An FPC Response - Amendments to the FPC's framework for the O-SII buffer

Overview

1. This paper contains feedback from the Financial Policy Committee (FPC) on responses to the FPC Consultation Paper on ‘Amendments to the FPC’s framework for the O-SII buffer’.

2. This paper also contains the FPC’s final policy in the form of a box (Appendix 1) to be inserted into the FPC’s framework for the other systemically important institutions (O-SII) buffer.^{footnote [1]}

3. This paper is relevant to Prudential Regulation Authority (PRA)-regulated ring-fenced banks and large building societies that are subject to the O-SII buffer.

Background

4. The O-SII buffer is the UK’s capital buffer for UK domestic systemically important banks (D-SIBs) and applies to ring-fenced banks and large building societies. It raises the capacity of these banks to withstand stress, thereby increasing their resilience. This reflects the additional damage that these banks could cause to the UK economy if they were close to failure.

5. Under the Capital Requirements (Capital Buffers and Macro-prudential Measures) Regulations 2014, the FPC must maintain a framework for setting O-SII buffer rates that reflects the extent to which the failure or distress of a ring-fenced bank or large building society might pose a risk to the UK financial system.^{footnote [2]}

6. The FPC conducted a review of its O-SII buffer framework, in line with its commitment in the 2020 Q3 Record and December 2020 Financial Stability Report to consider information that became available during the Covid-19 (Covid) shock, about how the framework operates in stress.

7. The Consultation Paper, ‘Amendments to the FPC’s framework for O-SII buffer’, outlined changes that the FPC proposed to make to the framework. These proposals are summarised below.

FPC consultation

8. The FPC’s consultation set out its proposed revisions to the O-SII buffer framework, as follows:

1. To change the metric used to determine O-SII buffer rates from total assets to the UK leverage exposure measure.
2. To recalibrate the thresholds used to determine O-SII buffer rates to prevent an overall tightening or loosening of the framework relative to its pre-Covid level.

9. The proposal aimed to ensure that the framework still addresses the key systemic risk intended by the FPC: the risk that a distressed ring-fenced bank or large building society disrupts the supply of credit to the real economy. It achieves this as follows:

1. First, it excludes from the framework central bank reserves,^{footnote [3]} which grew significantly during the pandemic but do not reflect a bank’s potential to disrupt the credit supply. This exclusion mitigates the risk that future changes in central bank balance sheets inadvertently affect banks’ lending decisions by interacting with the O-SII buffer. It also allows banks to draw on central bank liquidity as necessary without becoming constrained by the associated effect on buffer requirements.
2. Second, the proposal brings into the framework committed but undrawn credit facilities. Experience during the pandemic suggests that these can form an important part of the credit supply in stress.

Summary of responses

10. The FPC received three written responses to its Consultation Paper. One response was out of scope of the consultation. The other two responses generally welcomed the proposed amendments to the FPC’s O-SII buffer framework. Respondents particularly supported the proposal to replace the total assets metric with the leverage exposure measure.

11. Respondents suggested a number of changes to the calibration of the new thresholds and the components of the metric used to determine O-SII buffer rates. Topics covered by respondents included individual bucket calibration, indexing of thresholds, and exclusion of gilts and central bank reserves from the metric used to determine O-SII buffer rates.

Changes to draft policy

12. In light of the responses received, the FPC is finalising its policy as proposed, subject to one change relating to the calculation of firms’ leverage exposure measure used to determine O-SII buffer rates. Specifically, the FPC has determined that the average of firms’ quarter-end leverage exposure measure over the year will be used to determine O-SII buffer rates, rather than the year-end value. An average measure is less subject to volatility at year end and would be a better proxy for a firm’s potential to disrupt the credit supply in distress.

