Capital Requirements Regulation

What is happening with the Capital Requirements Regulation? An update on the PRA’s final response to last year’s Consultation Paper

Hannah Fearn, Managing Associate, Sullivan & Worcester UK LLP

In the first quarter of 2018, the UK’s Prudential Regulation Authority (“PRA”) caused a stir by publishing a Consultation Paper regarding the eligibility of guarantees (including credit insurance) as unfunded credit protection for the purposes of calculating capital requirements under the EU Capital Requirements Regulation (“CRR”).¹ The PRA’s proposals caused serious concern in the credit insurance market. In a welcome development, which finally ends the uncertainty caused by the Consultation Paper, the PRA has now published its response, including an updated Supervisory Statement.²

The key issues arising out of the Consultation Paper and relating to non-payment insurance included:

• The proposal that the provider of the credit protection must be obliged to pay the beneficiary “without delay and within days, but not weeks or months” of the counterparty’s default conflicted with the typical waiting periods agreed in insurance policies
• A lack of clarity as to whether policies containing market standard exclusions such as the “nuclear” exclusion would be considered eligible, where the operation of such exclusions is outside the strict control of the insured

If the PRA had published its final guidance in the form proposed last year, then the use of standard credit insurance policies for capital relief purposes would no longer have been an option for certain banks, which could have seriously reduced banks’ ability to finance transactions.

A change in the PRA’s views

Fortunately, the PRA has significantly changed its position on a number of aspects and provided some useful clarification on its expectations regarding the use of credit insurance to obtain capital relief:

• Waiting periods: The PRA has decided not to implement its proposal that guarantees must be required to pay out “within days”, meaning that standard waiting periods will not automatically render policies ineligible under the CRR
• Exclusions: The PRA has advised that a policy containing the nuclear exclusion may be acceptable where “in all circumstances the clause is immaterial to the guaranteed exposure and the risk of an obligor default under that exposure”. Banks and insurers will need to consider how this could be demonstrated in practice. The PRA also highlighted some examples of exclusions that will not be acceptable for certain risks
• Policy wording and residual risks: The PRA considers that in some cases the use of insurance as credit protection has, in practice, proved to be less effective than expected. For example, where a dispute has resulted in a lengthy delay in claims payment, or where a policy contains terms that are “broad and vague” (such as those relating to disclosure). In some circumstances the PRA will expect a bank to hold additional capital to account for the residual risks arising from the use of credit insurance as credit protection, even where an instrument meets the applicable CRR criteria

A positive outcome

On balance, the PRA’s amended position is a very positive development, and removes a number of the more serious concerns for the market that arose out of the Consultation Paper. While banks and insurers will no doubt be very relieved by the outcome of this consultation, it will be necessary to reflect on the detail of the PRA’s publication. The PRA’s specific concerns relating to the residual risks of using non-payment insurance highlight the importance of careful policy drafting to reduce the practical risks of dispute and to remove any uncertainty as to the scope of an insured’s obligations.

It is also notable that the PRA’s change in position appears to have been directly influenced by the responses received to its Consultation Paper. On this occasion, the coordinated efforts of a number of industry bodies have resulted in a positive change in the regulator’s approach.

Relevance to UK and EU banks

As a final note, the PRA’s Supervisory Statements are relevant to all firms bound by the CRR that are regulated by the PRA. For non-UK banks that are not regulated by the PRA, the PRA’s expectations will have limited direct relevance, and those institutions will need to consider the views of their local regulators. When the UK leaves the EU, it is expected that the provisions of the CRR will be transposed into UK law and become part of the UK statute book (as EU regulations will no longer have binding effect under English law). As such, the PRA’s Supervisory Statements and other published guidance on the CRR requirements applicable to credit risk mitigation will continue to be relevant to UK banks using non-payment insurance for capital relief purposes.

Find out more – ‘Credit Solutions for a New World’

Hannah Fearn will be expanding on the PRA’s final response to the 2018 Consultation Paper at our forthcoming conference ‘Credit Solutions for a New World’ on 24 April. For more information or to register to attend please contact Lindsey Warrington.

¹“Credit risk mitigation: Eligibility of guarantees as unfunded credit protection” - consultation paper (CP6/18) – https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/consultation-paper/2018/cp618.pdf
² Credit risk mitigation: Eligibility of guarantees as unfunded credit protection – policy statement (PS 8/19) and updated supervisory statement (SS17/13 ‘Credit risk mitigation’) – https://www.bankofengland.co.uk/prudential-regulation/publication/2018/credit-risk-mitigation-eligibility-of-guarantees. The PRA’s updated Supervisory Statement on Credit Risk mitigation, which sets out the PRA’s expectations and which is intended to facilitate firm and supervisory judgement in determining whether those expectations have been met, will come into effect on 13 September 2019.