CP12/22 – Risks from contingent leverage

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Responses are requested by Friday 3 February 2023.

The PRA prefers all responses to be sent by email to:CP12_22@bankofengland.co.uk.

Alternatively, please address any comments or enquiries to:
Capital & Compensation Standards Team
Prudential Regulation Authority
20 Moorgate
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EC2R 6DA

1. Overview

1.1 This Consultation Paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposals to update the PRA’s supervisory expectations for firms undertaking an Internal Capital Adequacy Assessment Process (ICAAP) in relation to the risks from contingent leverage, and to introduce a new data reporting requirement for collecting data on trading exposures where these risks may most likely arise. The proposals build on work done by the PRA, and the Bank of England more generally, in recent years to explore these risks.

1.2 Contingent leverage risks may arise from the use of certain forms of financing. Firms hold capital against these forms of financing under the leverage ratio framework, but there may be circumstances under which these trades are no longer or less available to firms, and firms have to replace them with trades that attract greater leverage ratio requirements. The proposals in this CP would help the PRA and firms better understand the significance of these risks, and better manage them should they materialise.

1.3 The proposals in this CP would result in changes to the PRA’s Supervisory Statement (SS) 31/15 ‘The Internal Capital Adequacy Assessment Process (ICAAP)’ (Appendix 1), the Reporting (CRR) Part of the Rulebook (Appendix 2), and the ‘Instructions for reporting on leverage’ (Appendix 4).

1.4 The policy proposals in this CP are:

• updates to the PRA’s expectations of firms undertaking ICAAPs to introduce guidance on assessing risks from contingent leverage as part of their assessment of risks of excessive leverage; and
• the introduction of a new reporting rule for firms to report data on trading exposures that may be sources of contingent leverage risk, as part of their existing reporting framework for the UK leverage ratio.

1.5 The PRA considers these proposals would help firms identify, monitor, and manage contingent leverage risk and would improve its ability to monitor the evolution of these risks with more granular data, helping the PRA take targeted action where relevant. The PRA considers that these proposals would further its secondary competition objective by clarifying the types of risks firms should consider in their ICAAP, improving transparency over its expectations for firms where these risks may be relevant and leading to a more consistent approach to managing these risks across firms.

1.6 The proposed changes to ICAAP expectations for contingent leverage risks are relevant to banks, building societies, and PRA-designated investment firms, and their qualifying parent undertakings (hereon referred to as ‘firms’) that are subject to the Internal Capital Adequacy Assessment Part of the PRA Rulebook. Consistent with the wider approach to ICAAPs, only firms for which contingent leverage is a relevant risk would be expected to produce detailed assessment for this purpose. The proposed reporting requirement is relevant to firms that are, at any point in time, subject to a leverage ratio minimum requirement pursuant to the Leverage Ratio – Capital Requirements and Buffers Part of the PRA Rulebook. None of the proposals in this CP are relevant to credit unions.

1.7 The PRA has a statutory duty to consult when making or changing rules (Financial Services and Markets Act 2000, ‘FSMA’, s138J). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. 

1.8 In carrying out its policy making functions, the PRA is required to comply with several legal obligations. Appendix 5 lists the statutory obligations applicable to the PRA’s policy development process. The analysis in this CP explains how the proposals have had regard to the most significant matters, including an explanation of the ways in which having regard to these matters has affected the proposals.

1.9 ‘Have regard’ considerations which were significant in the PRA’s analysis included the proposals’ positioning in relation to international standards and the relative standing of the UK. The proposals are aligned with incoming changes to the international standards (set by the Basel Committee on Banking Supervision), which recommend supervisory action (for example, additional reporting requirements) where concerns exist of certain transactions that have the result of inadequately capturing banks’ sources of leverage.^{footnote [1]} The proposed implementation of these changes could help maintain the UK as an attractive market for firms, by strengthening confidence in the resilience of the UK banking system.

Background

1.10 The leverage ratio is a simple indicator of a firm’s solvency that relates its capital resources to its exposures (these are referred to in the PRA rules as the ‘total exposure measure’). The lower a firm’s leverage ratio, the more the firm relies on debt to fund its activities. The general principles behind the leverage ratio are that: it should not seek to estimate the relative riskiness of assets; and that it should capture all exposures of a firm, whether on or off-balance sheet, regardless of the riskiness of the exposure.

