Banking regulation: a new paradigm, more challenges but similar consequences

The Bank of England recently published a discussion paper (here) setting out a comprehensive framework for coordinated stress and scenario tests of the UK banking industry.  

This process is challenging but necessary to underpin the resilience of the UK financial system.  As set out in the paper, other countries are going through similar exercises and there is a view that they can be instrumental to restore the credibility of the banking system.  

In 2014 the exercise will cover the eight banks covered in the recent regulatory capital shortfall exercise (Barclays, Co-op Bank, HSBC, Lloyds Banking Group, Nationwide, Royal Bank of Scotland, Santander UK and Standard Chartered).  For future years the Bank is considering the inclusion of medium-sized banks.  It is also likely to include UK subsidiaries of foreign globally systemic banks. 

At a high-level, the approach is reasonably straightforward.  Staff at the Bank design common stress scenarios for all banks which look into the next three to five years.  The severity of the scenarios is described in qualitative terms – “both sufficiently severe but also plausible”. 

Each bank goes through a similar process and creates specific stress scenarios.  These must be consistent with the bank’s business model and key vulnerabilities and be as severe as the common scenario.  

Then a bank assesses the impact of both types of stress scenarios and considers the management actions that may be needed to ensure that the bank can meet the capital requirements prescribed by the PRA (or at least the internationally agreed minimum capital requirements) after the stress.

Towards the formalisation of a new paradigm …

It seems that there are two major changes to banking regulation in this process. 

Firstly, going forward it would not be enough for a bank to just meet its capital requirements.    A bank should demonstrate that it would meet its capital requirements after a stress has taken place.  This could have implications on a bank’s capitalisation level.

The next change is about reducing the reliance on a bank’s internal models.  Officials at the Bank have raised these concerns before, for example, in this speech of Andrew Haldane (here).  In particular, the evidence about the large number of parameters that need to be calibrated is sobering.  The paper sets out the Bank’s intention to rely on a suite of models to assess capital adequacy, including a bank’s internal models, regulatory models and models of the entire financial system that build in the impact of interaction between institutions. This is consistent with the doubts that have been expressed.  You could say that the message is that a bank’s internal models would be credible if it is operated in a context where the bank has sufficient capital to meet its capital requirements after stress scenarios.

… which creates challenges for the Bank …

I suppose that for a regulator like the Bank defining “sufficiently severe but also plausible” stress scenarios is not perhaps the most significant challenge.  My guess is that the real challenge would be in terms of applying judgements to the results provided by banks and consolidating the impact across a number of scenarios for each bank and for the system as a whole.  One would hope that there will be enough transparency so that a bank’s executives understand where and how their conclusions may differ from those derived by the Bank.  

The other challenge would be the inclusion of medium-sized banks.  The paper is open about the challenge that this may represent for these banks.  The Bank would need to balance that against the recognition that medium-sized banks like Northern Rock can also create systemic disruption and put taxpayers’ money at risk (here).  One possible way of reducing the impact would be to integrate this exercise within the existing ICAAP and Pillar 3 disclosures frameworks.

… and for banks

UK banks have been undertaking stress and scenario tests for regulatory purposes.  The paper includes a list of the shortcomings that the FSA had identified: 

• “insufficient engagement by banks’ Boards and senior management with the stress-testing process;  
• insufficient integration of stress testing with banks’ annual business planning process, including the use of stress tests as a challenge to business plans; 
• inadequacies in scenario design, including the failure to identify key vulnerabilities, overly optimistic baseline assumptions and insufficiently stressful adverse scenarios;
• difficulties in reconciling risk data with reported balance sheets and risk-weighted assets;
• stress-testing infrastructures that have not been suitable for bank-wide stress testing;
• insufficiently justified or internally challenged assumptions and judgements around the translation of macroeconomic shocks into projected losses, including overestimation of banks’ ability to control margins and generate profits in stress scenarios; and
• inadequate determination and quantification of relevant management actions under different stress scenarios.”

The paper does not say much about how generalised these shortcoming are.  However, I found it very interesting that most, if not all, of those shortcomings are related to weaknesses in processes and governance rather than technical issues. 

There are also consequences …

And in case those reading the paper have doubts about the Bank’s determination to see this through, the Bank suggests that failure to address these shortcomings will result in regulatory intervention. 

“The exercise might reveal weaknesses in banks’ stress-testing and capital planning processes and governance. In those circumstances the PRA would consider what action was appropriate to ensure that shortcomings were addressed. The PRA has a variety of formal powers available. Additional capital requirements might be one tool. Withdrawing certain permissions, changing banks’ management and requiring specific actions to improve banks’ stress testing, risk management or capital planning processes are others.”

Summing up, we may be witnessing the formalisation of a new paradigm for banking regulation that places less reliance on a bank’s internal models but the potential enforcement side does not seem to be changing.  

The paper includes a number of specific questions and responses are requested by 10 January 2014.