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    Sam Woods of BoE on Importance of Horizon-Scanning to Identify Risks

    May 24, 2019

    Sam Woods of PRA, while speaking at an event in London, emphasized the importance of continually scanning the horizon to identify problems in the financial system. He presented examples of issues that PRA has identified in the areas of leveraged lending, mortgage market including risk-weights for large banks using internal models, treatment of equity-release mortgage holdings by insurers, and cross-border issues between banking and insurance sectors. He also warned that, unless supervisors keep questioning firms and themselves about the worrying developments in the markets, the work that has been done to make the financial system safer could be reversed.

    He mentioned that “horizon-scanning” has been become a strategic priority for PRA after the post-crisis reform period. The horizon-scanning activity aims to preempt and mitigate risks that may arise from firms risking up in ways that are excessive, or not properly controlled or capitalized, and from regulatory arbitrage. Although the new regulatory framework has been partly designed to change firms’ behaviors, as the framework settles down the scope for regulatory arbitrage might arise. He then offered concrete examples of issues that PRA has been working on. He pointed out the risks posed by the substantial bank loan exposures in the form of housing mortgages. Mr. Woods noted that mortgage market has seen a dramatic fall in spreads demanded over the risk-free rate, along with a marked shift in the high-loan-to-value (LTV) share of new lending by building societies. Although these shifts may be well within firms’ management capabilities and should be well-captured by the capital framework, this area requires close attention. 

    Another area of concern involves the significant decline, over the last decade, in the UK mortgage risk-weights for large firms using internal models; these risk-weights have declined from an average of 15.1% in 2009 to 9.7% in 2018. Thus, the capital requirement that results from that part of the regime (Pillar 1) has dropped by one-third. It is also notable that the average modeled mortgage risk-weight in the UK is lower than in many other jurisdictions. Regarding the level of risk-weights, a vital mitigant against cyclical modeling of mortgage credit risk is the stress-testing regime, which requires firms to carry the amount of capital they would need to keep lending through a severe housing bust. In some ways it is good if the stress-testing part of the regime (Pillar 2) takes more of the strain, because it results in buffer requirements that should be more usable in a stress than Pillar 1 minima. Moreover, Pillar 2A regime should capture concentration risk and any other aspects not captured by Pillar 1:

    • One way to do this is to compare the risk-weight level to some other crude benchmarks—such comparisons do not raise major worries, but nor do they suggest that risk-weights should be any lower.
    • Another way is to explore more sensitivities in stress-testing and to examine areas where non-linearities arise for higher levels of house price falls than those assumed in the main scenarios. A number of safeguards exist regarding this—moving of firms away from "Point in Time" modeling approaches, the leverage ratio, and (further down the track) the Basel 3.1 output floor. However, despite this, caution is required about any significant further moves down in Pillar 1 risk-weights for UK mortgages.

    The third area of concern is on the insurance side, where a lot of effort has been put into making sure that equity-release mortgage holdings are treated appropriately on insurance companies’ regulatory balance sheets. There has been an excessively wide variation of approaches for these assets at insurance companies, with practices at the more aggressive end of the market presenting a risk to policyholders and to the competition objective. BoE has, therefore, shored up this part of the framework and put in place a much more solid basis for this asset class going forward. Another area that scanners are always interested in is the border zone between banking and insurance. There are a number of cross-border activities that PRA is keeping an eye on. One is the use of credit insurance to optimize capital positions of banks. It is required to ensure that a risk that  disappears from a bank’s capital requirement has genuinely been moved across the border and that the receiving insurer is properly reserving and capitalizing for that liability.

    With respect to leverage lending, he highlighted that analysts often adjust leverage measures to remove large one-off costs and account for optimistic future growth in earnings. These add-backs have been growing steadily in recent years, so the risk metrics in an analyst’s company report are increasingly likely to contain some heroic (or unrealizable) assumptions. Compared to this, the move up the risk curve of UK lenders in the mortgage market looks rather benign. Regulators are required to make sure that both moves are properly managed and capitalized in the firms. Mr. Woods highlighted that, although the leverage ratio is sometimes presented as a simple measure, it is not straightforward as some important judgments go into calculating what banks’ exposures are for leverage ratio purposes. One area that requires close attention is where similar forms of financing—specifically repo, collateral swaps, and synthetic prime brokerage—are captured differently in the leverage exposure measure. Of these, the most important one to watch is collateral swaps. In conclusion, he reiterated that horizon-scanning will be an important part of the BoE effort in the coming period.

     

    Related Link: Speech

     

    Keywords: Europe, UK, Banking, Insurance, Horizon-Scanning, Financial Stability, Mortgage, Stress Testing, Pillar 1, Pillar 2, CCR, Leverage Ratio, PRA, BoE

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