1.11 The leverage ratio can guard against the danger that firms’ models or standardised regulatory requirements fail to reflect the true risk of its exposures. The leverage ratio also limits firms’ incentives to reduce estimates of risk weights over time; or to shift assets to those with lower – but potentially incorrectly measured – risk weights. It also protects against risks that are effectively unforeseeable.

1.12 While occasionally regulatory adjustments are made, calculation of the leverage ratio generally follows the specific accounting treatment of exposures. This means that certain forms of financing – specifically netted repurchase agreements (hereby netted ‘repo’), collateral swaps, other security financing transactions (SFT) and prime brokerage trades – are treated differently than other, economically similar, forms^{footnote [2]}. In particular, these forms of financing increase firms’ total exposure measure by less than other forms, such that less capital resources have to be held against them - in other words, they are more ‘capital efficient’.

1.13 These forms of financing play an important role in the financial system by facilitating the flow of cash and securities. They may also support market liquidity by allowing users to obtain securities to cover short positions, post collateral or raise cash. At the same time, this activity is a source of leverage risk for firms. Some of these trades may inadequately capture banks’ sources of leverage where these trades are no longer available in a stress. Banks should consider these sources of leverage as part of their risk management to prevent any potentially destabilising deleveraging process in a stress.

Summary of proposals

1.14 The purpose of the PRA’s proposals on contingent leverage risk (discussed in Chapter 2) is to help identify, monitor, and mitigate risks from contingent leverage by:

• updating the guidance provided to firms for assessing the risks of excessive leverage as part of their ICAAPs, to help them identify the risk of contingent leverage in their risk management processes; and
• introducing a new proposed PRA rule requiring relevant firms to report data on trading exposures where contingent leverage risks may arise, including netted repurchase agreements, agency models to transact security financing transactions, collateral swaps and prime brokerage positions.

1.15 The proposals in this CP follow on from the PRA’s work in recent years to explore and monitor contingent leverage risks, which the PRA had initially identified as part of its horizon-scanning activity to pre-empt and mitigate risks to its objectives.^{footnote [3]} These proposals have been developed following previous ad-hoc exercises with relevant firms to collect data on large firms’ use of trades that might be a source of contingent leverage risks, and associated qualitative assessments through supervisory reviews. The Bank of England also incorporated contingent leverage risks into its 2021 solvency stress test and the 2022 annual cyclical scenario.^{footnote [4]}

Implementation

1.16 The PRA proposes that the expected implementation date for the changes resulting from this CP would be Saturday 1 July 2023.

Responses and next steps

1.17 This consultation closes on Friday 3 February 2023. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP12_22@bankofengland.co.uk. Please indicate in your response if you believe any of the proposals in this consultation paper are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

2. The PRA’s proposals on contingent leverage risk

Sources of contingent leverage risk

2.1 Certain types of financing have a lower exposure measure value than other economically similar transactions in the calculation of the leverage ratio (and are therefore more capital-efficient)^{footnote [5]}. Contingent leverage risk arises when a firm can no longer rely on these capital-efficient forms of financing, for example in a stress. The crystallisation of this risk could lead to a fall in a firm’s leverage ratio, tightening its capital constraint, and leading to a potentially destabilising deleveraging process or a breach in capital requirements. The resulting leverage ratio reduction could also adversely affect market confidence in the firm.

2.2 Examples of trades where contingent leverage risks may arise include agency models to transact in security financing transactions (SFTs) or derivatives, SFT netting packages, collateral swaps, unsecured borrowing or lending of securities, internalised derivative positions (including written credit derivatives, equity swaps, total return swaps), or any trade structure that is more capital-efficient than economically similar trades^{footnote [6]}.

