Banking StandardsLetter from Andrew Bailey, Deputy Governor and Chief Executive Officer of the Prudential Regulation Authority, Bank of England
Thank you for your letter of the 28 March asking for the PRA’s response to the recommendations of the Parliamentary Commission on Banking Standards (PCBS) as set out in its third report. Below I have responded to the questions raised in your letter in turn.
Monitoring Trading Operations
You stated that “many banks told the Commission that, at present, they do not engage in proprietary trading, nor do they wish to do so”. You asked the PRA to exercise its judgement and hold the banks to their word. Our approach is that firms must adopt and follow a risk appetite which is, inter alia, consistent with the PRA’s statutory objective to promote the safety and soundness of the firms it regulates. Where there are indications that a firm is operating outside this risk appetite, we expect prompt remedial action to be taken.
We monitor firms’ adherence to their risk appetite by drawing together various evidence. For example, for the higher-impact banks, supervisors:
conduct reviews, including on-site, of risk and risk controls in a particular area (for example, trading desks);
undertake analysis of business models, based on internal data and interviews with management, in order to understand how banks seek to make money, including reliance on client-related vs trading income; and
continuously assess bank performance, strategy and risk positions through reporting to the PRA, regular meetings and reviews of management information.
Tackling Concerns through the Capital Regime
For all banks, we determine a minimum regulatory capital level (based on the Basel Pillar 1 & 2A methodology). A capital buffer is then calculated on top of this (Pillar 2B) to ensure that the minimum level of regulatory capital can be met, even after severe but plausible stresses.
Pillar 1 market risk capital requirements apply higher capital charges for large open positions than against hedged or less volatile positions.
Where a bank is taking risks that are not adequately captured under the Pillar 1 standards (for example illiquid trading book positions), we will impose capital add-ons via the Pillar 2 regime to ensure the risks are captured. Capital requirements must also be supported with robust risk management.
Strengthening International Standards on Trading Operations
A priority for the PRA is strengthening capital requirements for the trading book and we are engaging heavily with the Basel process to ensure tougher standards are implemented internationally to prevent opportunities for arbitrage.
The Basel 2.5 agreement (transposed into the UK via CRD 3) delivered material increases in market risk capital requirements. In particular, it required banks using internal models to include periods of stress within their models and increase their capital for credit risk in the trading book.
The Basel Committee is now conducting a fundamental review of the trading book further to toughen standards. There are significant changes being considered including:
strengthening capital charges on both sides of the trading book boundary to prevent banks from arbitraging capital requirements for risky positions by moving them between books;
Pillar 1 capital charges that require higher capital for positions which cannot be sold or hedged quickly in stressed conditions; and
reduced reliance on capital driven by internal modelling.
These changes, once agreed and implemented, should ensure firms’ hold more Pillar 1 capital against the most risky positions.
Reporting on Outcomes of Monitoring and Actions Taken
I would be happy to discuss the arrangements for reporting further, where there may be a number of approaches we could take.
Legislative Authority
No further legislative changes have been identified as necessary to help us fulfil the approach outlined above.
I hope that this letter outlines how we are tackling the prudential risks that can arise from proprietary trading in line with the PRA’s stated approach to banking supervision.
13 May 2013