PS8/22 | CP2/22 Definition of capital: Updates to PRA Rules and supervisory expectations

1. Overview

1.1 This Prudential Regulation Authority (PRA) Policy Statement (PS) provides feedback to responses to Consultation Paper (CP) 2/22 ‘Definition of capital: updates to PRA Rules and supervisory expectations’. It also contains the PRA’s final policy, as follows:

• amendments to the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook (Appendix 1); and
• updated SS7/13 ‘Definition of capital (CRR firms)’ (Appendix 2).

1.2 This PS is relevant to banks, building societies, PRA-designated investment firms, and PRA-approved, or PRA-designated, financial or mixed financial holding companies.

Background

1.3 In CP2/22, the PRA proposed to:

• revoke the UK Technical Standards for own funds requirements for institutions (UKTS) and replicate it in the PRA Rulebook with proposed amendments to align with updates to the Capital Requirements Regulation (CRR), in particular the rules relating to the prior permission regime to reduce own funds instruments; and
• update SS7/13 in order to enhance the quality of capital instruments issued by firms, simplify procedures where appropriate, and clarify PRA expectations in relation to permissions to reduce own funds instruments.

Summary of responses

1.4 The PRA received one response to the CP and two requests for clarification. Respondents generally welcomed the PRA’s proposals while suggesting changes and making observations which are set out in Chapter 2.

Changes to draft policy

1.5 Where the final rules differ from the draft in the CP in a way which is, in the opinion of the PRA, significant, the Financial Services and Markets Act 2000 (FSMA)¹ requires the PRA to publish:

• details of the difference together with a cost benefit analysis; and
• a statement setting out the PRA’s opinion on whether or not the impact of the final rule on mutuals is significantly different to the impact that the draft rule would have had on mutuals; or the impact that the final rule will have on other PRA-authorised firms.

1.6 After considering the responses, the PRA has made changes to the draft rules and SS, including:

• amending the draft rules to require that, once permission is received, the general prior permission (GPP) amount should be deducted from own funds when there is sufficient certainty regarding the transaction; and
• introducing an expectation in the SS that firms should notify the PRA every quarter regarding transactions taken under the GPP.

1.7 The PRA has made technical amendments to those draft rules that do not qualify as ‘CRR Rules’ under the FSMA definition, without affecting the overall policy outcome. This includes removing references to PRA permissions and, where appropriate, requiring firms to notify the PRA of certain matters instead (eg Article 2(8)).The PRA has also made minor changes to SS7/13 to improve readability and amended the effective date for implementation of the rules to 1 January 2023.

1.8 The PRA considers that the changes to the final PRA rules are not significant and that the cost benefit analysis as presented in CP2/22 remains unchanged. The changes amend the timing of own funds deductions to provide greater flexibility for firms and include minor technical updates to improve the accuracy of the rules. The PRA does not consider that the impact of the final rules will have a significantly different impact on mutuals relative to the impact of the draft rules on mutuals, or the impact of the final rules on other PRA-authorised firms.

1.9 When making rules, the PRA is required to comply with several legal obligations, including considering responses to consultation and publishing an explanation of the PRA’s reasons for believing that making the proposed rules is compatible with its objectives and with its duty to ‘have regard’ to the regulatory principles.^{footnote [1]} In addition, when making CRR rules or rules applying to certain holding companies, the PRA must consider certain additional matters, and publish an explanation of the ways in which that consideration has affected the proposed rules.^{footnote [2]} In CP2/22, the PRA set out this explanation in Chapter 3: ‘The PRA’s statutory obligations’. The PRA considers that those explanations remain appropriate after taking into account the consultation responses.

1.10 On 7 April 2022, HM Treasury published a letter supplementing its 2021 recommendations letter for the Prudential Regulation Committee (PRC), recommending that the PRC ‘have regard’ to the Government’s energy security strategy and the important role that the financial system will play in supporting the UK’s energy security. The PRA’s consultation covered by this PS was published prior to that date, however the PRA has now considered this new ‘have regard’. The PRA considers that this new ‘have regard’ does not affect the changes proposed to the draft rules. This is because these changes are related to the timing of own funds deductions by firms under a GPP alongside updates to the Own Funds and Eligible Liabilities (CRR) Part of the PRA Rulebook, and as such do not relate to energy security matters.