2.3 The capital-efficient nature of these trades depends on a set of conditions. However, these conditions may not always hold, particularly in a stress, and firms should manage these trades to factor in this potential risk. For example, adverse changes to market parameters or broader market conditions could reduce liquidity, the need for high-quality liquid assets or margining could rise, or a significant counterparty could default. At the same time, firms may be unable to withdraw from these trades. This may be due, for example, to contractual obligations, the need to maintain certain trades for liquidity management purposes, or to franchise risk.^{footnote [7]}

2.4 Examples of how the risk of contingent leverage may materialise are (but not limited to):

• netting: a client may withdraw or default from one leg of a transaction that is netted, or one-directional markets in stress could lead to a lack of availability of netting opportunities. If the firm cannot find or replace that transaction, this may result in loss of netting and an increase in the total exposure measure for the purposes of the leverage ratio;
• internalisation: a client may withdraw or default from one leg of a transaction that is internally offset for hedging purposes. If the firm cannot replace the offsetting leg, the firm may use a cash hedge for the remaining leg of the transaction, increasing its total leverage exposure. In the case of written credit derivatives, the loss of an offsetting leg may result in the loss of conditions that allow the firm to internalise the effective notional amount of the credit derivative, and increase a firm’s total exposure.
• collateral swaps: some lower-quality forms of collateral may become less available in certain market conditions, and firms may have to replace the affected collateral swaps with cash forms of financing.

2.5 The PRA proposes to introduce measures to help improve firms’ and its own understanding of the size of contingent leverage risks in the UK banking system, and the severity and types of market stress that could trigger these risks.

Changes to ICAAP supervisory expectations

2.6 PRA rules require firms to have in place sound, effective, and comprehensive strategies, processes, and systems to identify and manage any major sources of risk that affect their capital adequacy, including the risks of excessive leverage. Specifically, firms should consider their vulnerability due to excessive leverage or contingent leverage that may require unintended corrective measures to their business plans, including distressed selling of assets that might result in losses or in valuation adjustments to their remaining assets.^{footnote [8]}

2.7 The PRA proposes to insert guidance on the risks of contingent leverage into SS31/15 by adding a new section on the risks of excessive leverage. The proposed guidance is in Appendix 1 of this CP.

2.8 The purpose of the proposal is to make firms aware of the risks of contingent leverage and to update the PRA’s expectations of firms with regards to identifying, monitoring, and mitigating these risks in their ICAAPs. Under the proposed guidance, firms would be expected to consider the extent to which they would be able to continue to participate in certain activities as a result of using trades with a higher leverage exposure than before.

Changes to reporting requirements

2.9 Following the PRA’s identification of the risks from contingent leverage, the PRA considers that existing reporting requirements do not offer the data granularity needed for comprehensive monitoring of trades that may be a source of contingent leverage risk. To address this, the PRA proposes that firms subject to a minimum leverage ratio requirement (LREQ firms) report data on trades that the PRA has identified to be most relevant to the risk of contingent leverage at the same level of application as their existing leverage ratio reporting requirements. These are: collateral swaps; netted repos; agency trade models to transact in SFTs; and cash and synthetic prime brokerage positions.

2.10 Firms would be required to report a breakdown of these trades by the amounts internalised, netted, or guaranteed (ie any condition that leads to a reduction in the leverage exposure amounts). These data would be provided with a breakdown of the highest level of liquidity (Level 1 HQLA), exposures designated for franchise clients, and any intra-group exposures for firms that are headquartered outside of the UK. This would enable the PRA to use internal scenario assessments to judge the materiality of contingent leverage risks that may arise in a market stress. The proposed reporting tables and associated instructions are in Appendices 3 and 4 of this CP.

2.11 The PRA proposes the data would be reported on a six-monthly basis at the applicable reporting reference dates (30 June and 31 December). The proposed reporting change would be effective from 1 July 2023, with the first submission expected to the PRA in 2024, with a first reference reporting date of 31 December 2023. The PRA further proposes that firms would report data on both an end-period and averaged basis.^{footnote [9]} This is because the short-dated nature of these transactions means the activity on any given date may not be reflective of the overall activity over a longer time period. Consistent with the existing supervisory expectations outlined in SS45/15, the PRA considers that ‘best estimates’ of these calculations would be acceptable as long as they are measured consistently and prudently.

