## _cr16167 ## Source details **Canonical URL:** [_cr16167](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16167.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16167.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16167.pdf.json) --- ### EXECUTIVE SUMMARY — BACKGROUND - U.K. financial system size and structure: - Total financial assets owned by all financial institutions (excluding the BoE) are about GBP 20 trillion, "over ten times U.K. annual GDP." - About half of these assets are accounted for by banks. - Comparative ratios: 8.8 in the Netherlands, 5.6 in Switzerland, 6.4 in Japan, and 3.9 in the U.S.; exceeded only by Hong Kong SAR and some offshore financial centers. - Four banks and two insurers are classified as globally systemically important. - U.K. insurance sector: "the largest in Europe and third largest in the world." - U.K. hosts the largest fund management industry in Europe and two of the largest central counterparties (CCPs) in the world. - BoE: nearly a fifth of global banking activity worldwide is booked in the U.K.; around half of the world’s largest financial firms have their European headquarters in the U.K. - BoE research (Box 1) — implications: - No statistically significant relationship between banking system size and probability of banking crisis once credit booms and leverage are accounted for. - Larger banking systems may impose higher fiscal costs in the event of a crisis. - Policy implication: capital resilience, oversight, and resolution framework matter more than size; leverage and credit bubbles are better crisis predictors. ### MAJOR FINDINGS: RISKS, RESILIENCE, AND INTERCONNECTEDNESS - Overall assessment: - Since the last FSAP, the U.K. financial system has become much stronger and more resilient; better able to serve the real economy. - System remains exposed to risks due to size, complexity, and global interconnectedness; materialization could have major domestic and global impacts. - Financial stability in the U.K. is characterized as a global public good. - External and domestic risk drivers: - Global shocks cited: a negative growth shock in emerging markets; a rapid hike in global risk premia; renewed tensions in the eurozone — all could significantly impact U.K. banks and the financial system. - Domestic credit cycle concerns: segments of the U.K. property market—"notably buy-to-let and commercial real estate"—could become financial stability risks as the credit cycle matures while interest rates remain at historic lows. - Brexit-related uncertainties: - A vote to leave would usher in uncertainty and financial market volatility during potentially multi-year negotiations. - The eventual exit deal could affect trade, the real economy, passporting arrangements, and location decisions of international financial firms; effects are "highly uncertain" and were not covered in the stress tests. - Resilience of core sectors: - Banks: - Since the crisis, banks have more than doubled their risk-weighted capital ratios from pre-crisis levels, strengthened liquidity, and reduced leverage. - Stress tests by BoE and FSAP indicate largest banks would meet regulatory requirements and sustain capacity to finance the economy under severe shocks. Caveat: Brexit not included. - Insurers, asset managers, and CCPs: - These sectors "also appear resilient," per BoE, FCA, European authorities, and FSAP. - Interconnectedness and systemic amplification: - Cross-sector interconnectedness could amplify shocks and turn sector-specific distress into systemic events. - New patterns of interconnectedness from structural market shifts and new entrants complicate supervisors’ ability to "connect the dots across sectors." - Supervisory capacity and tools need upgrading to monitor cross-sector linkages and evolving market structures. ### REGULATORY REFORMS, FRAMEWORKS, AND IMPLEMENTATION - Reform achievements: - Wave of regulatory reforms since the crisis is "now near completion" to reduce failure probability and lower failure costs. - Reforms align with global agenda; include governance and conduct enhancements and ring-fencing retail banking. - Many reforms correspond to 2011 FSAP recommendations. - Macroprudential and microprudential frameworks: - Macroprudential: - New framework provides clear roles, powers, accountability, and coordination across agencies; track record "encouraging" though short. - Microprudential and conduct: - Oversight more rigorous and hands-on; focus on most systemically important firms implies less attention to small and mid-size companies. - Tradeoffs require vigilance due to correlated business models and reputational risk for supervisors. - Concern: downward trend of ratio of risk-weighted to total assets and methodological inconsistencies → recommendation to review internal models closely. - Stress testing and liquidity: - BoE’s new annual concurrent stress testing framework links microprudential and macroprudential frameworks; requires further investment to meet goals. - BoE liquidity framework is a "key shock absorber": - Broader access (including broker-dealers and CCPs) is positive; supervision by BoE and PRA is enabling. - Risk: ease of access could distort incentives — BoE should monitor for moral hazard and regulatory arbitrage. - Resolution and safety nets: - Transposition of the Bank Recovery and Resolution Directive completed reform of the U.K.’s Special Resolution Regime; broadly aligned with global standards. - Resolution powers, tools, and coordination domestically and cross-border are much stronger. - Ongoing challenges: complete multi-year resolvability process including ring-fencing and MREL; build operational principles for funding in resolution; establish effective insurance resolution regime; develop cooperation arrangements with smaller host countries outside CMGs. ### FSAP KEY RECOMMENDATIONS (selected; "Near term is one year. Medium term is 2–3 years.") - Financial stability policy framework: - Extend FPC’s powers of direction to the buy-to-let market. [HMT] — Near term - Extend perimeter of concurrent stress tests to cover large foreign subsidiaries. [BoE, PRA] — Medium term - Complete core data template and enhance analytical infrastructure for concurrent stress tests. [BoE, PRA] — Medium term - Develop cross-sector interconnectedness indicators using flow of funds, cross-sector exposures, market indicators, and thematic analysis. [BoE, FCA] — Medium term - Financial sector oversight: - Increase supervisory intensity on less systemically important banks (more frequent onsite inspections, scrutiny of asset classification and provisioning). [PRA] — Near term - Extend, if legally possible, AIFMD transparency reporting to cover non-EEA managers and funds; enhance international exchange. [HMT and FCA] — Near term - Ensure BCNs’ activities are sufficiently supervised and monitored. [FCA] — Near term - Broaden review of bank internal models to cover more less-material models and models of smaller banks. [PRA] — Medium term - Introduce EIOPA-like college agreements for insurers with significant business outside the EEA. [PRA, FCA] — Medium term - FMIs: - Consider alternative oversight structures for HVPS and finalize RTGS self-assessment against PFMI. [BoE] — Near term - Continue de-tiering project for payment systems and consider increasing settlement in central bank money for CCP-embedded payment system transactions. [BoE] — Medium term - Crisis management and resolution: - Develop operating principles for funding firms in resolution. [HMT, BoE, FSCS] — Near term - Work with international partners to develop an effective insurance resolution regime for systemic insurers. [HMT, BoE, PRA] — Medium term - Establish engagement approach with countries not in CMGs but where U.K. banks and CCPs have systemic presence. [BoE] — Medium term ### POLICY IMPLICATIONS AND PRIORITIES - Strengthen cross-sector surveillance and analytical capacity to monitor emerging interconnectedness and new market structures. - Review and strengthen internal models and supervisory approach to less systemically important banks to avoid blind spots. - Complete resolvability reforms (ring-fencing, MREL) and develop operational funding principles for resolution; establish insurance resolution regime for potentially systemic insurers. - Enhance concurrent stress testing framework by extending coverage to large foreign subsidiaries and completing core data templates and analytical infrastructure. - Monitor BoE liquidity facility use to mitigate moral hazard and regulatory arbitrage risks as access broadens. - Extend the FPC’s powers where necessary to address property-sector vulnerabilities (e.g., buy-to-let). --- ### BANKING SECTOR CONCENTRATION, MACROBACKDROP, AND FUNDAMENTALS - Concentration and competition: - Seven largest U.K. banks represent over 75 percent of total system assets. - By this measure, concentration is higher than Japan (71 percent), Switzerland (71 percent), Germany (48 percent), and the U.S. (48 percent), though lower than France (91 percent). - Challenger banks represent about 5 percent of lending market share. - Macroeconomic backdrop (selected indicators): - Real GDP changes: 2012 1.2; 2013 2.2; 2014 2.9; 2015 2.3; 2016 1.9; 2017 2.2 - CPI, end-period: 2012 2.7; 2013 2.0; 2014 0.9; 2015 0.1; 2016 1.3; 2017 1.9 - Unemployment rate (in percent): 2012 8.0; 2013 7.6; 2014 6.2; 2015 5.4; 2016 5.0; 2017 5.0 - Gross national saving (percent of GDP): 2012 12.9; 2013 12.1; 2014 12.3; 2015 12.0; 2016 13.2; 2017 14.0 - Current account balance (percent of GDP): 2012 -3.3; 2013 -4.5; 2014 -5.1; 2015 -5.2; 2016 -5.2; 2017 -4.7 - Bank fundamentals (2015 figures unless otherwise noted): - Basel III common equity Tier 1 capital ratio (2015): 12.6 - Simple leverage ratio (2015): 6.7 - Non-performing Loans to Total Gross Loans (2015): 1.4 - Non-performing Loans Net of Provisions to Capital (2015): 4.5 - Return on Assets (2015): 0.4 - Return on Equity (2015): 6.7 - Liquid Assets to Total Assets (Liquid Asset Ratio) (2015): 20.3 - Customer Deposits to Total (non-interbank) Loans (2015): 116.5 - Loan-to-deposit ratio (2015): 96.7 - Key macrofinancial risks (principal risks listed): - Sharp downturn in China and other EMs. - Sudden and sizeable increase in rates and steepening of yield curve. - Correction in U.K. property markets, with buy-to-let and CRE segments vulnerable. - Risk Assessment Matrix (selected entries): - British voters elect to leave the EU: Overall Level of Concern High; Likelihood of severe realization in 1–3 years High. - Sharp downturn in China and other EMs: Overall Level