Implementation

1.11 The changes introduced to the rules and SS will come into effect on 1 January 2023.

1.12 References related to the UK’s membership of the EU in the SS covered by the policy in this PS have been updated as part of this PS to reflect the UK’s withdrawal from the EU. Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [3]}

2. Feedback to responses

2.1 Before making any proposed rules, the PRA is required by FSMA to ‘have regard’ to any representations made to it, and to publish an account, in general terms, of those representations and its feedback to them.^{footnote [4]}

2.2 The PRA has considered the responses and requests for clarification received to the CP. This chapter sets out the PRA’s feedback to those responses, and its final decisions.

2.3 The responses have been structured in accordance with the headings under the CP:

• General prior permission;
• Liability-accounted AT1 instruments;
• Tier 2 instrument notification; and
• Other issues.

General prior permission (GPP)

2.4 The PRA proposed to require firms to immediately deduct the full GPP amount from own funds upon receiving PRA permission.

2.5 One respondent suggested that such an immediate deduction could result in unwarranted volatility in capital resources if some of the intended reduction transactions did not take place. That, in turn, could prompt market uncertainty on the capital adequacy of the relevant firm. The respondent considered that the proposed approach would not take into account the possibility that market conditions could deteriorate over the specified period, resulting in the intended transaction no longer being feasible.

2.6 After considering this response, the PRA has decided to amend the consultation rules to align the GPP deduction requirement with the existing approach for reductions in capital instruments. Under this approach, the deduction would only need to be recognised when the transaction is expected to take place with sufficient certainty. Consequently, the PRA has updated the SS at paragraph 10.3 with an expectation that firms notify the PRA every quarter regarding transactions taken under the GPP to ensure transactions are within the predetermined GPP amount.

2.7 This revised approach acknowledges that, by securing PRA permission, the firm has only indicated an intention to undertake the transaction without sufficient certainty on the actual transaction. During the approval process, the PRA would have assessed the current and forecast capital adequacy of the firm following a reduction transaction; the timing of deduction would not affect this assessment. In addition, the instruments will remain available to absorb losses until there is sufficient certainty that the transaction will take place.

Liability-accounted AT1 instruments

2.8 Under CP2/22, the PRA set out its view that some features or arrangements related to liability-accounted AT1 instruments could undermine the subordination of payments, or affect the ability of the instrument to absorb losses effectively.

2.9 One respondent requested clarification on whether a foreign exchange (FX) swap to hedge liability-accounted AT1 instruments would affect their eligibility as AT1 instruments.

2.10 The PRA has not made any changes to the draft policy. The PRA does not consider that such FX swaps would necessarily affect the eligibility of the instrument to qualify as an AT1 instrument. However, if the swap counterparty is the same party as the holder of the instrument, this may undermine the subordination of payments requirement in relation to AT1 instruments.

Tier 2 instrument notification

2.11 The PRA proposed to introduce an expectation that, notwithstanding the post-issuance notification requirement for Tier 2 instruments, firms should discuss new issuances of Tier 2 instruments which include new or complex features that could affect their capital eligibility with the PRA prior to issuing such instruments.

2.12 One respondent requested clarification on whether this expectation would constitute a prior permission requirement for proposed Tier 2 issuances, and also clarification on the time period required for supervisory discussions and decision. The respondent also asked whether the proposal was intended to cover specific forms of Environmental, Social, and Governance (ESG) instruments.

2.13 The PRA has not made any changes to the draft policy. The PRA does not intend to introduce a pre-notification requirement for Tier 2 instruments. The expectation to discuss such instruments prior to issuance seeks to provide the PRA with the opportunity to consider whether new or complex features in Tier 2 instruments could affect the loss absorbing capacity of the instrument and therefore quality of the firm’s capital. This is not limited to specific types of ESG capital instruments. In terms of timing, firms should discuss such instruments with the PRA as soon as practicable – for example, once the relevant terms and conditions, including any side agreements, are drafted. The PRA aims to provide feedback, if any, as soon as possible following the discussion. This will depend on the complexity of the features and the risk they may pose in relation to capital quality.

Other issues

2.14 The PRA received two requests for clarification that did not directly relate to the draft policy under consultation. The PRA has not provided feedback to that response in this PS but clarified bilaterally with the respondent.