Greg Kilminster
Head of Product - Content
US-UK financial regulatory working group update
The US-UK Financial Regulatory Working Group held its tenth official meeting in Washington DC, on 3 September 2024, marking another step in strengthening bilateral financial regulation. Officials from HM Treasury and the US Department of the Treasury were joined by regulators from both nations to discuss pressing topics, including banking, digital finance, and climate-related financial risks.
Some context
Established in 2018, the US-UK Financial Regulatory Working Group aims to bolster cooperation between the two nations’ financial regulatory frameworks. The group meets twice a year to discuss key developments in financial markets and regulation, fostering dialogue on issues like financial stability and sustainable finance. This latest session in Washington comes as both the US and UK face volatile market conditions and regulatory changes driven by digital and environmental factors.
Key takeaways
Economic stability outlook
The meeting opened with an assessment of the economic and financial stability in both countries. UK representatives outlined the government’s focus on fostering sustainable growth while ensuring stability in the financial services sector. Participants reviewed global market trends and stressed the importance of international coordination to manage potential risks.
Banking sector regulation
The UK’s representatives shared updates on the Bank of England’s second assessment of its major banks' resolvability and the progress of the Bank Resolution Bill. The discussion highlighted the global focus on implementing Basel III capital requirements, with both sides stressing the need for continued international collaboration on regulatory changes.
Sustainable finance and climate-related risks
Sustainable finance was a key focus, with discussions centred on climate-related financial risks and the importance of effective climate disclosures. UK authorities shared their latest steps in embedding climate risk management into financial supervision, aligning with international standards. The group also discussed the integration of sustainability into the wider financial landscape, including fund naming rules to prevent greenwashing.
Digital finance and AI regulation
Digital finance and artificial intelligence (AI) were explored, particularly AI’s role in financial services and how regulators can mitigate associated risks. Both the US and UK outlined their efforts to regulate the increasing use of AI and tokenisation in financial markets, while also discussing cross-border payments and ways to improve operational resilience through international cooperation.
Capital markets and the non-bank sector
Regulators examined developments in capital markets, particularly following the US shift to a shorter T+1 settlement cycle. The UK, similarly, is advancing its own move to a shorter cycle, with hopes to reinvigorate capital markets to boost investment. Non-bank financial intermediation (NBFI) was another issue, with both sides focusing on improving the resilience of this sector, particularly in relation to leverage and margin calls.
Next steps
The Working Group’s next meeting is set for May 2025. Both sides agreed to maintain an open dialogue, with continued focus on international cooperation to navigate the evolving regulatory landscape. Climate-related financial risks, digital finance, and operational resilience will remain top priorities as both the US and UK seek to strengthen their financial systems in an increasingly complex global environment.
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PRA shares credit risk management framework findings
The Prudential Regulation Authority (PRA) has released a thematic review outlining key findings from a recent Internal Audit (IA) review of the Credit Risk Management Framework (CRMF) among non-systemic UK deposit takers. The review, prompted by current macroeconomic uncertainties and concerns over deteriorating credit portfolios, assessed whether the existing controls are sufficient to mitigate credit risk effectively.
Some context
A total of 33 non-systemic banks and building societies participated in the review, representing 13% of the lending exposures within this category. The majority of firms had lending books of less than £1.5 billion, with most IA reviews carried out by external audit firms. The focus areas included governance over credit and affordability assessments, approval processes, and portfolio management.
Key takeaways
Moderate breaches dominate findings
The PRA’s analysis of 236 IA findings revealed that:
- More than half (53%) of issues were classified as moderate breaches of control procedures.
- A smaller portion (14%) involved more significant breaches.
- Fewer than 1% were classified as materially significant.
his suggests that while firms generally adhere to regulatory requirements, notable gaps remain, particularly around portfolio management and affordability assessments.
Affordability assessment issues
One of the main areas requiring improvement was the firms' ability to update affordability assessments in response to changing economic conditions. In particular, the review highlighted the need for quicker updates of rules, buffers, and data sources—such as the Office for National Statistics (ONS) expenditure data and stress rates—to ensure lending remains sustainable in an environment of high inflation and rising interest rates.
