from being entered. Banks should set a clear risk tolerance for delays to capital raising plans, including consideration of Board approved triggers for the implementation of management actions designed to preserve capital headroom. Where a bank’s access to external capital is exposed to enhanced risk (i.e. because there are limited sources of capital or because investors demand capital instruments with complex features), banks should consider building additional contingencies and management actions into their capital plans in order to mitigate these risks. If the PRA observes evidence of ineffective capital planning, supervisory intensity will increase including consideration of whether further action is required (see paragraph 4.13). If the issue persists, the PRA’s focus will ultimately shift towards ensuring the business can exit the market in an orderly manner (see Chapter 5).

4.6

The PRA buffer (also referred to as Pillar 2B) is an amount of capital banks should maintain in addition to their TCR and the combined buffers. The PRA buffer for established banks is calculated based on the amount of capital needed to remain above TCR under a severe but plausible stress scenario.⁵⁷ For new and growing banks, the amount of capital needed to survive such a scenario would generally be very large, as it would need to cover: ongoing losses; Risk Weighted Assets (RWA) growth associated with continued business expansion; additional losses arising from the stress scenario; and limited access to external capital because of the adverse market conditions. This could give rise to a disproportionate level of capital relative to the financial stability risks posed by new banks, as these banks should be able to exit the market easily if required.

4.7

In recognition of this, an alternative approach to calculating the PRA buffer for new banks was first introduced in 2013 based on the bank’s estimate of wind down costs. Banks have taken different approaches to calculating this so the PRA has clarified the purpose of the buffer and adopted a simpler approach to its calculation. The PRA buffer for new and growing banks is calibrated to allow banks time to find alternative sources of capital or make business model adjustments, in the event of a loss of investor support. The PRA is of the view that a reasonable amount of time to allow for banks to pursue alternative options is around six months. Therefore banks are expected to calibrate their PRA buffer to be equal to six months projected operating expenses, defined as those expenses associated with the day to day running of the business.

Table 3: Expense category and FINREP 2 line item

4.8

The operating expenses methodology for calibrating the PRA buffer is applicable to banks which have:

• been operating for five years or less since being authorised without restriction; and
• yet to achieve a profit over a full year of trading.

4.9

The buffer calculation should appear within the bank’s ICAAP with the projection covering the six months after the ICAAP reference date.⁵⁸ These projections should align with the bank’s business plan and may be subject to challenge by the PRA.

4.10

Interaction between the PRA buffer and the Capital Conservation buffer (CCoB) remains the same. To avoid double counting between the buffers, the component of the PRA buffer that relates to operating expenses is calculated as the excess amount of capital required over and above the CCoB. The Countercyclical Capital buffer is not part of this calculation.

4.11

As the buffer for new banks is not calibrated on the basis of a stress test, it does not necessarily provide sufficient capital for banks to survive a stress or execute a solvent exit. If a new or growing bank enters its buffer and is unable to restore its capital position or continues to erode capital, this may lead to the bank having to be resolved, subject to the statutory conditions being met. The boards of new and growing banks should be cognisant of this when setting their internal capital risk appetite.

4.12

When exercising its supervisory judgement, the PRA may, in exceptional circumstances, diverge from the stated approach to calculating the PRA buffer for new and growing banks, for instance where the stated approach does not achieve the intended outcome of avoiding a disproportionate level of capital relative to financial stability risks. Such divergence could also include instances where the PRA identifies heightened risks to its objectives which justify an earlier transition to the PRA buffer in line with established banks.

4.13

Banks should manage their capital position on a forward looking basis and, as outlined in SS31/15, should not use their PRA buffer in the normal course of business or enter into it as part of their base business plan. Where capital injections are needed, these should take place sufficiently in advance to avoid entering buffers. Responsibilities for the management of the bank’s capital position should be clearly defined in accordance with the Senior Managers Regime.

4.14

Use of the PRA buffer is not in itself a breach of capital requirements or Threshold Conditions (see 5.33 of SS31/15). However given the speed of capital depletion that is often experienced by new and growing banks, if such banks expect to enter their PRA buffer, the board is expected to act quickly and decisively to address the problem, given the PRA buffer has not been calibrated to provide sufficient capital to survive a stress or execute a solvent exit.. A bank should notify the PRA as early as possible when it has identified it may need to use its capital buffer and explain how it plans to restore its buffer (see 5.34 and 5.35 of SS31/15).

