CP6/23 - The non-performing exposures capital deduction

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Responses are requested by Wednesday 14 June 2023.

The PRA prefers all responses to be sent by email to:
CP6_23@bankofengland.co.uk.

Alternatively, please address any comments or enquiries to:
Capital Quality team
Prudential Regulation Authority
20 Moorgate
London
EC2R 6DA

1. Overview

1.1 This Consultation Paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposal to remove the Common Equity Tier 1 (CET1) deduction requirement in the PRA Rulebook, regarding non-performing exposures (NPE) that are treated as insufficiently covered by firms’ accounting provisions.

1.2 The proposals in this CP would result in changes to the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook and the Reporting (CRR) Part of the PRA Rulebook (Appendix 1).

1.3 The policy proposals included in this CP would:

• remove the CET1 deduction requirement for non-performing exposures (‘NPE deduction’) that are treated as insufficiently provided for by firms; and
• remove the associated reporting requirements for the NPE deduction.

1.4 The PRA considers that removing the NPE deduction requirement would enhance the definition of capital in a way that aligns with international standards. It would increase the scope for the PRA to take a judgement-led approach to the prudential risks associated with NPE under provisioning where necessary. It would also remove a requirement that imposes a potential competitive disadvantage compared to firms in jurisdictions that are not subject to the NPE deduction. Removing the associated reporting requirements would reduce all firms’ costs of monitoring, compliance, and data gathering in relation to the NPE deduction requirement. Overall, the PRA considers that the proposals would further its statutory objective of promoting the safety and soundness of firms through applying a more proportionate, targeted, and risk-based regulatory framework.

1.5 This CP is relevant to banks, building societies, PRA-designated investment firms and PRA-approved, or PRA-designated, financial or mixed financial holding companies.

1.6 The PRA has a statutory duty to consult when making rules, including rules revoking existing rules (FSMA s138J). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. 

1.7 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.

Background

1.8 Applicable accounting standards require UK firms to determine the appropriate level of provisioning for NPEs and defaulted assets.

1.9 In April 2019, prior to the UK’s withdrawal from the EU, the EU Capital Requirements Regulation (CRR) was amended^{footnote [1]} to include a CET1 deduction requirement applying to all new NPEs at EU firms for which accounting provisions were below levels prescribed in the CRR.

1.10 The EU introduced the NPE deduction requirement to encourage EU firms to reduce their stock of NPEs, to prevent any excessive build-up of them in the future, and to prevent the emergence of systemic risks in the EU non-banking sector. The requirement was seen as a key part of strengthening the EU banking union and was intended to address the risk of NPEs resulting in spill-over effects for EU Member States and the EU as a whole. The CRR amendment formed part of a package of measures to develop a consistent EU approach to address the risk of under-provisioning of EU NPEs. The EU considered it to be essential to address possible future NPE accumulation in order to ensure competition in the EU banking sector, preserve EU financial stability and encourage lending, and create jobs and growth in the EU.

1.11 When the UK withdrew from the EU, the CRR was incorporated into UK law by the EU (Withdrawal) Act 2018. It was then amended by HMT Statutory Instruments^{footnote [2]} and the PRA’s EU Exit Instrument^{footnote [3]} respectively. The CRR provision (Article 36(1)), which includes this NPE deduction requirement, was subsequently revoked and transferred into the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook from 1 January 2022.^{footnote [4]}

1.12 The PRA has reviewed the appropriateness of the NPE deduction requirement for the UK based on the PRA’s objectives and all the matters to which the PRA must have regard. In doing so, the PRA considered the aims of the NPE deduction requirement, its design, the degree to which it advances the PRA’s objectives, and the availability of supervisory tools should they be required to address the risk of UK firms building up significant NPEs. Having reviewed these factors, the PRA considers it would be appropriate in a UK context not to apply the NPE deduction requirement.

Implementation

1.13 The PRA proposes that the changes resulting from this CP would come into force the next calendar day after the publication of the final policy – anticipated for 2023 Q4.

Responses and next steps

1.14 This consultation closes on Wednesday 14 June 2023. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP6_23@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.