Quality assurance and underwriting process weaknesses
Several firms were found to lack comprehensive Quality Assurance (QA) controls. In some cases, only one of the two Lines of Defence (1LOD or 2LOD) was conducting QA. Other firms had insufficiently documented their QA processes, or lacked regular and frequent reviews, potentially allowing substandard lending practices to go unnoticed.
Management information needs improvement
The quality of management information (MI) presented another area for enhancement. Recommendations included the addition of forward-looking metrics, clearer commentary on data trends, and the inclusion of more relevant board-level metrics. Several firms also needed to address inconsistencies in portfolio monitoring MI and improve data reporting.
Credit risk appetite recalibration
Firms were advised to recalibrate their Credit Risk Appetite (CRA) to better align with their business strategy, lending policies, and the current economic environment. Some IA reviews found that CRA limits were either insufficiently granular or not appropriately monitored, resulting in a misalignment between risk appetite and lending practices.
Lending policy governance
Improvements were also recommended in the governance and control of lending policies. Several firms needed to update their policies more frequently to reflect strategic changes and ensure clear documentation of exception processes for ‘out of policy’ loans.
Collection processes under scrutiny
Given the current cost-of-living pressures, the PRA flagged the need for stronger contingency planning in firms’ collections processes. Detailed strategies for managing customers in financial difficulty and early warning systems to detect risks among vulnerable customer segments were identified as critical gaps.
Next steps
The PRA encourages all firms to use the review's findings as a guide when assessing their own CRMF controls. Chief Risk Officers are urged to focus on enhancing affordability assessments, quality assurance controls, and management information, while ensuring their credit risk appetite is fully aligned with current market conditions.
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Stress tests: A need for reform
In a speech at the Executive Council of the Banking Law Section of the Federal Bar Association, Federal Reserve Governor Michelle W Bowman outlined her concerns regarding the current stress testing regime for large banks. While recognising the value of stress testing as a tool for assessing bank resilience and informing capital requirements, Bowman highlighted several significant drawbacks that could undermine the process's fairness, transparency, and usefulness.
Key concerns and proposed solutions
One key concern is the year-over-year volatility of stress test results. This volatility can disrupt banks' long-term capital planning, as unexpected fluctuations in stress capital buffer requirements can necessitate adjustments to capital allocation and management. To mitigate this issue, Bowman suggested implementing techniques such as averaging results over multiple years or constraining variability in annual stress test scenario design.
Another significant concern is the lack of transparency surrounding the models used in stress testing. This opacity can hinder banks' ability to make informed business decisions and anticipate regulatory expectations. Bowman advocated for greater disclosure of model parameters and a more transparent reconsideration process for stress capital buffer requirements.
Furthermore, Bowman expressed concerns about the overlap between stress testing and other capital requirements, such as the market risk rule under the Basel III endgame proposal. This overlap could potentially lead to an over-calibration of capital requirements for certain activities, which could have negative consequences for the economy. To address this issue, Bowman called for a careful review of the calibration of market risk and operational risk requirements in relation to stress testing.
By implementing these reforms, Bowman believes that stress testing can be made a more effective and equitable tool for assessing bank safety and soundness. Increased transparency, reduced volatility, and a more streamlined approach to capital requirements can help ensure that stress tests provide valuable insights for both regulators and banks, without unduly burdening the industry.
Overlap with other capital requirements
Additionally, Bowman emphasised the importance of considering the broader context of stress testing within the overall regulatory framework. She noted that the stress capital buffer, while a crucial component, is just one of several factors that contribute to the overall capital adequacy of banks. Therefore, it is essential to ensure that all capital requirements are calibrated appropriately and work in a complementary manner.
Bowman also highlighted the need for ongoing dialogue and collaboration between regulators, banks, and other stakeholders to ensure that stress testing remains relevant and effective in a rapidly evolving financial landscape. By fostering open communication and seeking input from various perspectives, regulators can refine the stress testing process and address emerging challenges.
In conclusion, Bowman was unequivocal in her view that “there is a growing awareness of the need for a fundamental rethink and strategic reform of stress testing, and any such process must acknowledge and address these known issues within the framework”.