4.15

The PRA will undertake more intensive supervision if it becomes clear that a bank does not have a sufficiently forward looking approach to capital management and will consider whether further action should be taken. This may include the application of a risk management and governance scalar to reflect poor capital management; the use of a skilled person review under Section 166 FSMA; and restrictions being placed on the business.

4.16

The PRA’s approach for setting the PRA buffer is designed to support new banks in their early years of operation, and as such is time-limited. Once either of the conditions set out above (paragraph 4.8) no longer apply, the bank’s PRA buffer will be calibrated using the bank’s stress testing assessments, in line with established banks. However, as stated in paragraph 4.12, such an approach could be introduced earlier where the PRA identifies heightened risks to its objectives.

4.17

From the point of authorisation, new and growing banks should undertake stress testing as part of their ICAAP and business planning process. Banks should invest in developing their stress testing capabilities to ensure they have sufficient understanding of downside risks, can assess unexpected loss events and, in due course, transition smoothly to having a PRA buffer set on a stress test basis.

4.18

The ICAAP stress testing work should be proportionate to the scale of the bank, but should be adequate to allow calibration of the PRA buffer on a stress test basis. This will be subject to review and challenge as part of the capital Supervisory Review and Evaluation Process (SREP). Weaknesses in stress testing may be indicative of limitations in the bank’s risk management and governance capability. The PRA may apply a risk management and governance scalar if it concludes there are weaknesses in a bank’s risk management and governance capabilities.

4.19

As part of their ongoing capital management, new and growing banks should monitor their capital position against the PRA buffer calibrated on the basis of stress testing, to understand how this differs from their position against the PRA buffer being set based on operating expenses. Banks should plan for transitioning to the stress test buffer including building sufficient capital to be able to meet the stress test buffer at the point of transition. The PRA will engage with a bank well ahead of this transition to ensure this is the case.

4.20

The move to setting the PRA buffer based on stress testing may result in a sizeable increase in the amount of capital that a bank needs to hold. A plan for transitioning onto the stress testing approach will therefore be determined by the PRA dependent upon the circumstances, but usually this will be phased over two years to provide an incremental increase in the size of the buffer. If a bank does not have sufficient capital to meet the PRA buffer at the point of transition, as outlined in paragraph 4.14, it should notify the PRA as early as possible and explain how it plans to restore its buffer.

4.21

The Bank, as resolution authority, sets MREL for each institution. Should new banks meet the criteria for MREL in the first five years, for example by meeting thresholds for transactional accounts or providing critical functions to a scale, they will be granted a transition period. Firms are expected to plan for their MREL needs and reflect this in their capital planning.

4.22

Banks should expect the PRA to investigate whether any firm in breach or likely breach of its MREL is failing, or likely to fail, to satisfy the Threshold Conditions, with a view to taking further action as necessary. However, a breach or likely breach by a firm of its MREL does not automatically mean that the PRA will consider the firm is failing, or likely to fail, to satisfy Threshold Conditions.⁵⁹

4.23

The PRA expects firms to meet both MREL and maintain an amount of Common Equity Tier 1 (CET 1) capital that reflects their risk-weighted capital and leverage buffers (if applicable). The PRA expects firms not to double count CET1 towards both MREL and the amount reflecting the risk-weighted capital and leverage buffers (if applicable). While firms can meet MREL with CET1, they do not have to meet it with CET1.

4.24

As set out in SS7/13 ‘CRD IV and capital’⁶⁰ the PRA’s preference is for firms to adopt simple, plain vanilla share structures consisting of only one class of share that is fully subordinated to all other capital and debt, and has full voting rights and equal rights across all shares with respect to dividends and rights in liquidation. The PRA expects firms to refrain from features that may be ineffective (or less effective) in absorbing losses. For example, the PRA would expect firms to refrain from complex share structures, including transactions involving several legs or side agreements, where the same prudential objective can be achieved more simply. Complex features and structures complicate the prudential assessment and may also undermine instruments’ loss-absorbing properties.