The PRA has strengthened its approach to new and growing banks to promote competition and ensure effective supervision. Bruk Woldegabreil asked Alex Shapland, a Senior Adviser in our Financial Services Group, and Kantilal Pithia, Managing Director to share their views.
In April 2021 the PRA released Supervisory Statement 3/21 and Policy Statement 8/21 outlining its changing expectations for new and growing non-systemically important banks. Building on the 2013 Bank of England/FSA report on barriers to entry in banking, the regulator has set out more prescriptive goals covering profitability, governance, risk management and recovery planning. Collectively, the framework recognises that it will take time for new banks to mature in their approach, but sets clear benchmarks for progress to support a smooth transition at the end of the five-year period.
I spoke to Alex (AS) and Kantilal (KP) to find out more information on what this means for new and growing UK banks.
Q. Is this a big change from the PRA?
AS: Yes and no. The PRA has always been fairly supportive of new and growing banks and has provided a lot of encouragement for them over the last fifteen or twenty years. We’ve really come a long way. If you look back at the early noughties, there was fairly limited guidance available, but initiatives like the New Bank Startup Unit were a big step forward. It gave teams the opportunity to meet the regulator for valuable advice on their authorisation application and their regulatory business plan prior to submission. That just wasn’t an option before and there wasn’t much transparency over who to contact. But looking at the number of challenger banks in the UK, it’s clear that the investment really paid off. Since 2013 alone, the FCA and PRA have approved 26 new startup banks and a further 24 authorisations for new branches and subsidiaries (not including EEA passported banks). More competition is great for business and gives consumers more choice over how they want to use and access their bank. Streamlining the authorisation process could also really help, as it can be difficult to complete the necessary activities within the strict 12-month window.
What’s different about the PRA’s recent approach is the benchmarking element. Until now, new and growing banks haven’t really had that sort of prescriptive guidance in terms of measuring their maturity. There’s no doubt that these milestones will help banks gradually mature over the five-year period, and make the post-mobilisation transition much smoother.
Q. One of the key areas the PRA talks about is governance and Board composition. Alex, as an experienced Non-Executive Director (NED), how do you think the changes will improve governance?
AS: One of the main questions I get asked is ‘what should a Board look like for a startup bank?’. Five or ten years ago there weren’t any hard and fast rules about what any Board should look like, never mind specific guidance for startup banks, so this is a huge step forward. The PRA’s given really great guidance in this area, and have recommended two NEDs (including the chairman) post-authorisation or mobilisation, going up to three NEDs by year three, with the majority being NEDs within five years. It’s really drilling home the need for independence and avoiding conflicts of interest, which will ultimately help the Board offer robust challenge.
Q. The PRA highlights the importance of getting the right talent on the Board at the right time. What sort of things should new and growing banks consider when looking at skillsets across the board?
AS: Absolutely, that’s a really important point. For example, some NEDs may have experience working with startups post-authorisation, but they may not have experience beyond the five-year mark. At that point, the emphasis shifts slightly from establishing their operational processes, governance and risk management tools, to scaling those processes up. It’s important to think of Board composition in terms of the skillset each director can bring, what’s needed at that point in the bank’s development and to make the necessary changes over time.
Q. There’s also a strong focus on profitability within the first five years. As an ongoing challenge for all startups, do you think that puts undue pressure on new banks and could it potentially undermine risk management processes?
AS: It doesn’t necessarily put undue pressure on banks - again, it’s great to have some degree of benchmarking in this area. But it’s really important not to incentivise greater risk-taking to meet those profit goals and to properly embed a risk management culture from the word go, from the top down, which will mature over time. Essentially, new and growing banks should have a clear path to profitability within three years, and ideally, be profitable by five years – or at least have a credible strategy to get there.
KP: Profitability definitely has a knock-on impact on risk management, for example, having the ability to absorb losses, and factor them into financial planning. The PRA has also provided milestones for the risk management framework, with basic policies and processes in place from the off, a fit for purpose framework by three years that’s being continually refined, and a mature and embedded framework by year five – which is tied to the business model, including profitability expectations. Continuous improvement is also essential and new and growing banks must be developing their stress-testing capabilities to meet the expected standard by the five-year mark.
