June 12, 2019

PRA published a letter to CEOs, from Melanie Beaman (Director, UK Deposit-takers Supervision) communicating the overall findings from the review of 20 non-systemic deposit taking firms with different business models and activities. The letter summarizes findings from the review, which covers three elements: Internal Capital Adequacy Assessment Process (ICAAP) stress testing, based on the BoE published 2018 stress scenario; asset quality reviews; and funding and lending analysis. The review aimed to test the financial resilience of fast-growing firms and enhance the PRA knowledge of the funding and lending markets in which they operate. The letter highlights the aspects of risk management and control that the regulator considers all firms should be adopting.

In the review of stress test outcomes, the overall concern was that fast-growing firms could be underestimating the potential losses that could arise on their loan portfolios under the given scenario. In reviewing their own stress test results, few fast-growing firms explicitly took account of the average impairment rates that are published as part of the results of the BoE annual stress test for the major UK banks. Although these published numbers are average rates on broad portfolios, so may not be directly applicable, they are a helpful reference point and cross-check for an assessment of the risk profile of a particular loan book and how it might behave under stress. In general, the fast-growing firms exhibit concentrations in higher-risk market segments, which may be more vulnerable to stress. The letter states that all firms should ensure that risk concentration is taken into account in their provisioning and stress models. All firms should ensure that the management actions they propose in their ICAAP stress test are consistent with the stress scenario used.

The asset quality review found that risk appetite statements of these fast-growing firms tended to be high level and did not fully capture risks or include sufficiently granular metrics to enable the level of risk to be adequately monitored. Certain areas of weakness were also observed in some fast-growing firms’ information provided to management and boards (MI). Firms can seek to address this through broadening the range of risk metrics and enhancing both data quality and risk MI, as and when individual portfolios become more material in size. In some cases, forbearance practices were not in line with industry standards; poor practice could potentially mask the level of arrears, delay appropriate recovery actions and thus impact overall book performance in a downturn. PRA observes that firms benefit from MI, which provides sufficiently detailed information on key loan book risk characteristics or combinations of risk characteristics, which could identify potentially vulnerable segments.

The review also shows that a number of fast-growing firms exhibited a lack of diversity in funding sources, being almost entirely reliant on funding from competitively priced, short-term fixed rate retail deposits. Fast-growing firms were not found to be disproportionately reliant on wholesale funding. The analysis showed an element of over optimism in funding spreads assumed in many firms’ plans. More widely, most firms’ pursuit of aggressive balance sheet growth targets was driven from the asset side of the balance sheet, requiring firms to maximize funding from all available funding sources, including non-core funding such as secured funding, wholesale funding, SME, and corporate deposits, all of which could increase execution and refinance risks. However, better firms took into account various market pressures as well as their own ability to differentiate pricing on both sides of the balance sheet in both their baseline and stress testing projections.

 

Related Link: Letter

 

Keywords: Europe, UK, Banking, Fast Growing Firms, Governance, Risk Appetite, ICAAP, Stress Testing, Asset Quality Review, PRA

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