Removing the non-performing exposures capital deduction

On 14 March, the PRA published CP6/23, laying out proposals to remove the Common Equity Tier 1 (CET1) deduction requirement regarding non-performing exposures (NPE) that are treated as insufficiently covered by firms' accounting provisions. The proposals also include removing the associated reporting requirements for the NPE deduction.

This is the latest piece of previously-adopted EU regulation to be reworked by the UK regulators to support their updated objectives. The PRA's proposals align with its new objective to support the competitiveness of the UK (whilst maintaining alignment with international standards), as set out in the Financial Services and Markets Bill which is currently working its way through the legislative process and expected to be finalised in May 2023. The removal of prescriptive requirements also paves the way for the move to a more judgement-based approach whilst addressing the issues of proportionality and competition within the UK market.

Prior to the UK's withdrawal from the EU, the EU Capital Requirements Regulation (CRR) was amended to include a CET1 deduction requirement applying to all new NPEs at firms for which accounting provisions were below prescribed levels. The EU introduced the NPE deduction requirement to encourage EU firms to reduce their stock of NPEs, to prevent any excessive build-up in the future, and to prevent the emergence of systemic risks in the non-banking sector.

Under existing accounting standards, firms are required to provide or write off credit losses from exposures (by considering various exposure-specific factors such as ability to repay) and take account of estimated cash flows and collateral values.

The NPE deduction supplements these provisioning requirements, requiring firms to deduct `the applicable amount of insufficient coverage for non-performing exposures' — a perceived shortfall in provisioning — from CET1 capital for all new NPEs from April 2019 onwards.

The `applicable amount of insufficient coverage' determines how much of an NPE must be deducted from CET1. It is calculated as the difference between:

• The gross value of an NPE multiplied by specific prescribed factors; and
• The total value of the accounting and regulatory capital adjustments related to the same NPE.

The prescribed factors vary based on how long each type of NPE has remained non-performing and whether the exposure is secured or unsecured, and the type of collateral held against it.

In CP6/23, the PRA has reviewed the appropriateness of the NPE deduction requirement for UK banks, building societies, PRA-designated investment firms and PRA-approved/designated financial or mixed financial holding companies. It notes that the NPE deduction requirement was originally designed and calibrated to provide a suitable backstop for the EU as a whole. The PRA has determined that the deduction should be removed as it does not provide an objectively accurate measure of NPE provisioning levels for PRA-regulated firms.

For example, for secured exposures, the NPE deduction requirement does not recognise collateral charged against an exposure, and instead requires firms to calculate a perceived provisioning shortfall based on the gross exposure amounts. As such, an NPE against which a firm had made adequate provisions could be treated as insufficiently covered, which may reduce a firm's CET1 capital level in a way that was not prudentially required. The PRA therefore considers that the deduction requirement does not reflect the expected recoverable value of each exposure for UK firms. The PRA retains several other tools to address provisioning shortfalls, where necessary.

The PRA considers that removing the NPE deduction requirement would enhance the definition of capital in a way that aligns with the international (Basel) standards — it notes that the current EU application is super-equivalent to Basel and as such may increase capital requirements unnecessarily.

Removal of the deduction requirement would increase the scope for the PRA to take a judgement-led approach to the prudential risks associated with NPE under-provisioning where necessary. It would also eliminate the potential competitive disadvantage compared to firms in jurisdictions that are not subject to the NPE deduction.

Finally, removal of the NPE deduction and associated reporting requirements would allow potential risks to be addressed in a more proportionate way within the UK, by removing the complexity and resource burden of monitoring, compliance, data gathering and calculation. The PRA finds that the capital impact from the NPE deduction requirement and the operational costs to comply with the associated reporting requirements are likely to be relatively greater for smaller firms than for larger firms with a larger capital base and more advanced systems and resources. Removal of the NPE deduction requirement would have a relatively greater impact in reducing reporting costs for smaller firms, advancing the PRA's secondary competition objective.

The consultation closes on 14 June and the changes resulting from it would come into force the day after publication of the final policy — likely to be in Q4 2023.