At a glance:
- The last few weeks have seen significant stresses and contagion in global banking markets. Banks, regulators and resolution authorities have, in many cases, been put to the test.
- While there may be more twists and turns ahead, regulators have already seen enough to conclude that recent events raise questions about the future supervisory, regulatory and resolution frameworks, including some of the elements that were put in place in response to the Great Financial Crisis (GFC).
- In the short term we expect supervisors to focus on ensuring that the risk management failures that contributed to recent events are not present in other banks as well as to identify and address liquidity-related vulnerabilities in the sector.
- In the medium term, we see a focus on banks’ business models and on stronger regulatory standards including for rules governing bank liquidity and third-country market access.
- In the longer term, the authorities will have to consider whether the bank resolution framework, painstakingly put in place following the GFC, needs some adjustment.
Relevant to: Board members, CEOs, CFOs, CROs, Treasurers, Heads of Regulatory Affairs.
The significance of the events of the last weeks
In the last few weeks, global banking markets have been extremely turbulent, driven principally by events in the US and Europe. These events are being analysed extensively and our understanding of their root causes will undoubtedly improve as new information emerges.
However, banking supervisors are already taking rapid action to ensure that the failings that drove several regional banks in the US and one Global-Systemically Important Bank (G-SIB) in Europe to the point of failure are not repeated. They will expect banks’ Boards and senior management teams to be doing the same. Any lessons learned will undoubtedly feed into the medium- and longer-term regulatory policy agenda. The Basel Committee on Banking Supervision (BCBS) has already “agreed to take stock of the regulatory and supervisory implications stemming from recent events, with a view to learn lessons ”. That said, we do not expect the BCBS to rush to make changes to its capital framework, given that the existing Basel 3.1 package has yet to be implemented fully.
This note sets out our views on European regulators and supervisors’ near-term priorities and, beyond that, the questions we expect them to be asking themselves about the impact of recent events on their current and future policy agenda.
Immediate supervisory priorities
In the immediate term the questions for supervisors will include: how well banks are set up to identify and react to liquidity vulnerabilities; are banks doing enough to manage interest rate risk in the banking book; are supervisors and banks comfortable with the treatment of assets held at amortised cost; and what are the implications of recent events for the AT1 market.
- Liquidity vulnerabilities: we have now had our first real experience of a bank run in an era of widespread online banking, instant or near instant payments and rapid transmission of information and speculation on social media. Recent events show liquidity ratios and holdings of High-Quality Liquid Assets (HQLA) are not calibrated for a deposit run of the magnitude or speed experienced by some of the banks which failed. Moreover, fire sales - even of HQLA - can impose losses on a bank and rapidly erode previously strong levels of capitalisation. We expect supervisors to:
- identify banks with vulnerable liquidity profiles such as concentrations of balances above deposit insurance thresholds;
- challenge banks on how well they can manage intraday liquidity;
- require banks to develop better early warning indicators to spot emerging runs;
- ask potentially vulnerable banks to increase the stock of HQLA;
- ask banks with access to central bank lending facilities to preposition collateral to enable rapid drawdown of liquidity if needed;
- require banks to toughen their stress tests and revisit recovery plans, including liquidity funding plans; and
- make more use of Pillar 2 liquidity approaches.
This will be coupled with ongoing supervisory scrutiny in the EU of diversification of banks’ funding sources, with supervisors already expecting banks to need to increase reliance on market-based funding as TLTRO III winds down.
- Interest rate risk in the banking book (IRRBB): EU and UK supervisors already examine banks’ IRRBB through the Pillar 2 framework. The ECB has noted that “substantial supervisory work” has been undertaken to tackle banks’ vulnerabilities to interest rate risk. The PRA has also taken a robust approach to IRRBB, including using Pillar 2A add-ons to reflect deficiencies it has found in individual banks’ approaches.
- Supervisors will expect Boards and Board Risk Committees to be asking searching questions about interest rate exposures, challenging the executive on how well these risks are really understood and managed and whether the assumptions underpinning their own scenarios and stress tests are sufficiently severe. In addition, banks of all sizes should be ready for ad hoc requests for information on their IRRBB positions.
- Scrutiny of assets held at amortised cost: we expect supervisors to examine the extent to which EU and UK banks hold securities on an amortised cost basis, and the extent to which doing so may be concealing unrealised mark-to-market losses.