1.15 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [5]}

2. The PRA’s proposals

2.1 The PRA proposes to remove the CET1 deduction requirement for NPEs that are treated as insufficiently covered by firms’ accounting provisions and related reporting requirements for CRR firms. The proposals in this chapter would amend:

• the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook (Appendix 1); and
• Chapters 5 and 6 of the Reporting (CRR) Part of the PRA Rulebook (Appendix 1).

The NPE deduction requirement

2.2 Under existing accounting standards, firms are required to provide or write off credit losses from exposures by considering various exposure-specific factors such as ability to repay, and take account of estimated cash flows and collateral values. In addition, a firm may further adjust an exposure value for regulatory capital purposes under additional value adjustments,^{footnote [6]} regulatory expected losses for exposures subject to the Internal Ratings Based (IRB) approach to credit risk, and other relevant capital deductions.

2.3 The NPE deduction supplements these provisioning requirements and is set out under CRR Article 36(1)(m) of the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook. It requires firms to deduct ‘the applicable amount of insufficient coverage for non-performing exposures’ – a perceived shortfall in provisioning – from CET1 capital for all new NPEs from April 2019 onwards.

2.4 The ‘applicable amount of insufficient coverage’ determines how much of an NPE must be deducted from CET1 under the CRR. It is specified in CRR Article 47c, and is calculated as the difference between:

• the gross value of an NPE multiplied by specific prescribed factors; and
• the total value of the accounting and regulatory capital adjustments related to the same NPE.

2.5 The prescribed factors vary based on how long each type of NPE has remained non-performing and whether the exposure is secured or unsecured, and the type of collateral held against it.

2.6 The NPE deduction requirement was originally designed and calibrated to provide a suitable backstop for the EU as a whole. However, the PRA considers that the deduction does not provide an objectively accurate measure of NPE provisioning levels for PRA-regulated firms. While the European Banking Authority’s (EBA) quantitative impact analysis of EU policy options for an NPE deduction included data from 10 UK firms, the EU NPE deduction requirement was not tailored to, or calibrated specifically for UK firms.

2.7 For secured exposures, the NPE deduction requirement does not recognise collateral charged against an exposure, and instead requires firms to calculate a perceived provisioning shortfall based on the gross exposure amounts. As such, an NPE against which a firm had made adequate provisions could be treated as insufficiently covered, which may reduce a firm’s CET1 capital level in a way that was not prudentially required. The PRA, therefore, considers that the deduction requirement does not reflect the expected recoverable value of each exposure for UK firms.

2.8 In addition, the factors applied to determine the applicable amount do not take effect until the third year of an unsecured exposure becoming non-performing.

2.9 The PRA recognises that there are prudential benefits in providing a backstop to firms’ NPE provisioning levels. However, the PRA considers that the NPE deduction introduced under the CRR is not the most appropriate, proportionate, and effective means to address underlying issues with NPE provisioning at PRA-regulated firms, or to ensure the adequacy of their provisioning against different types of NPE.

2.10 The PRA retains several tools to address provisioning shortfalls where necessary. Should the PRA have significant concerns that provisioning is not sufficient to reflect the expected shortfall from a firm’s exposures, it has the capacity to exercise its own powers to address any potential risks of under provisioning. The automatic deduction mechanism could, in some cases, require a deduction that is greater than warranted according to the underlying risks and applicable accounting standards, or lower than required in order to fully address these risks.

2.11 Considering the issues above, the PRA proposes to remove the NPE deduction requirement by deleting CRR Article 36(1)(m) from Chapter 3 of the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook. Certain aspects of the associated definition of NPEs^{footnote [7]} are used in the Non-Performing Exposures Securitisation (CRR) Part of the PRA Rulebook. The PRA does not propose any changes to these Articles.

Reporting

2.12 CRR firms provide information on NPEs and provisioning through regulatory reporting requirements.^{footnote [8]} The PRA would also continue to monitor provisioning levels as part of its ongoing supervisory approach. Separately to this reporting on provisioning, firms are also required to provide information specifically on the NPE deduction requirements. These templates require firms to submit granular data on NPEs according to collateral type, including:

• the calculation of the CET1 deductions;
• minimum coverage requirements and exposure values for each NPE not subject to forbearance; and
• minimum coverage requirements and exposure values for each NPE subject to forbearance.

