The Prudential Regulation Authority (PRA) has recently written a “Dear CEO” letter, intended to outline the Authority’s priorities for international banks that operate in the UK. The letter was sent to “the wide and diverse range of international banks that [the FCA] supervises” and helps such organisations identify and manage potential risks. What are the PRA’s priorities for this year?
The shock of the Covid-19 pandemic was a severe test of financial institutions’ resilience, and a test of how able such organisations are to support businesses and households. The PRA believes that “the banking sector remains resilient to outcomes for the economy that are much more severe than the Monetary Policy Committee’s central forecast,” but have nonetheless identified a number of challenges for banks to grapple with. In particular, the changing macroeconomic environment – with the Central Bank beginning to taper its huge stimulus programme and raising interest rates – will force firms to reassess the sustainability of business models that have benefitted from an accommodative government measures. Further, the economic recovery is likely to be “uneven” across sector – meaning firms will need to monitor credit and traded risk within their portfolios, and manage risk closely as official support schemes are withdrawn.
The PRA point to the default of Archegos last year as brining to light “deficiencies in banks’ risk management governance and framework.” They also suggest this is a “symptom of a broader root cause and manifestation of an inappropriate internal risk culture” and argue that, in some instances, “lessons from the global financial crisis had not been sufficiently learnt.” Clearly, as risks increase with stimulus being withdrawn, it will be important for banks to manage their risk tolerance and ensure risk management practices are a key priority.
Operational risk and resilience
For the PRA, “Covid-19 continues to reinforce the importance of the firms’ ability to prevent, adapt, respond to, recover and learn from operational disruptions.” Evidently, the pace at which markets have moved throughout the pandemic underlines the need for a level of resilience that can withstand such changes. There are also more specific risks noted by the PRA, such as the threat of cybercrime. Resilience is clearly something the Authority is taking seriously, as they have set a deadline for the end of March for firms to “identify and map their important business services; set impact tolerances for these; and initiate a programme of scenario testing.” The PRA will be overseeing and review operational resilience programmes and seeking to understand how firms will achieve optimal outcomes.
The PRA has noticed that there is a renewed trend towards “outsourcing” and “third party risk management.” While this can offer technological improvements in cloud services especially, the PRA notes that “firms should ensure their important business services can remain within impact tolerances even when they rely on outsourcing or third party providers.”
Financial risks arising from climate change
Climate change is emphasised as a “key PRA priority.” The Authority suggests that firms are focused on the profit-making opportunities that are now available as a result of advances in the green finance and ESG market, but are not sufficiently attuned to the risks. Importantly, the PRA does not believe that firms are adequately “quantifying” climate-related risk and incorporating these risks into business strategies and decision-making. While the PRA does not identify specifically what these risks are, the Authority has pledged to “incorporate supervision of climate-related financial risks into our core supervisory approach,” assessing firms’ management of climate risks in the same way as any other risk. The key aim is to integrate the assessment and management of climate risk into business practice and risk management.
Diversity and Inclusion
This letter reinforces the aim of the PRA to encourage diversity. Its belief is that promoting diversity within the financial sector helps mitigate risk by bringing “a mix of views, perspectives and experiences within firms.” Moreover, an “inclusive” culture is said to “reduce the risk of groupthink, encourage debate and innovation, and support the safety and soundness of firms.” In turn, the PRA believes this can help reduce systemic risk in the international banking system. The PRA emphasises in its New Year letter that it expects firms to “challenge themselves to understand their gaps and consider where they can make progress.”
Risk-free rate transition
Over a decade on from the initial LIBOR scandal, the PRA is keen to ensure that firms transition away from any contract referencing LIBOR. They have pledged to work with the Financial Conduct Authority (FCA) to “remove any remaining dependencies on LIBOR, including synthetic LIBOR.” However, as the financial world transitions from LIBOR, it is equally important that it is replaced with an adequate alternative. The PRA suggests that any use of LIBOR-esque credit-sensitive rates should go through robust risk assessment processes. This will be key to ensuring that no systemic risks emerge from this change.
The letter briefly mentions a few other risks for international banks to consider throughout 2022 and beyond, and note the importance of regtech and data strategy, for example. However, the five priorities set out in the PRA’s “Dear CEO” letter serve as a good summary for the major risks facing international banks – and the wider financial community – as we attempt to move past all the turbulence of the Covid-19 pandemic.
Author: Harry Clynch