13. The FPC considers that the use of an average of firms’ quarter-end leverage exposure measure when setting rates in 2023, based on 2022 data, would not be appropriate since it would include financial results reported prior to the finalisation of this policy. As such, the FPC has decided that the use of an average of firms’ quarter-end leverage exposure measure will only take effect after the PRA’s December 2023 review of O-SII buffer rates. Thus the December 2023 review will be based on end-2022 leverage exposure measure. The detail of this change is explored below.

14. The FPC does not expect there to be any increased costs associated with the use of the average of quarter-end leverage exposure measure, since firms already report this metric at this frequency to the PRA.^{footnote [4]} As a result, the cost benefit analysis, as presented in the FPC’s Consultation Paper, remains unchanged.

FPC objectives (including remit and recommendations letter from the Chancellor)

15. The Consultation Paper set out the Committee’s expectation that the cost benefit profile of the O-SII buffer would remain broadly in line with the analysis set out in the current framework. This includes the FPC’s assessment of the impact of the O-SII buffer on matters relevant to the FPC’s secondary objective, including competition and economic growth.^{footnote [5]}

16. Following responses to the consultation, the FPC has again considered the analysis set out in the Consultation Paper, and remains of the view that the framework as consulted on best achieves its objectives. In light of the responses to the consultation, the FPC decided that O-SII buffer rates should be determined based on firms’ average of quarter-end leverage exposure measure. The FPC considers that this supports its primary objective as this measure would be a better proxy for a firm’s potential to disrupt the credit supply.

Implementation and next steps

17. In order to give firms time to adjust to the updated framework, the FPC has decided that the changes set out in this paper will only take effect after the PRA’s December 2022 review of O-SII buffer rates. The changes will instead come into effect in time for the PRA to review rates under a revised framework in December 2023. In addition, the FPC has decided that the use of an average of firms’ quarter-end leverage exposure measure will only take effect after the PRA’s December 2023 review. Thus the December 2023 review will be based on end-2022 leverage exposure measure. Rates set in 2023 will apply from January 2025.

18. The FPC also reminds firms that in October 2021, the PRA announced its intention to continue to freeze O-SII buffer rates at pre-Covid levels for a further year.^{footnote [6]} The FPC welcomed this announcement. The PRA is required to review the O-SII buffer rates once a year, but, as per the October 2021 statement, confirmed that, barring an unforeseen change in circumstances, it does not expect the 2022 review to result in any changes. The ongoing rate freeze, together with the FPC’s changes to the framework as set out in this paper, should give banks clarity and allow them time to adapt to these changes.

FPC response to the consultation

Feedback to responses

19. The FPC has considered the responses received to its consultation. This section sets out the FPC’s feedback to the responses relating to amendments to the FPC’s O-SII buffer framework, and its final decisions.

20. The FPC’s feedback to the consultation responses, and its final decisions, are grouped into the following categories in line with the proposed revisions:

1. Changing the metric from total assets to the UK leverage exposure measure; and
2. Recalibrating the thresholds that determine O-SII buffer rates.

21. This section contains the FPC’s judgement and decisions in relation to the O-SII buffer framework, and a summary of the Committee’s underlying deliberations in relation to those judgement and decisions.

Changing the metric from total assets to the UK leverage exposure measure

Exclusion of central bank reserves from the metric used to determine O-SII buffer rates

22. Respondents supported the exclusion of central bank reserves from the metric used to determine O-SII buffer rates.

23. One respondent raised a concern about unintended consequences if, in future, central bank reserves were reintroduced into the leverage exposure measure, and proposed that central bank reserves be excluded from the metric used to determine O-SII buffer rates on an ongoing basis.

24. The FPC recognises that its judgement on the appropriateness of the leverage exposure measure as the metric used to determine O-SII buffer rates is partly based on the exclusion of central bank reserves. Central bank reserves grew significantly during the pandemic, but do not reflect a bank’s potential to disrupt the credit supply. Thus, the FPC considers that a metric that excludes central bank reserves is more appropriate.