2.13 In parallel with removing the NPE deduction requirement, the PRA proposes to amend the associated reporting templates under the relevant appendices by removing:

• row 0513 (ID 1.1.1.25.A) from template ‘C 01.00 – Own funds (CA1)’, the existing Capital+ templates PRA101 and PRA102, and the CP16/22 templates PRA 101a and PRA102a, to remove the requirement to report on the NPE deduction;
• template ‘C 35.01 - NPE loss coverage: the calculation of deductions for non-performing exposures (NPE LC1)’;
• template ‘C 35.02 - NPE loss coverage: minimum coverage requirements and exposure values of non-performing exposures excluding forborne exposures that fall under Article 47c (6) CRR (NPE LC2)’;
• template ‘C 35.03 – NPE loss coverage: minimum coverage requirements and exposure values of non-performing forborne exposures that fall under Article 47c (6) CRR (NPE LC3)’; and
• references to the above templates from the COREP index (CA1).

Taxonomy

2.14 COREP Own Funds reporting (COR001a) are currently reported using version 3.0 of the EBA taxonomy. PRA101 and PRA102 reporting modules for Capital+ are currently reported using version 3.4.1 of the Bank of England Banking taxonomy. Should the policy proposals in this CP be taken forward, the PRA intends to provide guidance in the final policy statement following this consultation that firms would no longer be required to report against the NPE deduction reporting templates. The final taxonomy changes required to remove the templates would be implemented to a separate timeline together with the taxonomy changes in relation to the final Basel 3.1 reforms and Strong and Simple policy packages.

PRA objectives analysis

2.15 The proposal to remove the NPE deduction and associated reporting requirements would contribute to advancing the PRA’s safety and soundness objective. It would help to enable the PRA to apply a judgement-led approach to address the adequacy of firms’ provisioning for NPEs. This would allow the PRA to determine the nature and extent of any supervisory tools required to ensure a firm’s NPE provisioning is appropriate.

2.16 The PRA has assessed whether the proposals in this CP facilitate effective competition. The PRA considers that the capital impact from the NPE deduction requirement and the operational costs to comply with the associated reporting requirements are likely to be relatively greater for smaller firms as compared to larger firms with a larger capital base and more advanced systems and resources. Therefore, the PRA considers that removing the NPE deduction requirement would have a relatively greater impact in reducing reporting costs for smaller firms, advancing the PRA’s secondary competition objective.

2.17 The Financial Services and Markets Bill 2022 includes measures to amend the PRA’s objectives by introducing a new secondary competitiveness and growth objective. At the point that this Bill receives Royal Assent, this new secondary objective would require the PRA (in discharging its general functions in a way that advances its primary objectives and so far as reasonably possible) to act in a way that facilitates (subject to aligning with relevant international standards): (a) the international competitiveness of the economy of the UK (including in particular the financial services sector through the contribution of PRA-authorised persons); and (b) its growth in the medium to long term. In light of this and the proposed implementation date for the changes proposed in this CP, the PRA has also considered whether the proposals set out in this CP would facilitate competitiveness and growth as described in the new objective. For the same reasons as those set out in this chapter, the PRA considers that the proposals would facilitate competitiveness and growth as described in the new objective and that the proposals would be in the same form if the objective applied at the date of this CP’s publication.

‘Have regards’ analysis

2.18 In developing these proposals, the PRA has had regard to the regulatory principles (including as they will be amended by the Financial Services and Markets Bill 2022), the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation 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 proposals:

1. The principle that a burden or restriction which is imposed on a person should be proportionate to the benefits which are expected to result from the imposition of that burden (FSMA regulatory principle): The PRA has assessed the burden imposed by the NPE deduction and whether a more proportionate approach could minimise these burdens on UK firms. The burdens would be removed as a result of the proposals and instead allow for a judgement-led supervisory approach which would ensure a more proportionate approach to the risk of NPE provisioning in UK firms.