PRA objectives analysis

2.12 The PRA considers that the proposals in this CP advance the PRA’s primary objective to promote the safety and soundness of PRA regulated firms. The proposed ICAAP guidance and reporting requirement would help embed contingent leverage risks into firms’ ongoing risk assessments. This would, in turn, help firms better identify and manage these risks, potentially avoiding losses or breaches in regulatory requirements due to unforeseen market circumstances. Through its successive reviews of firms’ ICAAPs and data submissions, the PRA would also gain a better understanding of the materiality of contingent leverage risk in the UK financial system, and so be in a better position to take action where appropriate. This would also enable the PRA to provide firms with ongoing feedback to help enhance firms’ capabilities to monitor and mitigate these risks.

2.13 The PRA considers that the proposals in this CP would facilitate effective competition. The proposals would help firms identify and assess contingent leverage risks, where relevant to their business – leading to a more consistent approach to managing those risks across firms. A better understanding of contingent leverage risk would also help the PRA focus its supervisory intervention on those firms and trades where the risk is greatest.

Cost benefit analysis (CBA)

Changes to ICAAP expectations

2.14 The PRA considers that its proposed changes to the ICAAP expectations would help firms identify, manage, and pre-empt contingent leverage risk. This would improve the resilience of firms and the UK banking system, reduce the potential for losses to firms, and help avoid potential deleveraging processes that could damage both firms and the wider economy. It would also have macroeconomic benefits, set out in more detail in the PRA’s CP5/21 ‘Implementation of Basel standards’, arising from reducing the likelihood of firm failure and any subsequent systemic failure.

2.15 Firms that have not considered contingent leverage risks in past ICAAPs would face costs to introduce and maintain internal systems and risk management procedures to consider these risks. However, only firms for which contingent leverage is a relevant risk would be expected to produce detailed assessments of the risk, consistent with the wider approach to ICAAPs. The burden on these firms would also be reduced by the PRA’s proposed guidance, which would assist them in assessing contingent leverage risk.

Changes to reporting rules

2.16 The proposed data reporting requirement would improve the PRA’s ability to regularly and consistently monitor and estimate the size of contingent leverage risks. It would also enable the PRA to apply enhanced supervision where necessary, and so reduce the probability of contingent leverage risks materialising in the future and resulting in losses (and potentially capital requirements breaches) for firms.

2.17 The PRA has considered how it can do this in a proportionate manner that best serves its primary and secondary objectives, is consistent with the existing reporting requirements, and that allows efficient implementation by firms. The approach proposed in this CP follows a number of iterations of previous ad-hoc collection exercises that allowed the PRA to determine the most proportionate way to meet its objectives for contingent leverage risks.

2.18 The PRA expects that the proposed regulatory reporting change would affect around 45 firms, which is all those expected to be in scope of the UK leverage ratio requirement at the time the reporting change would become effective.^{footnote [10]}

2.19 To mitigate the cost impact of the proposals, the PRA would require the relevant data to be reported on a six-monthly basis, as opposed to quarterly, in line with previous ad-hoc data collection exercises. The PRA considers that this approach provides sufficient data to monitor the evolution of the relevant risks in the UK banking system. The PRA has also aligned the proposed templates with existing definitions used in the reporting framework, providing consistency for firms for compiling the data. The proposed system and averaging requirements would be incorporated into, and aligned with, existing leverage ratio reporting rules that the relevant firms have used since the first quarter of 2022. The level of application of the reporting requirement would also be consistent with that of existing leverage ratio reporting.

2.20 There would be two types of costs to firms from operationalising the reporting templates within their business: one-off investment and ongoing costs. The PRA has estimated these costs, using responses to a survey on reporting and disclosure requirements. That survey asked firms to provide estimates of the incremental cost of recent updates to regulatory reporting and disclosure requirements, including the implementation of the European Banking Authority (EBA) Taxonomy 2.7 and Financial Reporting (FINREP), and the EBA Taxonomy 2.9 and reporting requirements for non-performing and forborne exposures that were required at the end of 2019. The PRA has compared the scope of those changes to the proposals in this CP, and based on this and the survey estimates, has estimated the cost per firm of its proposals. The cost per firm was then matched to the population of firms likely to be affected to estimate total costs, and the net present value was determined by using a discount factor^{footnote [11]}. There is, however, considerable uncertainty around these estimates, which reflects the limited sample available to the PRA and the difficulty in separating the incremental costs of the changes from current ongoing costs of reporting regulatory data.