25. The FPC considers that the use of the leverage exposure measure as the metric used to determine O-SII buffer rates retains the simple, transparent approach of the framework. As part of its review of the O-SII buffer framework at least every second year, the FPC will consider any intervening changes to the leverage exposure framework and any resulting impact on the intended operation of the O-SII buffer framework, as appropriate.

Gilts in the O-SII buffer metric

26. Two respondents proposed that gilts should be excluded from the metric used to calculate O-SII buffer rates. The respondents argued that the metric proposed by the FPC would likely incentivise banks to reduce their direct and indirect gilt holdings, which would be counterproductive, especially given the Monetary Policy Committee’s recent policy decisions around its stock of UK government bond purchases. Respondents argued that holding gilts did not imply a greater systemic importance or greater capacity to disrupt the economy and thus the arguments for excluding central bank reserves from the metric apply equally to holdings of UK gilts. One respondent also pointed to the importance of indirect gilt holdings in supporting the financing of UK pension funds.

27. As set out in PRA Policy Statement 21/21 ‘The UK leverage ratio framework’, the FPC notes that the PRA does not consider there to be any prudential grounds to exclude sovereign exposures from the leverage exposure measure.^{footnote [7]} The FPC considers that the leverage exposure measure is an appropriate proxy for a bank’s potential to disrupt the credit supply, noting that sovereign debt is a form of credit provision. This includes where firms hold gilts as collateral for financing, for example to pension funds. Thus the FPC does not agree that the arguments for excluding central bank reserves from the metric used to determine O-SII buffer rates apply equally to holdings of UK gilts. The FPC considers that the inclusion of gilts in the metric is appropriate.

28. In addition, excluding gilts from the metric used to determine O-SII buffer rates would effectively create a new measure, separate to the leverage exposure measure, which would increase complexity for regulated firms.

Calculating the UK leverage exposure measure for setting O-SII buffer rates

29. One respondent suggested that firms’ O-SII buffer rates should be set based on an average of quarter-end leverage exposure measure for that calendar year, as opposed to the year-end leverage exposure measure. The FPC agrees that an average measure is less likely to be subject to volatility at year-end and would be a better proxy for a firm’s potential to disrupt the credit supply. Therefore, in its final policy, the FPC decided that O-SII buffer rates should be determined based on firms’ average of quarter-end leverage exposure measure. Since firms already report the leverage exposure measure at this frequency, there would be no additional burden on firms.

30. The FPC considers that the use of an average of quarter-end leverage exposure measure when setting rates in 2023, based on 2022 data, would not be appropriate since it would include financial results reported prior to the finalisation of this policy. As such, the FPC decided that the use of an average of firms’ quarter-end leverage exposure measure will not take effect until after the PRA’s December 2023 review of O-SII buffer rates. Thus the December 2023 review will be based on end-2022 leverage exposure measure.

Recalibration of the thresholds that determine O-SII buffer rates

Calibration of the new thresholds

31. One respondent suggested recalibrating the new O-SII buffer rate bucket thresholds for each individual bucket, to maintain approximately equivalent headroom to thresholds. The FPC consulted on calibrating the new thresholds based on an average difference between relevant firms’ (those subject to an O-SII buffer) total assets and leverage exposure measure in 2019 to prevent an overall tightening or loosening of the framework, relative to its pre-Covid level. As such, the FPC proposed that each of the O-SII buffer thresholds should reduce by £15 billion, which should ensure, on average, that banks maintain 2019 levels of headroom below a threshold. The FPC recognised that some banks have a slightly higher UK leverage exposure measure relative to total assets, than other banks. For banks where the UK leverage exposure is relatively high compared to total assets, the recalibrated thresholds might reduce their headroom from the next rate threshold.

