The conversation around bank failure has perhaps not been a mainstream topic in recent years. The PRA's supervisory statement shows that preparing for it is still very much on the regulator’s agenda, and understandably so, given the lessons learned about the consequences of bank failure in 2008/2009, and the number of new entrants to the banking market.
According to the regulator, although 22 new banks have been authorised since 2013, many of them underestimate the subsequent development that's required. In the statement, the PRA specifically says that challenger banks can often "fail to appreciate the ongoing need to invest in systems and controls to ensure they remain commensurate with the evolving needs of the business".
It goes on to say that "there is also insufficient focus on planning for downside scenarios, including the ability to effect an orderly exit, which should be of particular focus given the greater likelihood of bank failure in the early years of operation". The PRA accepts that bank failure is normal in a competitive environment, and "does not seek to operate a zero-failure regime and works with the [Bank of England (BoE)] as resolution authority, if necessary, to ensure banks are able to fail in an orderly way, without threatening financial stability".
As the full economic fallout from COVID-19 remains to be seen, it's possible that challenger banks could see an increase in bad debts on their balance sheets as government support measures start to be withdrawn. This has the potential to create levels of stress among newer banks, many of whom, according to the PRA, don't yet have well established systems and controls to manage the consequences. It's therefore prudent to plan for an eventuality where we start to see banks move along the continuum of recovery planning and wind down planning, to potential resolution.
The PRA requires banks to have a recovery plan in place, which will be implemented once predefined triggers are breached, with the aim of improving the capital and liquidity position of the bank so that it can continue as a going concern.
Potential actions might be the sale or closure of part of the business, raising additional funding from existing shareholders, debt for equity swaps, or selling assets on the balance sheet. Cost saving measures should also be included, such as suspension of dividends, cancellation of bonuses, and other operational cost cutting exercises.
Should the recovery plan not work, the next step would be solvent wind down: providing a way for banks to exit the market "in an orderly way, by winding down their business to the point it can be liquidated safely, repaying all depositors and creditors in full".
As such, the PRA requires challenger banks to have and maintain a credible and comprehensive recovery and solvent wind down plan (WDP). As the PRA considers that the likelihood of failure may be higher during these early years, they believe a WDP should minimise any disruption or impact on depositors, or wider financial stability.
The PRA also requires banks to undertake resolution planning, so that the regulator has the necessary information to carry out their preferred resolution strategy. The PRA states that for newer challenger banks, the most likely resolution strategy would be insolvency, under the bank insolvency procedure. The bank’s depositors would be paid out under the financial services compensation scheme (FSCS), up to guarantee limits, assets liquidated, businesses wound up, and creditors paid off.
The resolution strategy is the responsibility of the regulator, but any challenger bank must be able to provide information that the regulator needs to move forward with the process. This includes producing – within 24 hours – a single customer view for the benefit of the FSCS that provides required data on depositors, including amounts on deposit that exceed coverage levels provided by the FSCS. Other required information would be information on key services, suppliers, or third-party contractors.
Prior to the Banking Act 2009 (BA 2009), there was no specific procedure available for banks and financial institutions in distress. The BA 2009 was passed to give the BoE, the Treasury, and the Financial Services Authority (FSA) – later replaced by the FCA and PRA – (collectively the tripartite authorities) powers to deal with failing banks.
The resolution regime is comprised of a set of stabilisation tools, which can only be used if the statutory resolution objectives are unlikely to be met by placing a failed bank into insolvency – known as the public interest test. If this public interest test is met, the BoE may use one or more of the following stabilisation tools to ensure the continuity of critical economic functions.
The BoE has the power to transfer all or part of a bank (either through a share or business sale) to a private sector purchaser.
The BoE can transfer all or part of a bank (through a business sale) to a bridge bank (a company owned and operated by the BoE).
Carry out a bail-in to absorb the losses of a failed bank and recapitalise it (or its successor) using the firm’s own resources. Shareholders and creditors are written down and/or converted into equity to restore solvency, in a manner that respects the order in which losses would fall in an insolvency.
For parts of the firm that don't need to be maintained permanently, but may need to be wound down in a measured way, there are two tools that can only be used in conjunction with one or more of the stabilisation tools.
Allows assets and liabilities of the failed bank to be transferred to (and managed by) a separate asset management vehicle, with a view to maximising their value through an eventual sale or orderly wind-down.
This procedure places the residual part of a failed bank that's not transferred to a bridge bank or private sector purchaser into administration. The priority of the administrator is to ensure that the residual part continues to provide necessary services (for example IT infrastructure, or mortgage servicing) to the new owner of any transferred business until permanent arrangements for those services can be put in place.
In addition to these pre-insolvency stabilisation options, the BA 2009 introduced the bank insolvency procedure.
The bank insolvency procedure is a specific liquidation procedure with the primary objective of ensuring that, upon a bank’s failure, depositors with eligible claims under the FSCS are paid promptly. Bank insolvency is only available to banks who have depositors with claims eligible for compensation from the FSCS. The bank liquidator is obliged to work with the FSCS to achieve this primary objective, while also working towards a secondary objective of winding up the affairs of the failed bank in the normal manner.
Ordinary insolvency procedures remain an option for failed banks. But, where the tripartite authorities consider that insolvency proceedings are the appropriate means of dealing with that failure of a UK bank with eligible depositors, it's likely that the bank insolvency procedure would be used, to protect the interests of depositors.
It must be frustrating for leaders of challenger banks to turn their attention to ‘how to fail well’ when all their energies understandably want to focus on innovation, growth, and success. Nevertheless, the PRA is keen that post authorisation, challenger banks continue to invest in and evolve their controls and risk management processes, giving due time and attention to downside scenario planning.
In doing so, management often find that they become much more aware of the strengths and vulnerabilities in their businesses, enabling them to take appropriate action.
With regulatory focus now on challenger banks' downside planning, it's possible that the PRA or FCA will review the recovery plans and solvent wind down plans of these institutions, as they have done with other sectors.
Not only will focused, well thought through plans demonstrate regulatory commitment, the process undertaken to put these together can ultimately improve a challenger bank’s overall financial and operational resilience.
For more information, contact Andy Charters.