of Concern Medium; Likelihood High; expected impact High. - Premature/disorderly steepening of U.K. yield curve: Overall Level of Concern High; Likelihood Medium; expected impact Medium. - Large correction in U.K. property markets: Overall Level of Concern Medium; Likelihood Medium; expected impact Medium. ### PROPERTY MARKET (Box 2) - Residential: - Annual house-price growth slowed mid-2014 to mid-2015, then accelerated and outpaced nominal GDP growth; little evidence of credit-fueled boom: mortgage lending growth and housing transactions remain well below pre-crisis levels. - Buy-to-let: - Lending grew from 4 percent of mortgage stock in 2002 to 16 percent in mid-2015. - FPC requested powers of direction over buy-to-let to level regulatory playing field. - Commercial real estate (CRE): - Annual price growth around 10 percent as of mid-2015; prime U.K. and prime London CRE have grown rapidly since 2013; BoE suggests overvaluation limited to certain prime locations. - Credit risks reduced vs 2008 due to lower bank CRE exposure and international investors accounting for more than half of CRE financing flows. - CRE is macroeconomic risk because many SMEs rely on CRE as collateral. ### CYBER RISK (Box 3) - Cyber risks threaten financial stability by disrupting critical functions; capital and liquidity buffers alone cannot protect firms. - Amplifying factors: increasing IT reliance, interconnectedness, deliberate and evolving cyber attacks, difficulty of detection and recovery. - U.K. initiatives: - FPC-led diagnostic exercises: cyber risk questionnaire and CBEST (voluntary penetration testing). - 2015 FPC recommendation: BoE, PRA, FCA work with core firms to complete CBEST tests and adopt individual cyber resilience action plans. - FPC endorsed a work plan to develop recovery capabilities and governance; international coordination ongoing; November 2015 U.K.–U.S. joint exercise conducted. ### STRESS TESTS — COVERAGE, METHODOLOGY, LIMITATIONS - Solvency stress tests: - Covered seven major banks/building societies on global consolidated group basis; represent over 80 percent of PRA-regulated banks’ lending to the economy. - FSAP solvency stress test based on end-2015 data covering 2016–20; BoE concurrent stress test based on end-2014 data covering 2015–19. - Liquidity stress tests: - Covered ten U.K. firms (seven in solvency tests plus three large subsidiaries of foreign banks). - Based on end-December 2015 data; performed by BoE using FSAP scenarios. - Scenarios: - BoE 2015 scenario: synchronized global downturn and correction in market risk appetite (Asia and euro area focus). - FSAP scenario: broad-based dislocation with jumps in yield curves and spillovers to vulnerable EMs; explores valuation losses from credit spread and term premia shocks, potentially triggered by faster-than-anticipated U.S. monetary normalization. - Limitations: - Brexit risks not quantified and not incorporated into stress tests. - Santander U.K. plc excluded from consolidated home supervision due to foreign parent supervision. --- ### SPILLOVERS, MARKET STRUCTURAL CHANGES, AND LIQUIDITY RISKS - Structural intermediation changes: - Some hedge funds attempt to supplant bank functions in repo markets; distress in one hedge fund may spread network-wide. - Links between insurers, pension funds, hedge funds, and alternative capital are growing (longevity swaps, alternative capital participation). - Market-making and liquidity: - Regulation and technology have reduced dealer market-making activity; primary dealers’ trading book inventories declined from GBP 400 billion in mid-2008 to GBP 250 billion at end-2014 (FCA analysis). - Standard liquidity metrics stable since end-2011, but higher-frequency analysis shows markets increasingly sensitive to news, raising probability of volatility spikes. - Risk channel: volatility spikes in low-liquidity environment could trigger large redemptions from open-ended funds and rapid liquidity deterioration. - Recommendation: comprehensive stress tests for asset management sector; expand analytical toolkit beyond partial assessments suggesting SCB funds resilience. - Cross-border spillovers and policy spillovers: - Likelihood of cross-border spillovers declined with reduced foreign exposures of U.K. banks. - Appendix IV GFM findings: a one percentage point increase in the CCB in the U.K. would reduce U.K. output by 0.1 percent and output in other economies covered by the analysis by less than that. - Policy spillovers are small but concentrated among selected advanced and some emerging economies; may be larger in very small economies with large U.K. exposures. ### MACROPRUDENTIAL FRAMEWORK - Institutional setup: - BoE has financial stability mandate centered on FPC; FPC identifies, monitors, and mitigates systemic risk. - FPC can make recommendations and has powers of direction over tools prescribed by HMT. - FPC conducts regular quarterly surveillance and annual perimeter discussion. - Direction powers exist over tools targeting excessive leverage and credit growth; FPC requested powers over buy-to-let lending. - Tools in use (per source note 10): - CCB under Basel III, sectoral capital requirements, LTV and DTI ratios on owner-occupied mortgage lending, leverage ratio (including countercyclical leverage ratio