The Prudential Regulation Authority is proposing additional checks and balances for U.K. banks with large global footprints to ensure that they are properly capitalized across all geographies and protected from the risk of contagion.
In an Oct. 4 speech, Bank of England Deputy Governor Sam Woods, who is also head of the PRA, said it is essential that U.K.-based banks with large overseas operations are "at least as strong as their parts," and announced that the PRA was launching a consultation on a raft of proposed regulatory updates to this end.
In particular, the PRA wants to be sure that these banks are capable of managing the risks associated with "double leverage," that is to say, financing the additional capital requirements of an overseas subsidiary by raising debt externally in the U.K. This is cheaper than equity, but the bank must rely on dividend income to service this debt, which can prove unpredictable.
Holding companies using double leverage can put extra pressure on their subsidiaries to upstream dividends to meet debt repayments, and this can in turn erode their capital positions, according to a PRA consultation paper.
If an individual bank were found to have "excessive levels" of double leverage, the PRA would set a "firm-specific" target. The PRA also wants to ensure that banks have spread capital appropriately across the subsidiaries in all the geographies in which they operate, with resources "close to risks."
The PRA "aims to address the risk of entities within groups being under-resourced for the size of the risks they face," the paper said.
In countries where subsidiaries are subject to especially tough prudential requirements, the parent bank must show that it has allocated additional resources, although the PRA expects that this will apply in only a small number of cases. In these situations, the aggregate capital added as a percentage of group risk-weighted assets would be around 0.09% on average, according to the paper.
Even though overseas subsidiaries may technically fall outside the PRA's regulatory scope, and are usually resolved by authorities in the country where they are located, failures and distress can pose risks to the group as a whole, including "reputational contagion," according to the PRA.
Banks are already required to carry out internal stress tests to show the resilience of the group as a whole, and must ensure that capital is spread appropriately across different countries. However, the PRA's latest proposals will "formalize" existing arrangements, according to the paper. In particular, banks must "explicitly monitor and report on whether there are payment and maturity mismatch risks due to the use of double leverage, and the extent to which these risks are properly managed and mitigated."
The PRA said it does not expect these additional requirements to result in any significant additional costs for banks, because they will be able to rely on existing analysis and information. The proposed changes would "not materially affect London's position as a leading international financial center," the paper added.
A consultation period on the proposed changes will run until Jan. 4, 2018, with the PRA aiming to put the finalized policy into action Jan. 1, 2019.