32. The FPC considers that there are no macroprudential grounds for recalibrating thresholds on an individual bucket basis. For example, this approach would have the effect of calibrating two of the buckets based on individual firm data at a point in time;^{footnote [8]} the FPC considers this would be an inappropriate basis to calibrate thresholds for the framework as a whole. Such an approach would also create buckets of unequal size. This could create uneven incentives to become more systemic between firms in different buckets. The FPC therefore considers that the alternative approach suggested by the respondent would be inconsistent with the overall framework.^{footnote [9]}

Indexation of thresholds

33. One respondent urged the FPC to consider indexing the nominal thresholds corresponding to O-SII buffer rates, in order to avoid downward creep in what is considered to be a systemically important firm.

34. The FPC recognises the relative nature of the O-SII buffer. In designing the framework, the FPC judged that the size of a bank’s O-SII buffer should reflect the greater costs to the economy if that bank fell into distress relative to a smaller, non-systemic bank. The FPC has not ruled out indexing in the future should it judge this appropriate.

35. The FPC is mandated to review its O-SII buffer framework at least every second year. The appropriate level of thresholds is within the scope of such reviews. Therefore, if the Committee judges that the absence of threshold indexation could be adversely impacting the intended aims of the framework, the FPC will conduct analysis on the case for indexing the thresholds as part of its next review.

Annex

The FPC will implement the changes set out in this paper by adding a new box to the framework.

• Box 1A: Amendments to the FPC’s framework for the O-SII buffer following the FPC’s review in 2021

  1. The Financial Policy Committee (‘the FPC’ or ‘the Committee’) must have a framework for the O-SII buffer and review this framework at least every second year.^{footnote [10]}

  2. Following its December 2020 review, the FPC was not required to review the framework again until December 2022. The Committee decided, however, to undertake a review in 2021 Q3 in line with its commitment in the 2020 Q3 Record and 2020 Financial Stability Report to consider information that became available during the Covid-19 (Covid) shock about how the framework operates in stress.

  3. In response to the 2021 Q3 review, the Committee amended its framework as follows:

  1. Changed the metric used to determine O-SII buffer rates from total assets to the UK leverage exposure measure.
  2. Recalibrated the thresholds that determine O-SII buffer rates to prevent an overall tightening or loosening of the framework relative to its pre-Covid level.

  4. Details of how the UK leverage exposure measure is calculated can be found in the UK Leverage Ratio Framework.^{footnote [11]}

  5. The amendment ensured that the framework still addressed the key systemic risk intended by the FPC: the risk that a distressed ring-fenced bank or large building society disrupts the supply of credit to the real economy. It achieved this as follows:

  1. First, it excluded from the framework central bank reserves, which grew significantly during the pandemic but do not reflect a bank’s potential to disrupt the credit supply. This exclusion mitigates the risk that future changes in central bank balance sheets inadvertently affect banks’ lending decisions by interacting with the O-SII buffer. It also allows banks to draw on central bank liquidity as necessary without becoming constrained by the associated effect on buffer requirements.
  2. Second, it brought into the framework committed but undrawn credit facilities. Experience during the pandemic suggested that these can form an important part of the credit supply in stress.

  6. The FPC decided that the changes would come into effect in time for the PRA to assess rates under a revised framework in December 2023, based on end-2022 financial results. Rates set in 2023 would then apply from January 2025.

  7. The FPC consulted on these amendments in an FPC Consultation Paper which was published on 15 November 2021. The Consultation Paper gives a detailed explanation of the change, including a cost benefit analysis. The FPC’s Response published on 23 May 2022 sets out feedback on responses to this consultation and confirms the FPC’s final policy decision.

  Motivation for the amendments

  8. Total assets across ring-fenced banks grew significantly in 2020 (Chart A). This was not driven by lending (which stayed broadly constant) but by very high growth in central bank reserves. Such growth does not reflect an increase in a bank’s potential to disrupt the credit supply, the key externality that the FPC intends the O-SII buffer to address.

  Chart A: Aggregate assets and central bank reserves for ring-fenced banks ^{(a) (b)}

  

  Footnotes

  • (a) Ring-fenced banks of major UK banks and Nationwide.
  • (b) Reserves shown here are based on the definition used in the UK leverage ratio.