buffer and leverage surcharge for systemically important institutions). - Implementation caveats: - Effectiveness depends on willingness to act and resources; recommend promoting public understanding of FPC role and maintaining political support. ### MICROPRUDENTIAL OVERSIGHT — BANKING, RING-FENCING, GOVERNANCE - Post-crisis reforms: - U.K. implementing single rulebook; preparing to adopt TLAC via MREL. - Remuneration rules from 2009 in effect since January 2010. - U.K. assessed Compliant or Largely Compliant with all Basle Core Principles in this FSAP. - Ring-fencing (Box 6): - Banking Reform Act 2013 requires banks with core deposits > GBP 25 billion to create by 2019 a ring-fenced body (RFB) for U.K. core activities. - RFB subject to systemic risk buffer between 0 and 3 percent. - Six banks expected to be subject: HSBC, Barclays, Lloyds, RBS, Santander U.K., and Co-op. - Implementation challenges: significant investment, potential re-evaluation of business models, Part VII transfer complexity and High Court verification uncertainty. - Governance reforms (Box 7): - Senior Managers Regime (SMR) in force March 2016; Certification Regime and Conduct Rules in place. - SMR identifies senior management functions and prescribes responsibilities; Certification Regime requires firms to certify fitness/propriety annually. - Example PRA functions listed include Chairman; Chief Executive Officer; Chief Risk Officer; Head of Internal Audit; Head of Key Business Areas; Group Entity Senior Manager; Head of Overseas Branch. ### SUPERVISORY APPROACH — TRADEOFFS AND RECOMMENDATIONS - Supervisory tradeoffs: - Emphasis on large firms results in higher tolerance for risks from mid-size and small firms. - Offsite monitoring, thematic reviews, and data analysis help detect risk build-up but do not fully substitute for onsite validation. - Persistent downward trend of ratio of RWAs to total assets and methodological inconsistencies across institutions → intensify review of internal models. - Recommendations: - Increase supervisory intensity for less systemically important banks (more onsite inspections, asset classification and provisioning scrutiny). - Expand Asset Quality Reviews (AQR) and supervisory guidance on credit risk for smaller firms. - Improve data on credit exposures and performance for better offsite analysis. ### FMIs, HVPS, RTGS, AND DE-TIERING - FMI supervision strengthened; BoE lead supervisor for all FMIs enabling consistent PFMI implementation. - Priorities: - Reduce FMIs’ dependence on bank services through de-tiering and settlement in central bank money for CCP-embedded payment systems. - Increase number of transactions settling entirely in central bank money via the HVPS. - BoE RTGS self-assessment underway; consider alternative oversight options as CHAPS Co has limited powers vis-à-vis BoE-operated RTGS. ### BOE CONCURRENT STRESS TESTING FRAMEWORK AND LIQUIDITY FRAMEWORK - BoE concurrent stress test: - Launched 2015; covers banks/building societies with retail deposits of GBP 50 billion or more; five-year horizon. - From 2016, annual stress scenario countercyclical; biennial exploratory scenario complementary. - Results have direct—though not mechanical—impact on setting buffers. - Implementation priorities: improve analytical infrastructure, build supervisory models, expand BoE TD models, address coverage gaps for foreign banks. - BoE liquidity framework: - Two broad facility sets: Sterling Markets Framework (SMF) and Emergency Liquidity Assistance (ELA) framework (largely unpublished). - BoE capacity for covert ELA and available FX for FX ELA. - Benefits: supports a large financial sector under liquidity stress. - Risks: reduced incentives to self-insure, global liquidity arbitrage, concentration of activities in U.K. - Mitigants: safeguards, BoE/PRA monitoring of liquidity plans, close links with foreign supervisors; increased vigilance recommended. - Ongoing work on BoE balance sheet and capital: - New division developing forward-looking capacity to evaluate BoE balance sheet impacts under scenarios; priority input to Bank’s capital adequacy framework. - Box 8 key points: - Policy solvency more important than balance-sheet capital; BoE does not retain seignorage revenue. - Crown indemnities supporting crisis-related operations will wind down as QE exits. - BoE balance sheet may remain large; liquidity insurance implies contingent balance sheet risks. - Design objectives: ensure policy solvency, capital efficiency, sufficient capital buffers, and ability to supply additional capital expeditiously. - Risk coverage principle: risks from Bank independent policies covered first by prudent risk management and second by capital; extraordinary-operation risks may be backed by Crown indemnities. ### RESOLUTION, MREL, AND RESOLVABILITY - Framework: - U.K. resolution framework robust and broadly aligned with FSB Key Attributes. - BoE legally and operationally positioned for resolution mandate; broad range of stabilization options including bail-in available. - MREL and resolvability: - MREL implementation timelines: phased in from 2016 to 2019 for G-SIBs and to 2020 for other banks. - BoE estimates MREL implementation will require long-term restructuring of liabilities of around GBP 223 billion. - First round of resolvability