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Federal Reserve Vice Chair presents recommendations for capital reforms re-proposals
During a speech at the Brookings Institution in Washington, DC, Michael S. Barr, Vice Chair for Supervision of the Federal Reserve, presented proposed changes to the capital reforms as a result of Basel III endgame and capital surcharge for global systemically important banks (G-SIB). These proposals, previously open for consultation, are set to undergo significant changes based on the feedback received.
Barr highlighted the importance of thoroughly reviewing key changes and receiving public input. He clarified that the proposed adjustments are interim steps, with ongoing consideration of comments received on the 2023 proposal and subsequent re-proposals as part of the final rulemakings.
Recommended Changes
Barr provided a comprehensive overview of the changes, their rationale, and the anticipated impact across major rule areas, including credit risk, equity exposures, operational risk, market risk, derivative activities, and tiering.
Credit Risk: The proposed changes involve reducing risk-weights for residential real estate and retail exposures, broadening the scope of reduced risk weight for certain low-risk corporate debt, and eliminating the minimum haircut for securities financing transactions.
Equity Exposures: Regarding the treatment of tax credit equity financing exposures, Barr plans to recommend lowering the risk weight for such structures due to their lower inherent risk compared to other equity investments.
Operational Risk: Three changes are proposed for operational risk: eliminating the adjustment of a firm’s operational risk charge based on its operational loss history, calculating fee income on a net basis for its contribution to the operational risk capital requirement, and reducing operational risk capital requirements for investment management activities to better reflect historical operational losses.
Market Risk: With respect to a bank’s trading and derivatives activities, the suggested adjustments aim to facilitate internal model usage for market risk, introduce additional improvements for modelling incentives, and clarify the treatment of uniform mortgage-backed securities positions. He also recommends adjustments to the capital treatment for client-cleared derivatives activities.
Cleared Derivatives (G-SIB Surcharge): Barr intends to recommend that the Board does not adopt the proposed changes to capital requirements associated with client clearing. Instead, improvements in the calculation of the capital surcharges for G-SIBs will be made to reflect changes in the global banking system since the Board adopted the G-SIB surcharge in 2015. This will account for the effects of inflation and economic growth in the measurement of a G-SIB’s systemic risk profile. As a result, a G-SIB’s surcharge would not change based simply on growth in the economy.
Tiering: Under the re-proposal, the most stringent set of requirements applies to G-SIBs and other internationally active banks. For firms with assets between $250 and $700 billion that are not G-SIBs or internationally active, the re-proposal would apply new credit risk and operational risk requirements and market risk and CVA frameworks only to firms engaging in significant trading activity. For large banks with assets between $100 and $250 billion, the re-proposal would maintain a simpler capital framework, exempting them from applying credit risk and operational risk frameworks of the expanded risk-based approach and maintaining a simpler definition of capital.
Impact: The re-proposals would increase aggregate common equity tier 1 capital requirements for the G-SIBs by 9%. For non-GSIB firms, the impact from the re-proposal would mainly result from the inclusion of unrealized gains and losses on their securities in regulatory capital, estimated to be equivalent to a 3% to 4% increase in capital requirements over the long run. Additionally, the remainder of the re-proposal would increase capital requirements for non-GSIB firms subject to the rule by 0.5%. Barr also mentioned that the Federal Reserve is looking carefully at how the stress test complements the risk-based capital rules.
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APRA seeks feedback on potential prudential framework changes
The Australian Prudential Regulation Authority (APRA) has released a discussion paper on changes to the prudential framework mainly to replace Additional Tier 1 (AT1) capital with more reliable and effective forms of capital.
Key takeaways
Under the proposed approach:
- Larger banks would be allowed to replace 1.5% of AT1 with 1.25% Tier 2 and 0.25% Common Equity Tier 1 (CET1) capital.
- Smaller banks would be allowed to fully replace AT1 with Tier 2, with a reduction in Tier 1 requirements.
Regarding implementation timelines, APRA proposes starting the transition to the new capital framework from 1 January 2027, with all existing AT1 instruments to be replaced by 2032. The existing AT1 capital instruments will continue to be eligible as regulatory capital until their first call dates without immediate impact on existing investors. APRA is not proposing changes to AT1 settings for insurers.
Next steps
The deadline for feedback is 8 November 2024.
APRA plans to provide an update on the consultation process in late 2024 and formally consult on specific changes to prudential standards in 2025.
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