- This may be less of an issue among EU and UK banks . Under the asset classifications available under IFRS 9, there is a category of assets that are held at amortised cost, but this is not as widely used by UK/EU banks as the “hold-to-maturity” (HTM) category is by banks under US GAAP. Nevertheless, supervisors will be looking for outlier banks which have significant amortised cost portfolios and subjecting them to additional scrutiny/stress testing. Under IFRS 9, transfers of securities from amortised cost to fair value or vice versa are very uncommon, as they are only permitted when a change in the bank’s business model happens. We would therefore anticipate significant regulatory challenge of any proposed transfers of securities between available for sale and amortised cost portfolios.
- Implications for the AT1 market: supervisors will be keeping a very close eye on conditions in the AT1 market and assessing the implications of a shift in investor appetite for AT1 instruments for banks’ ability to reduce existing MREL shortfalls. The EBA’s December 2022 Risk Assessment Report highlighted that, even before the recent market turmoil, both pricing (i.e. the spread between MREL-eligible and non-eligible instruments) and investor demand were constraining MREL issuance by EU banks.
- There is already evidence that banks are not exercising calls on existing AT1 instruments, preferring to keep existing securities in issue until the market calms.
Medium-term implications (next 12 months)
In the medium term, supervisors will redouble their efforts in relation to recovery plans, particularly for banks with structural vulnerabilities in their business models; and they may face calls to push for stronger regulatory standards, particularly for liquidity. In the UK, we could see the PRA revisit aspects of its proposed Simpler Regime for smaller banks and, in the EU, a tougher stance on third-country branches (TCBs).
- Recovery plans: we expect supervisors and banks to revisit the triggers for activating recovery plans, with a particular focus on whether they enable banks to activate their plans early enough, especially in a “fast burn” crisis. This will include looking at early warning indicators such as CDS spreads, share price movements, shifts in price to book value, social media sentiment and other early signs of distress. Supervisors may expect banks to stand ready to activate recovery plans at times of significant events, such as raising capital in the market.
- Business model sustainability : recent events have demonstrated that even banks with healthy levels of regulatory capital and liquidity can be taken to the Point of Non-Viability (PONV) very quickly when creditors and investors lose confidence in the viability of a bank’s business model. They also show how business model doubts can be exacerbated by seemingly unrelated events in banking markets that make participants more risk averse. While better recovery plans may be a stop-gap solution, addressing the underlying causes of the business model vulnerabilities is the more effective remedy.
- Supervisors are likely to place an even greater emphasis on analysing structural vulnerabilities in bank business models and take earlier and more intrusive action when they identify deficiencies. Tougher reverse stress testing may be used to help identify underlying weaknesses in a bank’s business model. Supervisors will expect Boards and senior management teams to be able to demonstrate that they have a viable and sustainable business model and are taking timely and effective action to remedy any vulnerabilities. Supervisors could press for granular actions tied to specific dates and outcomes and linked to senior management responsibilities (not only in countries with individual accountability regimes).
- Banks’ use of capital buffers: it is not yet clear whether recent events will lead banks to reduce their supply of loans to the economy and to a general tightening of credit conditions, and/or an increase in the provision of credit by non-bank financial institutions. There are concerns that this may happen, but no strong evidence of it yet. However, if this is the outcome, we would expect the debate about the usability of banks’ capital buffers to resurface, given supervisors’ clear view that buffers are there to be used in stressed conditions to enable the flow of lending to support economic activity to continue.
- Stronger regulatory standards: recent experience will strengthen UK and EU regulators' arguments that long-term financial sector competitiveness is best served by maintaining high regulatory standards that are consistent with international agreements. This may slow or halt what has been growing political and industry pressure to find ways to reduce the burden of the regulatory regime to support international competitiveness. The implementation of Basel 3.1, which is currently in consultation in the UK and in final stage negotiations in the EU, will be crucial in this.
- The PRA is currently consulting on a Simpler Regime for smaller banks in the UK (as set out in CP5/22 and CP4/23). The PRA has proposed a £20bn asset ceiling for being considered a “simpler” bank, along with restrictions on trading activity, a prohibition on provision of settlement or clearing services, and stringent limits on the proportion of non-UK activities . The extent to which the PRA will progress with these proposals as currently set out remains to be seen. They could potentially be vulnerable to shifts in political discourse around bank risk, regulation, and the UK competitiveness agenda (see above).