assessments completed in 2015; Recovery and Resolution Plans shared in CMGs. - Recommendations and operational needs: - Establish explicit BoE power to depart from pari-passu where necessary to preserve financial stability. - Expand system-wide contingency planning to include FCA and FSCS in Crisis Management MoU and high-level discussions. - Develop operational principles for funding in resolution, update HMT/BoE MoU re resolution fund use, consider indemnities to BoE for ELA supporting solvent firms in resolution. - Finalize contractual recognition of bail-in governed by third-party jurisdiction laws and regime for resolving U.K. branches of non-EEA firms. - Establish cooperation arrangements with non-CMG host countries where U.K. G-SIBs have systemic presence. ### BREXIT — OBSERVATIONS, SHORT-TERM AND LONG-TERM RISKS - Importance and scale: - Financial services ~8 percent of U.K. GDP and 3½ percent of employment. - EU countries account for about a third of U.K. financial services surplus. - Roughly half of the largest financial institutions in the world have European headquarters in the U.K. - Short-term effects of a vote to leave: - Heightened financial and FX market volatility; lower business investment during potentially multi-year negotiations. - British banks: higher impairment losses, lower profitability, higher funding costs, potential credit curtailment. - Insurers and investors: valuation losses. - While a member during negotiations, firms would not face direct obstacles to accessing EU markets but may restructure in anticipation. - Long-term effects conditional on passporting and EEA membership: - Loss of passporting likely to lead to exits from some EEA markets, subsidiarization, higher funding costs, or activity shifts to subsidiaries. - European headquarters of global banks in London may relocate. - Replacing EU-embedded banking regulations with domestic rules would cause upheaval, could shrink banking industry and diminish London’s global role. - Uncertainty: quantification not feasible; effects differentiated across industry segments. ### ASSET MANAGEMENT, INSURANCE, CCPs, PAYMENTS, LEGAL ENVIRONMENT - Asset management: - UCITS domiciled in U.K. would need conversion to nationally-regulated funds if outside EEA; U.K. AIFs would become non-EEA AIFs without product passport. - Marketing non-EEA AIFs to EEA investors requires National Private Placement Regime of each EEA country; may not provide easy access. - Likely consequence: relocation of funds targeted to EEA investors to the EEA; asset managers may set up EEA subsidiaries. - Insurance: - U.K. insurers relatively insulated even with EEA exit due to subsidiary operations in other EU countries; Lloyd’s is notable exception. - Impact on Lloyd’s and London insurance market could be significant absent cross-border supervisory recognition. - CCPs: - Exit could majorly impact U.K. CCPs: absent EEA membership or EMIR equivalence, U.K. may be treated as "third country"; EU banks may need higher capital buffers or not be permitted to use U.K.-based CCPs. - Interoperability arrangements between U.K. and EU CCPs may be halted until recognition; euro-denominated business may shift to euro area. - Payment and settlement systems: - Passport rights under Payment Services Directive could be lost; providers might need separate EU legal entities at significant cost. - Central securities depository business impact smaller due to EU legislation not fully in place. - Legal environment: - Mutual recognition of judgments and cross-border resolution may become challenging. - U.K. would lose access to ECJ; uncertainty whether English law choice in derivatives contracts between two non-U.K. counterparts in the EU would be accepted post-exit. ### STRESS TEST METHODOLOGY, CALIBRATIONS, AND TAIL SHOCKS - Institutional perimeter for solvency test: - Seven institutions: Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, Nationwide Building Society, The Royal Bank of Scotland Group plc, Santander U.K. plc, Standard Chartered plc. - Market share: ~80 percent of PRA-regulated banks’ lending to the U.K. real economy. - Data dates: - Effective date: end-December 2014 (BoE test) and end-December 2015 (FSAP test); market risk effective dates noted as February 20, 2015 and end-December 2015 respectively. - Hybrid stress testing process: - BoE-designed scenarios; bank bottom-up projections; BoE in-house challenger models; aggregation/adjustments by BoE. - FSAP top-down macroprudential stress tests using IMF-generated scenarios. - For IRB exposures: separate credit risk model calibrated for 5 Basel asset classes and 15 geographies. - Detailed mortgage stress by LTV vintage using structural Merton-based approach. - Tail shocks (selected calibrations): - Global recession scenario: - U.K. real GDP growth contracts by 2.3 percent year-on-year from Q4 2014 to Q4 2015; peak deviation from baseline in 2017 at -7.7 percent. - Unemployment rises by 3.5 pps by 2017/Q3. - Equity prices decline by 36 percent peak-to-trough. - Residential property prices fall by 20 percent. - China real GDP falls to 1.7 percent in 2015/Q4. - VIX peaks at 46 pps in 2015; oil price troughs at USD 38; renminbi depreciates 10 percent vs USD by end-2015; euro depreciates about 25 percent vs USD and 15 percent vs