A new regulatory requirement for PRA firms
On 30th April 2018, the PRA published its Policy statement (PS) PS9/181 on Group Policy and Double Leverage, finalising its Consultation paper (CP) CP19/172.
The PS updates a number of proposals covered within the CP, primarily intended to ensure that the banking Group has appropriate financial resources to manage prudential risks to the whole Group including its subsidiaries, covering:
(i) Assessment and mitigation of risks to group resilience due to ‘double leverage’;
(ii) Assessment and mitigation of risks highlighted by prudential requirements applied by local regulatory authorities on overseas subsidiaries of UK consolidation groups; and
(iii) Improved monitoring of the distribution of financial resources across group entities.
This blog focuses on the new regulatory requirements around Double Leverage (DL) and key considerations and implications for affected Groups and subsidiaries. We see these requirements impacting large, international UK based banks with significant subsidiary entity structures across various jurisdictions.
These requirements take effect from 1 January 2019.
International banking groups are inherently complex, comprising many legal entities (both regulated and unregulated) across jurisdictions. The consolidated group is regulated to capture risks and relationships between the entities on a consolidated basis as well as a solo basis.
Double leverage occurs when a parent entity in a group provides capital support to a subsidiary through downstreaming equity as an equity injection or externally issued non-core capital.
The double leverage ratio is defined in terms of the qualifying parent undertaking’s (QPU) Common Equity Tier 1 (CET1) capital investment in its subsidiaries divided by its own CET1 capital:
Debt funding is generally more cost efficient than equity raised capital. However, this potentially causes payment and maturity mismatches, with timing and certainty differences in the cash flows.
Externally issued debt cost is certain with a specific maturity on the debt, compared to dividends received from subsidiaries where the amounts are not certain and the equity investments from the Group to the subsidiary are perpetual. Furthermore the dividends flows to the Group are dependent on the subsidiaries performance and discretion, subject to local regulatory requirements and capital position.
The PRA has outlined several expectations in order to address the risks arising from excessive double leverage. It requires firms to assess and mitigate the risks they face as part of their consolidated capital adequacy assessment. Firms must also demonstrate that they are able to cover their cash flows adequately in both normal and stressed conditions.
The requirements comprise the following key elements:
We have identified a number of key considerations for affected firms:
- The UK focus is on PRA authorised entities and groups only. There is no current indication as to whether EU and US regulatory requirements will be developed to follow the UK direction of travel.
- As a result there is a risk of further divergence and fragmentation in regulatory requirements, moving away from the post-crisis convergence of rules focused on global stability.
- This affect could be exacerbated by differences between the post Brexit UK and EU regulatory regimes.
- Credit rating agencies, however, already take into account and consider double leverage when determining the credit worthiness of holding companies and make their rating decisions from a debt perspective. This would suggest that the market therefore already has some discipline and limitations on the amount of double leverage a firm can operate within.
We see a number of implications emerging for firms:
Subsidiaries’ capital position
- A requirement for increased flexibility in the movement of capital within a group, in particular where there is potential future capital support required in the subsidiaries to meet local regulatory requirements under both current and increasing capital regimes under normal and stressed conditions.
- There is a risk of a weaker capital position (i.e. available resources) within subsidiaries as a result of an increase in dividend flow back to the group.
- The reduction in legal entity capital buffer levels on top of minimum capital requirements potentially exposes subsidiaries to further impacts under stress conditions and with insufficient capital held to cover the risks. As a result this could put the capital position and the safety and stability of the legal entity at risk.
- Further additional capital requirements and changes to required regulatory capital i.e. P2A and P2B may require additional capital to be held in subsidiaries meaning further capital support from the group.
- An additional challenge will arise where the required build-up of the capital stack through varying forms of capital AT1 and Tier 1, compared to the CET1 focus of double leverage, and the required increased dividend flows to group or reduction in group investments in their subsidiaries to manage double leverage %.
- Local regulators could react to the new requirements by imposing restrictions on dividend capital flows to the Group and may increase minimum capital requirements in its jurisdiction. This in turn would restrict flows back to the Group or require further capital support from the Group.
Group capital position
- There is a potential for lower capital requirements at the Group level compared to the aggregated legal entities’ individual capital requirements and capital held locally. This is due to diversification benefit in positions, netting benefits across exposures and elimination of intragroup exposures.
- Furthermore, the capital requirements for the Group are generally lower compared to the subsidiaries, driven by the advanced approaches adopted by the Group. There is potential further regulatory arbitrage and fragmentation within the group subsidiaries, impacting both the capital required at the group and its subsidiaries’.
- Group profits and dividends flows may not be matched at the subsidiary level. The dividends to the Group are dependent on the subsidiaries capital position and local regulatory requirements, and therefore not certain in terms of both the quantum and the timing. In addition, the Group servicing cost for example its external debt cost and bank levy may not be applied at the subsidiary level, both of which potentially create an equity capital gap at the Group level.
- Double leverage may have the unintended consequence of reducing the support from Group and may require the legal entities to become more capital self sufficient.
- The latest Basel reforms and the move towards output floors based on a revised standardised approach, could increase capital requirements for either the Group and/or its subsidiaries. This would drive up double leverage at the Group level from the increased level of capital support required with the likely outcome of reducing the level of equity held at the Group level or increasing the equity investment in the Group’s subsidiaries.
- Level of application at group and home v host supervisor of subsidiaries, with potential uneven playing field for the industry, with varying impacts across banks in different jurisdictions and under different regulatory requirements.
Group profitability and strategy
- Reduction in the ability of the group to manage its strategy, shareholders and market expectations due to the requirement for retaining equity to meet the regulatory requirements at the Group level.
- Continued focus on banks performance and profitability, with return metrics such as RoE and RoRWA requiring adequate return in the business as well as for shareholders.
- Market and shareholder expectations of performance and profitability in turn drive the firm share price and market value. This would mean increased levels of equity required to be held by firms requires an increased level of return for the same assets and existing businesses.
- Regulatory capital requirements are driving changes to banks’ strategies and businesses, with increased regulatory requirements leading banks to reduce or possibly exit low returning businesses or locations.
- Increased regulatory requirements aim to drive a safer banking industry with higher levels of cash and equity held, and with lower levels of leverage and risk, resulting in lower returns. This model is likely to come under pressure from shareholders looking to maximise returns and could be viewed externally as a conservative or inefficient strategy.
- Increased regulatory requirements protect firms in times of stressed market conditions however lower market and shareholder expectations may be required on the levels of return, compared to previously seen double digit RoE levels.
- Higher levels of equity capital are required to be held at group level from the equity focus of double leverage, decreasing profitability metrics i.e. RoE and potentially restricting capital flows to its shareholders i.e. share buybacks and reduction in dividend to shareholders.
Further considerations and points to address
In addition to the above impacts, we see some challenges that firms need to consider and potentially address.
In our view the PRA regulatory requirement of Double Leverage could have potentially significant impacts across firms but also presents an opportunity for firms to review their: legal entity structures, capital and cash flow positions, booking model, business mix, performance and profitability and overall strategy.
For more details, please contact the authors of this blog.