2.21 The table below sets out the expected costs of implementing the reporting proposals based on the survey mentioned above. The cost per firm, based on survey responses, is estimated to be approximately £76,000 for implementing the reporting templates, and £33,000 annual ongoing costs to report to the PRA. For all firms, the total estimated one-off and annual ongoing costs are estimated to be approximately £3.4 million and £1.5 million, respectively. The PRA considers these limited costs proportionate to the benefits of the proposed reporting requirements.

Cost estimates for the proposed reporting requirement

2.22 The PRA considers that the actual cost could be lower than that suggested by the survey. To the extent the data the PRA proposes to collect are generally part of firms’ trading books, or have daily revaluation of collateral, firms should already have the capacity to value their trading book assets on a daily basis at a sufficiently granular level, with only limited exceptions.

‘Have regards’ analysis

2.23 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT Recommendations letter from 2021 and the supplementary Recommendations letter sent April 2022 and given that the proposed rule change in this CP is a ‘CRR rule’ (as defined in section 144A of FSMA), the additional have regards applicable to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposal:

• International standards (CRR rules ‘have regards’): The PRA considers that its proposals would be aligned with incoming international standards (set by the Basel Committee on Banking Supervision). These highlight the risk that certain transactions and structures – particularly the trades identified in the PRA’s proposed ICAAP guidance and reporting template – could inadequately capture banks’ sources of leverage, and they recommend supervisory action (for example, additional reporting) where concerns exist.
• Proportionality (FSMA regulatory principle): The PRA considers its proposals proportionate to the risk identified. In line with the PRA’s ICAAP approach, firms are already required to identify, manage, and monitor risks that are significant to their capital adequacy, including the risks from excessive leverage. The ICAAP embeds proportionality since only firms that consider these risks relevant to their business would be required to assess them in their ICAAPs. The proposed data reporting requirement would only apply to firms that are sufficiently large to be captured by the minimum leverage requirement (and associated enhanced reporting requirements), and therefore pose risks to financial stability. Those firms also account for the vast majority of relevant trade activity and are therefore most vulnerable to contingent leverage risks. The proposed template was designed to cover information that is necessary to the assessment of the risks, and the PRA considers that the proposed frequency (six-monthly rather than quarterly, as with other reporting requirements for LREQ firms) is proportionate to the monitoring purpose of the requirement. Further, firms subject to a minimum leverage ratio requirement already report other data on both an end-period and averaged basis.
• Competitiveness (HMT Recommendation Letters) and Relative Standing of the UK (CRR rules ‘have regards’): The proposals would aid in making UK firms more resilient to the risk of excessive leverage by increasing firms’ and the PRA’s visibility over the materiality of contingent leverage risks. The PRA considers this would help maintain the UK as an attractive market for firms, by strengthening confidence in the resilience of the UK banking system. While there would be some compliance costs from these proposals, the PRA considers that these are expected to be small overall, and limited to firms that are most vulnerable to contingent leverage risks. The PRA considers that the compliance cost of these proposals would not impact the competitiveness of the UK as a financial centre.
• Transparency: The PRA considers the ICAAP proposals would provide clarity on the PRA’s expectations for assessing contingent leverage risks, fostering consistency across firms and supporting their ability to mitigate these risks in the future.
• Efficient and economic use of PRA resources (FSMA regulatory principle): The PRA’s proposals rely on firms to assess their own exposures as part of their ICAAPs that the PRA would review as part of its supervisory evaluation process. The PRA considers this would result in a proportionate use of resources for the PRA and respective firms.

2.24 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for this proposal, it is because the PRA considers that ‘have regard’ to not be a significant factor for these proposals.

Impact on mutuals

2.25 The PRA considers that the impact of the proposals on mutuals is expected to be no different from the impact to other PRA firms. While mutuals have restrictions in the regulatory framework to undertaking some of the activities that the PRA judges could give rise to contingent leverage risks, some of their exposures (for example, netted repurchase agreements or collateral swaps) could expose them to these risks. Similarly to other firms, mutuals would only be expected to consider contingent leverage risks in their ICAAPs to the extent that those risks are relevant to their business model.

Equality and diversity

2.26 The PRA has assessed whether these proposals give rise to equality and diversity implications, and considers that, given the nature of the changes proposed, there is no impact.