2. Efficient and economic use of PRA resources (FSMA regulatory principle): The PRA has taken into account the need to achieve the most prudential benefit from the use of PRA resources. The removal of the NPE deduction requirement would remove the need for the PRA to monitor information provided by the firm in relation to the requirement, including potentially duplicative reporting.

3. Desirability of sustainable growth (FSMA regulatory principle): The PRA has taken the desirability of sustainable growth into account when considering the mechanism and impact of the NPE deduction. The PRA sought to develop a more targeted and proportionate approach. This could help to support firms to invest in or lend to sustainable industries.

4. Smart regulatory reform (HMT recommendation letter): The PRA has considered the government’s aim to deliver smart regulatory reform when reviewing the NPE deduction requirement. Removing the NPE deduction would ensure that the PRA can take a more targeted approach to under provisioning for NPEs where necessary.

5. International standards (FSMA CRR rules requirement): The EU-specific NPE deduction is super-equivalent to Basel international standards and may increase capital requirements at firms unnecessarily in addition to the Basel standards. The PRA considered whether this deduction was necessary for UK firms specifically. The proposed change to remove the NPE deduction and associated reporting requirements would align our rules with the Basel standards.

6. Relative standing of the UK and competitiveness (FSMA CRR rules requirement/HMT recommendation letter): The PRA has taken the competitiveness of the UK into account when developing its proposals. The PRA has assessed whether the NPE deduction had an adverse impact on the relative standing of the UK and its competitiveness compared to non-UK firms not subject to the requirement. The PRA considers that removing the NPE deduction and instead using a judgement-led approach would directionally enhance the relative standing of the UK and its competitiveness.

7. Competition (HMT recommendation letter): The PRA has assessed whether the proposals in this CP facilitate effective competition. The PRA considers that the capital impact from the NPE deduction requirement and the operational costs to comply with the associated reporting requirements are likely to be relatively greater for smaller firms as compared to larger firms with a larger capital base and more advanced systems and resources. Therefore, the PRA considers that removing the NPE deduction requirement would have a relatively greater impact in reducing reporting costs for smaller firms, advancing the PRA’s secondary competition objective.

8. Targeted only at cases in which action is needed (The Legislative and Regulatory Reform Act 2006 (LRRA) and the Regulators’ Code): The proposed approach was designed to ensure that action is taken on a more targeted basis. As such, its removal would enhance the PRA’s capacity to exercise a judgement-led supervisory approach by taking action only in cases where it was necessary and where those actions would be appropriate rather than through a capital deduction in all cases. The PRA considers this to be a more effective approach to addressing expected losses from NPEs.

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

Cost benefit analysis (CBA)

2.20 The PRA considers that the removal of the NPE deduction and associated reporting requirements would result in a net benefit for PRA-regulated firms and that the NPE deduction is not calibrated for UK firms. As such, the PRA assesses there to be more proportionate ways to achieve the intended outcomes.

2.21 Removing the NPE deduction would remove the requirement for firms to apply a capital deduction that may not be necessary or sufficient. This could improve the capital position of UK firms. The proposed approach could also result in the capital position of firms better reflecting the underlying resilience level of those firms.

2.22 The PRA considers that removing the NPE deduction and reporting requirements would allow potential NPE risks to be addressed in a more proportionate manner. The proposals in this CP would remove the complexity and resource burden for firms to calculate and report on NPEs based on each individual exposure in complying with these requirements. For example, the relevant reporting templates require firms to track each loan and disclose provisioning factors related to them as opposed to calculating provisions and exposures on a portfolio basis for other regulatory purposes. Firms are required to complete hundreds of cells of data each quarter under the reporting requirements, and to show the calculation inputs including where no deduction is made.

2.23 As a result of the proposals, firms would be required to revise internal policies, processes, and reporting in relation to the NPE deduction. This could incur some one-off costs for firms but given the nature of the proposals, the PRA does not consider that these would be material.

Impact on mutuals

2.24 The proposed rules would apply equally to all PRA-authorised firms. Therefore, The PRA, considers that the impact of the proposed rule changes on mutuals is expected to be no different from the impact on other firms.

Equality and diversity

2.25 The PRA considers that the proposed rules have no impact on equality and diversity.