Publication alert: PRA - CP12/22: Risks from contingent leverage
We communicate that the Prudential Regulation Authority (PRA) has published the CP12/22: Risks from contingent leverage.
1. Context
PRA rules require firms to have in place sound, effective, and comprehensive strategies, processes, and systems to identify and manage any major sources of risk that affect their capital adequacy, including the risks of excessive leverage. Specifically, firms should consider their vulnerability due to excessive leverage or contingent leverage hat may require unintended corrective measures to their business plans.
In this context, the PRA has published the Consultation Paper (CP) 12/22 which sets out the proposals to update the PRA’s supervisory expectations for firms undertaking an Internal Capital Adequacy Assessment Process (ICAAP) in relation to the risks from contingent leverage, and to introduce a new data reporting requirement for collecting data on trading exposures where these risks may most likely arise. The PRA considers these proposals would help firms identify, monitor, and manage contingent leverage risk and would improve its ability to monitor the evolution of these risks with more granular data, helping the PRA take targeted action where relevant.
2. Main points
Changes to ICAAP supervisory expectations. The PRA proposes to insert guidance on the risks of contingent leverage into in Supervisory Statement on the ICAAP and the SREP (SS31/15) by adding a new section on the risks of excessive leverage. Under the proposed guidance, firms would be expected to consider the extent to which they would be able to continue to participate in certain activities as a result of using trades with a higher leverage exposure than before.
- In carrying out an assessment of the risk of excessive leverage firms should consider any contingent leverage risk in transactions and trade structures that receive lower leverage ratio exposure measure values than other economically similar transactions (e.g agency models to transact in security financing transactions (SFTs) or derivatives, SFT netting packages, collateral swaps)
- The extent to which firms can use these more capital efficient forms of trades may be limited in certain conditions (e.g in the event of the default of counterparties, the movement of certain market parameters, or changes to broader market conditions).
- Firms should consider the extent to which they would need, and be able, to continue to participate in these trades and the extent to which they would instead need to use economically similar transactions or structures that receive higher leverage ratio exposure measure values.
- To the extent that firms would not continue to participate in such trades in certain circumstances, firms should consider what implications this might have for their revenues. Examples of risks and assumptions that firms should pay particular consideration to include, but are not limited to: i) Contractual obligations; ii) Franchise risk; iii) Liquidity management.
- As part of their ICAAP responses, firms should set out contingent leverage risks by each relevant trade structure that optimises leverage exposure.
Changes to reporting requirements. The PRA proposes that firms subject to a minimum leverage ratio requirement (LREQ firms) report data on trades that the PRA has identified to be most relevant to the risk of contingent leverage at the same level of application as their existing leverage ratio reporting requirements. These are: i) collateral swaps; ii) netted repos; iii) agency trade models to transact in SFTs; and iv) cash and synthetic prime brokerage positions:
- Firms would be required to report a breakdown of these trades by the amounts internalised, netted, or guaranteed (ie any condition that leads to a reduction in the leverage exposure amounts). These data would be provided with a breakdown of the highest level of liquidity (Level 1 HQLA), exposures designated for franchise clients, and any intra-group exposures for firms that are headquartered outside of the UK. This would enable the PRA to use internal scenario assessments to judge the materiality of contingent leverage risks that may arise in a market stress.
- The PRA proposes the data would be reported on a six-monthly basis at the applicable reporting reference dates (30 June and 31 December).
3. Next steps
This consultation closes on Friday 3 February 2023.
The proposed reporting change would be effective from 1 July 2023, with the first submission expected to the PRA in 2024, with a first reference reporting date of 31 December 2023. The PRA further proposes that firms would report data on both an end-period and averaged basis