  9. The evolution in balance sheets demonstrated that total assets and lending do not necessarily move together over time in a stress, suggesting that total assets were no longer the most appropriate proxy for a bank’s potential to disrupt the credit supply.

  10. The growth in central bank reserves also had the effect of pushing banks towards O-SII buffer rate thresholds, irrespective of their potential to disrupt the credit supply. This risked creating an incentive for banks to manage the size of their balance sheets by constraining lending. It also risked influencing banks’ decisions about their use of central bank liquidity.

  11. In light of these factors, the FPC considered an alternative proxy that excluded central bank reserves would be more appropriate.

  12. Experience during the pandemic also suggested that committed but undrawn credit facilities can form a key part of the credit supply. In its May 2020 Financial Stability Report, the FPC observed that in 2020 Q1, the major UK banks had expanded their net lending by around £20 billion, as business drew down committed credit lines. This compared to a reduction in net lending of £3 billion over 2019.^{footnote [12]} Committed but undrawn credit facilities are not captured by total assets, which again suggested that total assets was no longer the optimal metric to determine O-SII buffer rates.

  13. The FPC therefore changed the metric used to determine O-SII buffer rates from total assets to the UK leverage exposure measure, as this both excluded reserves and brought committed but undrawn credit facilities into the framework.

  Detail of amendments to the O-SII buffer framework

  (i) Amended metric to determine O-SII buffer rates

  14. The FPC has changed the metric used to determine O-SII buffer rates from total assets to the UK leverage exposure measure. O-SII buffer rates should be determined based on firms’ average of quarter-end leverage exposure measure. The use of an average of firms’ quarter-end leverage exposure measure will not take effect until after the PRA’s December 2023 review of O-SII buffer rates. Thus the December 2023 review will be based on end-2022 leverage exposure measure.

  (ii) Recalibrated O-Sll buffer rate thresholds

  15. The FPC has adjusted the thresholds used to determine O-Sll buffer alongside the change in metric, in order to prevent an overall tightening or loosening of the framework relative to its pre-Covid level. The FPC has calibrated this adjustment based on financial results from 2019, before the large expansion in central bank reserves during the pandemic.

  16. Previously, thresholds were expressed in terms of total assets. Following the FPC’s amendments, the revised thresholds are expressed in terms of the UK leverage exposure measure.

  17. As at December 2019, the UK leverage exposure measure for banks attracting an O-SII buffer was on average c.£15 billion lower than those banks’ total assets. The FPC has therefore reduced the previous O-SII buffer thresholds by a constant £15 billion. This should prevent an overall tightening or loosening of the framework relative to pre-Covid levels. The revised thresholds are set out in Table 1 below:

  Table 1: Previous thresholds and recalibrated thresholds for determining O-SII buffer rates

  Buffer rate	Previous total asset thresholds (£ billions)	Recalibrated UK leverage exposure measure thresholds (£ billions)
  0.0%	<175	<160
  1.0%	175 to <320	160 to <305
  1.5%	320 to <465	305 to <450
  2.0%	465 to <610	450 to <595
  2.5%	610 to <755	595 to <740
  3.0%	≥755	≥740

  The Financial Policy Committee

  Andrew Bailey, Governor
  Jon Cunliffe, Deputy Governor responsible for financial stability
  Ben Broadbent, Deputy Governor responsible for monetary policy
  Dave Ramsden, Deputy Governor responsible for markets and banking
  Sam Woods, Deputy Governor responsible for prudential regulation
  Nikhil Rathi, Chief Executive of the Financial Conduct Authority
  Sarah Breeden, Executive Director for Financial Stability, Strategy and Risk
  Colette Bowe
  Jon Hall
  Anil Kashyap
  Elisabeth Stheeman
  Carolyn Wilkins
  Gwyneth Nurse attends as the Treasury member in a non-voting capacity