November 1, 2021
5 mins

PRA publishes DP1/21 – A strong and simple prudential framework for non-systemic banks and building societies

The PRA has published DP1/21 – “A strong and simple prudential framework for non-systemic banks and building societies”. The discussion paper sets out options for the implementation of a “strong and simple” framework for non-systemic banks and building societies.

Executive Summary

Under existing PRA rules, which have been based on the rules of the European Union, core regulatory requirements are broadly the same for all firms, regardless of size or complexity. This can give rise to a “complexity problem” as there are costs to the firm of understanding, interpreting and operationalising the prudential requirements. These costs are, relatively, higher for smaller firms than larger firms and have negative impacts, e.g. by encouraging firms to take higher risks or by deterring new entrants to the market.

Implementing a revised framework, whereby smaller firms are subject to simpler regulation as operated in other jurisdictions, would, therefore, represent a significant shift, and it would not be appropriate to have a single set of strong and simple prudential rules for all non-systemic firms. Rather, they must expand and become more sophisticated as the size and/or complexity of the firms increase, converging towards the full Basel standards. Hence, the PRA intends to start by developing a simpler regime for the smallest firms before broadening out the framework. There are, however, points to be considered. For example, implementing a simpler framework could introduce new barriers to growth, given the need for increased regulation as the firm becomes larger or more complex, which could deter smaller firms from growing.

The scope of the revised framework has not yet been determined and firms are asked to provide feedback on this area. A number of considerations are raised in the paper including:

  • balance sheet size
  • whether or not the firm operates under the IRB approach
  • whether or not the firm operates a trading book
  • whether or not the firm provides services to the wider financial system
  • the level of risk of the activities of the firm.

The paper also seeks feedback on the approach to be taken to the new regime, as there are options which sit on a spectrum between:

  • an approach which takes the existing prudential framework as a starting point and modifies those elements that appear to be overly complex for smaller firms (streamlined approach); or
  • a fully focused approach based on a narrower, but more conservatively calibrated, set of prudential requirements (focused approach).

The potential changes to the regime discussed in the paper are wide ranging, and include:

  • Changes to the requirements for capital quality
  • Replacing the current Pillar 1 and Pillar 2A requirements with a single, simple, capital requirement with fewer buckets than in the current standardised approach, though this reduced sensitivity would lead to a more conservative calibration in order to maintain resilience. An alternative would be a new set of risk-weighted Pillar 1 requirements based on the existing standardised approach, or the new standardised approach set out in Basel 3.1
  • For Pillar 2A, options include increasing Pillar 1 requirements to cover those risks, or setting the scope of the new regime to be such that firms which fall into it do not face those risks (e.g. by excluding high risk credit portfolios, market risk and counterparty credit risk)
  • The Capital Conservation Buffer (CCoB) and firm-specific PRA Buffer (PRAB) could continue, be replaced with a single standard requirement, or removed altogether
  • The Liquidity Coverage Ratio (LCR) and the proposed Net Stable Funding Ration (NSFR) could continue, or a simpler measure such as a required minimum level of liquid assets as a percentage of funding liabilities could be applied
  • The Internal Capital Adequacy Assessment Process (ICAAP) could be simplified through updated guidance on the expected content, or by creating a standard template that contains all of the required information
  • Similarly, the Internal Liquidity Assessment Process (ILAAP) may be simplified by the PRA outlining a simpler set of requirements for small firms
  • Pillar 3 disclosures could be reduced or eliminated, with smaller reliance placed on the disclosures in annual accounts
  • Regulatory reporting would be aligned to the simpler regime.

In addition to the above, the PRA highlights three areas where limited change is expected:

  • On recovery and resolution, the PRA notes that there are already elements that make the existing approach simpler for smaller firms, but possible further simplification could include applying “Simplified Obligations” for recovery planning to in-scope firms, and providing additional guidance on expectations
  • The PRA also notes that quality of governance and risk management is especially important for maintaining resilience, and hence there would be no intent to cut back on the PRA’s expectations of the boards and management teams of firms. However, it may be possible to reduce the number of required senior manager roles and their responsibilities
  • A simpler regime would need to continue to incorporate requirements on operational resilience, which the PRA view as important to all firms, including smaller ones.

Firms are invited to reply by Friday 9 July 2021, following which a consultation paper will be published which will set out the draft rules.