sterling in 2015. - Disorderly U.S. monetary normalization scenario: - U.K. GDP growth contracts by 1.6 percent in 2016; peak deviation in 2017 at -6.9 percent. - Real house prices fall by 40 percent in 2016 and 2017. - Real equity price falls by 40 percent during 2016. - Banks’ lending rates rise by 1.1 pps by 2017; bank credit falls by 6.7 percent. - Output falls by 11.9 percent in the fragile three (Brazil, South Africa, and Turkey), and by 1.3 percent in other emerging economies. - Scenario includes idiosyncratic and system-wide funding risk shock linked to banks’ capital ratios under stress. - Calibration and regulatory standards: - Capital definition per Basel III/CRD IV/PRA rulebook; CET1 computed using CRD IV end-point definition. - CET1 ratio hurdle rates: 4.5% of RWAs in stress and 7% in baseline (BoE stress test). - Leverage ratio hurdle: 3 percent met with Tier 1 capital; two definitions noted (PRA SS3/13 and IMF stress test definition). ### REPORTING FORMAT FOR RESULTS (SOLVENCY AND LIQUIDITY) - Solvency outputs: - Minimum stressed CET1, Tier 1, CAR and leverage ratio by bank. - Evolution of stressed CET1 and leverage ratio for aggregate of all 7 banks (BoE stress test). - Evolution of CET1, Tier 1, CAR, and leverage ratio for aggregate banking system and by bank type. - Contribution of key drivers to aggregate net profits and aggregate CET1 capital ratios. - Cumulative impairment charges by bank for the U.K. and other countries impacted. - Number of banks and share of total assets below hurdle rates. - Liquidity stress testing matrix: - Institutional perimeter: 10 firms (7 major banks/building societies + 3 largest subsidiaries of foreign investment banks) providing ~80 percent coverage of banking sector total assets. - LCR liquidity stress test data base date: December 31, 2015 (PRA interim LCR reporting). - Cash flow liquidity stress test relies on PRA048 return as of January 1, 2016. - Tests: LCR on three scenarios; implied cash flow tests for 5 days (cumulative) and 30 days (noncumulative); maturity mismatch analysis; single currency analysis under PRA ILG. - Tail shocks for liquidity (selected calibrations): - LCR ‘U.K. retail stress’: run-off rates up to 15 percent for retail deposits and 60 percent for corporate deposits; liquidity risk from undrawn facilities 50 percent. - LCR ‘U.K. wholesale stress’: freeze of wholesale funding with run-off rates of 75 percent for operational deposits and 100 percent for not-fully covered corporate deposits; rollover of secured funding backed by non-Level 1/2A assets up to 0 percent. - Implied cash-flow assumptions include haircuts up to 60 percent for securities and bank loans mobilizable in repos; no new unsecured issuance; call-back rates up to 100 percent; cash outflows up to 75 percent. ### BASEL CORE PRINCIPLES (BCP) ASSESSMENT — SELECTED FINDINGS - Assessment used revised BCPs (September 2012); U.K. authorities agreed to be assessed against EC and AC; qualitative assessment found U.K. Compliant or Largely Compliant with all BCPs. - Institutional reforms: - Financial Services Act 2012 replaced FSA with PRA and FCA; FPC assigned financial stability responsibility. - BoE and Financial Services Act (May 2016) merges PRA into BoE creating Prudential Regulatory Committee (PRC) and preserving operational independence. - Supervisory approach: - Shift to rigorous, hands-on, systemically focused approach since 2011. - Stress testing central to supervisory toolkit. - Tradeoffs and resource concerns: - Emphasis on largest firms concentrates resources and may overstretch supervisory resources given system size and complexity. - Offsite monitoring primary for less systemically important firms; recommend expanding onsite/testing for these firms. - Disclosure and data: - Need for more comparable, relevant, reliable, and timely data on balance sheets, income, losses, and off-balance sheet exposures. - Controls and auditors: - Increased engagement with internal/external auditors for largest firms; more consistency needed in supervisor-auditor engagement. - Credit risk and AQRs: - AQRs at nonsystemic banks are too sporadic; no explicit supervisory guidance on credit risk for majority of banks. ### AML/CFT, ABUSE OF FINANCIAL SERVICES, AND SUPERVISORY GAPS - Key findings: - Testing of management and control of financial crime and abuse is limited; pockets of financial activities receive less than adequate supervision. - Recommended actions (selected): - Propose stronger, proactive backstops to evaluate banks in lowest risk categories more frequently for control quality and ML risk exposure. - Evaluate adequacy of supervision of less systemically important firms and enhance validation/probing techniques. - Promote accountability of managers beyond largest firms; strengthen supervision of operational risk across all firms. - Authorities’ response (paragraphs 91–97): - Authorities welcome IMF review, acknowledge progress since 2011, and state ambition for U.K. to be "best regulated in the world." - Cite steps taken: advocacy for tough capital/leverage/liquidity standards; robust resolution regime and total loss absorbency standards; Senior Managers and Certification Regime; alignment of incentives; consumer protection and enforcement. - Authorities consider current scrutiny of smaller firms appropriate, proportionate, and aligned with statutory objectives. - Welcome IMF findings on AML/CFT supervision and describe FCA’s approach as risk-based and outcome-focused. *International Monetary Fund — United Kingdom Financial Sector Assessment Program — excerpt (PDF chapter).