- The speed with which deposit runs played out during recent events was unprecedented. This in turn raises questions about the calibration of the current liquidity frameworks (LCR and NSFR). This may form part of the “lessons learned” exercise which the BCBS is conducting. One key question will be what level of stress these ratios should be designed to withstand. Some may characterize the speed of runs we have seen as “extreme”. Others will argue that the fact that they have happened mean that they are “severe but plausible” and that banks therefore need to be ready to withstand them.
- The appropriate supervisory treatment of TCBs is currently being debated as part of the EU’s CRD6/CRR3 Banking Package proposal. Given the EU principle of applying all regulatory requirements to banks of all sizes, some EU policymakers could argue that the EU should impose even more restrictive conditions on allowing TCBs to access EU markets, especially if their home supervisor does not apply Basel 3.1 across-the-board. This may reignite the debate in the EU about the forced subsidiarisation of at least some TCBs. We do not expect the PRA’s long-standing approach to the treatment of TCBs to change.
Longer-term implications (12 months and beyond)
Longer-term, questions for global, UK and EU regulators will revolve around the effectiveness of the resolution regime, especially as it applies to G-SIBs and D-SIBs, the balance between going and gone concern capital and liquidity and the G-SIB and D-SIB frameworks. In the UK, HMT will think carefully about its position on ring-fencing.
- The future of the bank resolution regime: supervisors, resolution authorities and the banks themselves have spent the last ten years trying to make sure that no bank is “too big to fail” such that, even if a large bank runs into difficulties, it can be resolved in an orderly fashion without recourse to public funds. There is no doubt that significant progress has been made. However, the bank resolution regime was not applied consistently in recent events and the Swiss Finance Minister has concluded that a G-SIB cannot be wound up in line with its resolution plan. Other authorities will take a different and more positive view of the feasibility of resolution for G-SIBs, given the published results of resolvability assessments in the US and the UK and their authorities’ experience of using resolution tools. Nevertheless, the Financial Stability Board has indicated that its members will assess what, if any, lessons should be learned from recent events. We expect there to be a debate about whether more needs to be done to strengthen the effectiveness of the existing resolution framework, including how well it responds to rapidly changing market dynamics.
- Going and gone concern capital: in light of the above, there may be questions about whether regulators should insist that the largest banks hold even higher levels of going concern capital and liquidity, to reduce the likelihood that they reach the PONV. This does, however, sit awkwardly with the evidence from recent events that high levels of regulatory capital and liquidity do not always prevent banks from being brought to the PONV in a period of market stress.
- UK ring-fencing regime: HMT recently published a call for evidence in relation to the ring-fencing regime. As part of this, HMT asked whether the UK authorities should be able to remove banking groups from being subject to ring-fencing if they were judged to be resolvable. Recent developments could influence the extent to which the Government and the UK authorities are prepared to rely fully on the resolution regime as an alternative to ring‑fencing.
- G-SIB and D-SIB frameworks: the BCBS may choose to look again at the metrics governing G-SIBs and D-SIBs and consider how they could evolve to capture banks that are too small to be designated as individually systemic, but which could collectively be seen as “systemic as a herd”, or banks that have a dominant position providing lending or other financial products to a significant sector/industry.
- Competition in the banking system: in response to widespread concerns about regional banks in the US, many depositors have moved their deposits to the strongest banks and money market funds. This, particularly if it is replicated in other countries, together with recent questions about the feasibility of applying resolution tools to G-SIBs, will inevitably increase concerns about the largest banks becoming even larger. However, what the solution to this is, in particular whether there is political appetite to constrain the size of banks, remains unclear.
 Pablo Hernández de Cos’s speech on the future of the macroprudential framework tools.
 Bank of England Governor Andrew Bailey’s response letter to the Chair of the Treasury Committee Harriett Baldwin MP sets out that “On average major UK banks’ and building societies’ bond portfolios held at amortised cost make up around 3% of their total assets”, which is considerably lower than for some US regional banks.
 This Financial Stability Institute Insights Paper summarises the supervisory approach to assessing the sustainability of banks’ business models
 Current Simpler Regime proposals include:
- Disapplying NSFR and associated reporting and disclosures if a bank can demonstrate it meets a new “retail deposit ratio”, which measures use of relatively more stable retail funding.
- Not applying Pillar 2 liquidity guidance to Simpler-regime banks, except where idiosyncratic risks are identified.
- A new enhanced internal liquidity adequacy assessment process template.
- Removing the requirement for Simpler-regime banks to report four out of the five regulatory liquidity returns.
- Reducing (for listed Simpler-regime banks) or eliminating (for non-listed ones) capital and liquidity disclosures.