In May 2023, the PRA updated the UK’s leverage ratio framework to address the risk of contingent leverage through the introduction of Pillar II capital assessments of contingent leverage and supervisory reporting for LREQ firms. From 1 January 2024, firms will face new obligations relating to contingent leverage, for which they must be prepared.
The leverage ratio measures a firm’s solvency in relation to its capital resources. The higher the ratio, the less dependent a firm is on debt to fund its activities. Firms may reduce their leverage exposure through capital efficient trades such as collateral swaps or netted repurchase agreements, where the exposure risk is offset by forms of collateral or through netting agreements.
Contingent leverage risk arises in times of stress, where some of the assumptions regarding these trades may no longer apply. It may materialise through events such as a counterparty default or market conditions making it more difficult to obtain lower-level collateral or netting opportunities. Such stresses may lead to a firm selling assets to reduce its exposure and maintain a compliant leverage ratio. In extreme instances, this deleveraging could impact other firms in the market, reducing their leverage ratios and forcing them to take the same action, causing knock on effects throughout the financial system.
To ensure firms and the PRA have a greater visibility and understanding of relevant risks, the requirements set out in PS5/23 require firms to assess contingent leverage risk as part of their ICAAP process. Firms will also be required to report data on trading exposures which may be sources of contingent leverage risk as part of new Contingent Leverage Reporting (LRV002) templates.
Updates to SS31/15 now require firms to assess the risk resulting from contingent leverage and consider that trade structures may be a source of contingent leverage risk. The PRA expects firms to assess the contingent leverage risk to transactions and trade structures that receive lower leverage ratio exposure measure values than other economically similar transactions. Such trade structures include:
- Collateral Swaps
- Repurchase transactions (both repos and reverse repos)
- Agency repurchase agreements and other agency models to transact in SFTs or derivatives
- Internalised positions
As part of their ICAAP, firms should set out their assessment of contingent risk for each trade structure, where the trade structure is assessed by the firm to pose a material risk. Materiality should be judged on the extent the firm engages in the relevant trade, in particular where they are subject to contractional obligations, franchise risk or liquidity management considerations. Further, firms will need to quantify the impact on the firm’s leverage ratio should the capital optimisation benefits from the trades be lost or replaced with less optimal alternatives.
To report relevant information on the risk associated with leverage in a stress scenario, the PRA has introduced new contingent leverage reporting templates (LV49.00 to LV52.00). The 4 new templates cover the same areas of focus as the ICAAP; collateral swaps, repurchase transactions (both Repo & Reverse Repos), agency repurchase transactions and internalised trades. All LREQ firms will be required to complete these templates every six months from 1 January 2024 (first reporting period end 30 June 2024).
As a market leader in Prudential Regulatory Assurance, KPMG in the UK is well placed to offer guidance to firms on the impact to their ICAAP process and the preparation of the new LVR002 Contingent Leverage templates. For a conversation on how you may be impacted by these changes and how KPMG can assist, please get in touch.