Q. The PRA has introduced a new methodology to calculate buffer requirements for new banks. Kantilal, what does this change mean for new banks, and will it impact financial stability?
KP: The current prudential regime is quite tough for smaller banks, and the PRA is also creating a ‘strong and simple’ framework to improve proportionality for all firms captured within it. The new buffer calculation will apply for the first five years, based on six months of operating expenses, and will be replaced by a methodology based on stress testing, in line with the wider prudential regime. That’s good news for new banks, but it does mean that the buffer may not be adequate to deal with stressed conditions, or to manage a solvency wind down plan.
AS: That’s a really key area of interest for the Board, to assess and challenge capital risk management. The Board needs to set an appropriate capital risk appetite and ensure the firm can work within that to survive under stressed conditions. It really relies on looking ahead, seeking additional investment where needed, and avoiding dipping into capital buffers to cover business expenses. If new and growing banks genuinely need to access their buffer, Boards have to act very quickly and there could be regulatory repercussions if the PRA feels that it was due to poor risk management or governance.
Q. What about minimum requirements for own funds and eligible liabilities (MREL)? Do new banks still need to meet those requirements?
KP: Yes, if the bank is in scope, they will need to meet MREL and CET1 capital in full, regardless of how long they have been authorised for. The key issue is that MREL requirements are set across three categories, which are in turn based on the value on the balance sheet and currently the number of transactional accounts although this may change. Looking at the Bank of England’s discussion paper last year, banks were concerned that crossing the threshold between categories could happen very quickly and have a big impact on the capital requirement, hindering growth for new banks. But the updated approach to MREL outlines a new ‘stepped glide’ method that gives at least three years’ notice before moving into a new MREL threshold, with six to eight years to reach the requirements. With additional steps in between, it should be easier to build up the MREL capital gradually, and firms expecting rapid growth can discuss that with the regulator at authorisation to create a smooth transition.
Despite these changes, MREL will still disproportionately affect both smaller banks and building societies, where leverage is the binding constraint. It’s essential for banks to keep monitoring their categorisation and practice good capital management to ensure they can meet MREL requirements as they grow. The overall benefit of MREL is also debatable given CET1 capital requirements and the range of prudential measures introduced since 2008. But it’s worth remembering that breaching MREL requirements does not automatically mean the bank is failing the threshold conditions for authorisation.
Q. As MREL is ultimately to support resolution, what else does the PRA expect of startup banks in terms of recovery and resolution planning?
KP: It’s really the same as for other banks, but recognising that startups are in a more vulnerable position and may be more likely to use them. With recovery planning, new banks may have fewer options available and the key is to make sure the plans are feasible. That includes early warning indicators, good governance processes, assessing all recovery options and – crucially - making sure they’re credible. This should be backed up by scenario testing and fire drills to check the plans are genuinely fit for purpose.
Solvency wind down is a bit trickier, because of the reduced new bank buffer and in some cases, it may not be possible. The plan needs to be in place from authorisation or the end of mobilisation, and the bank must maintain them until they move to a stress testing-based buffer. But depending on the situation, the PRA and Bank of England may ultimately decide it’s not doable and jump straight to resolution - probably through the Bank Insolvency Procedure if the business is small enough.
AS: For solvency wind down plans, it’s also really important to get the right degree of oversight from the Board, who’ll ultimately sign it off. Having good governance processes in place is also essential for accountability, to set the triggers for the plan, and working out who does what if it goes into action.
Q. The Brexit financial services agreement is still a work in progress. What impact could the FCA’s approach to new and growing banks have, in terms of maintaining the UK’s position as an international financial hub?
AS: The UK is keen to retain the City’s current status and to continue to make it attractive for overseas business. The goal is to create a more proportionate approach, with clearer regulatory requirements, which should in turn attract new entrants from overseas. In the past, these banks may have struggled to establish a UK footprint, as the system was more complex and less transparent. In theory, it should make the UK a more attractive destination for banking.
If you'd like more information on the PRA’s approach to new and growing banks, get in touch.