* ### EXECUTIVE SUMMARY ___________________________________________________________________________ 6 ### EXECUTIVE SUMMARY ### BACKGROUND - The U.K. has a large, complex, and globally interconnected financial system: - Total financial assets owned by all financial institutions (excluding the BoE) are about GBP 20 trillion, "over ten times U.K. annual GDP." - About half of these assets are accounted for by banks. - Comparative ratios: 8.8 in the Netherlands, 5.6 in Switzerland, 6.4 in Japan, and 3.9 in the U.S.; exceeded only by Hong Kong SAR and some offshore financial centers. - Four banks and two insurers are classified as globally systemically important. - The U.K. insurance sector is "the largest in Europe and third largest in the world." - The U.K. hosts the largest fund management industry in Europe and two of the largest central counterparties (CCPs) in the world. - According to the BoE, nearly a fifth of global banking activity worldwide is booked in the U.K., and around half of the world’s largest financial firms have their European headquarters in the U.K. - Box 1 — Size of the Financial System and Financial Stability: BoE research conclusions (summary): - Once credit booms and leverage are taken into account, there is no statistically significant relationship between banking system size and the probability of a banking crisis. - Evidence from the recent financial crisis suggests that bigger banking systems were not associated with lower output growth post-crisis. - Larger banking systems may impose higher fiscal costs in the event of a crisis. - Policy implication: capital resilience, proper oversight, and a proper resolution framework are more relevant for financial stability than size alone; degree of leverage and credit bubbles are better predictors of financial crises. ### MAJOR FINDINGS: RISKS, RESILIENCE, AND INTERCONNECTEDNESS - Overall assessment: - Since the last FSAP, the U.K. financial system has become much stronger and more resilient; it is better able to serve the real economy. - The system remains exposed to risks due to size, complexity, and global interconnectedness; materialization of these risks could have major impacts domestically and globally. - Financial stability in the U.K. is characterized as a global public good. - External and domestic risk drivers: - Global shocks (examples cited): a negative growth shock in emerging markets; a rapid hike in global risk premia; renewed tensions in the eurozone — all could significantly impact U.K. banks and the financial system. - Domestic credit cycle concerns: as the domestic credit cycle matures while interest rates remain at historic lows, trends in segments of the U.K. property market—"notably buy-to-let and commercial real estate"—could become financial stability risks. - Brexit-related uncertainties: - A vote in favor of leaving would usher in a period of uncertainty and financial market volatility during potentially multi-year negotiations. - The eventual exit deal could have profound effects on trade, the real economy, passporting arrangements, and location decisions of international financial firms headquartered in London. - These effects are "highly uncertain" and have major long-term implications for the U.K. financial sector and its global standing. - The possible impact of Brexit is inherently difficult to quantify and "has not been covered in the stress tests." - Resilience of core sectors: - Banks: - Since the crisis, banks have more than doubled their risk-weighted capital ratios from pre-crisis levels, strengthened liquidity, and reduced leverage. - Stress tests by both the BoE and the FSAP indicate the largest banks would be able to meet regulatory requirements and sustain capacity to finance the economy under severe shocks. - Caveat: Brexit effects not included in stress tests. - Insurers, asset managers, and CCPs: - These sectors "also appear resilient," based on assessments by the BoE, FCA, European financial authorities, and the FSAP. - Interconnectedness and systemic amplification: - Despite sectoral resilience, interconnectedness across sectors could amplify shocks and turn sector-specific distress into systemic events. - New patterns of interconnectedness are emerging due to structural market shifts and new entrants; these are not inherently risky but complicate supervisors’ task of "connecting the dots across sectors." - Supervisory capacity and tools need upgrading to monitor cross-sector linkages and evolving market structures. ### REGULATORY REFORMS, FRAMEWORKS, AND IMPLEMENTATION - Reform achievements: - A wave of regulatory reforms since the crisis is "now near completion," aimed at reducing failure probability and lowering the cost of failures. - Reforms align with the global regulatory agenda and include governance and conduct enhancements and the decision to ring-fence retail banking from riskier activities. - Many reforms correspond to recommendations of the 2011 FSAP (see Appendix I). - Macroprudential and microprudential frameworks: - Macroprudential: - New framework provides clear roles and responsibilities, adequate powers and accountability, and promotes coordination across agencies. - Track record to date is "encouraging," though relatively short. - Microprudential and conduct: - Oversight has become more rigorous and hands-on. - Supervisory focus on the most systemically important firms is appropriate but implies less individual attention to small and mid-size companies; supervisors rely more on data monitoring, thematic reviews, and outlier analysis. - This tradeoff requires vigilance because business models of smaller firms can be correlated, and failures—even if not systemic—may cause reputational risk for the supervisor. - Noted concerns: downward trend of the ratio of risk-weighted to total assets and methodological inconsistencies across banks → recommendation that internal models be reviewed closely. - Stress testing and liquidity: - The BoE’s new annual concurrent stress testing framework is a key link between microprudential and macroprudential frameworks; further investment is needed for it to meet ambitious goals. - The BoE’s new liquidity framework is described as a "key shock absorber": - Ensuring the Bank is "open for business" in distress can stop propagation of shocks through liquidity contagion. - Broader access (including broker-dealers and CCPs) is positive, enabled by supervision of all accessing entities by BoE and PRA. - Risk: relative ease of access could distort incentives over time — BoE should monitor participating firms for signs of moral hazard or regulatory arbitrage. - Resolution and safety nets: - Transposition of the Bank Recovery and Resolution Directive has completed reform of the U.K.’s Special Resolution Regime for banks; it is broadly aligned with global standards. - Resolution powers, tools, and coordination arrangements domestically and cross-border are much stronger. - Key ongoing challenges: - Complete multi-year process to facilitate resolvability of U.K. financial firms, including implementation of ring-fencing and Minimum Requirements for Own Funds and Eligible Liabilities (MREL). - Build operational principles for funding firms in resolution. - Establish an effective resolution regime for insurance companies whose failure could be systemic. - Develop appropriate cooperation arrangements with smaller host countries where U.K. banks play a systemic role but which are not part of Crisis Management Groups (CMGs). ### FSAP KEY RECOMMENDATIONS (Table 1 — selected entries, with time frames and responsible parties) - Note: "Near term is one year. Medium term is 2–3 years." - Financial stability policy framework: - Extend the Financial Policy Committee’s (FPC) powers of direction to the buy-to-let market. [Her Majesty’s Treasury (HMT)] (¶4, ¶21, Box 2) — Near term - Extend perimeter of concurrent stress tests to cover large foreign subsidiaries. [BoE, PRA] (¶41) — Medium term - Complete core data template and enhance analytical infrastructure for concurrent stress tests. [BoE, PRA] (¶41) — Medium term - Develop a set of cross-sector interconnectedness indicators using flow of funds data, cross sector exposures, market based indicators, and information produced by thematic analyses. [BoE, FCA] (¶15) — Medium term - Financial sector oversight: - Increase the supervisory intensity on less systemically important banks, for example through more frequent onsite inspections and greater scrutiny of asset classification and provisioning. [PRA] (¶27) — Near term - Extend, if legally possible, the scope of transparency reporting under the Alternative Investment Fund Managers Directive (AIFMD) to cover non-European Economic Area (EEA) managers and funds, where relevant for systemic risk monitoring, and strive for enhanced international exchange of information. [HMT and FCA] (¶34) — Near term - Ensure that Broker Crossing Networks’ (BCNs) activities are sufficiently supervised and monitored. [FCA] (¶33) — Near term - Broaden the review of bank internal models to cover a greater sample of less material models and models of smaller banks. [PRA] (¶28) — Medium term - Introduce agreements similar to those under EIOPA requirements for colleges for insurers with significant business outside the EEA. [PRA, FCA] (¶31) — Medium term - Financial markets infrastructures: - Consider alternative structures for oversight and management of risk within the U.K. High Value Payments system (HVPS) and finalize the self-assessment of the RTGS infrastructure against the Principles for Financial Markets Infrastructures. [BoE] (¶38) — Near term - Continue with the de-tiering project for payment systems and EUI and consider increasing settlement in central bank money for CCP-embedded payment system transactions by increasing the number of CCP members that are also members of the HVPS. [BoE] (¶37) — Medium term - Crisis management and resolution: - Build on current arrangements to develop operating principles for funding of firms in resolution. [HMT, BoE, and the FSCS] (¶51) — Near term - Work with international partners to develop an effective resolution regime for insurance firms that could be systemically significant at the point of failure. [HMT, BoE, PRA] (¶47) — Medium term - Establish an approach for engaging with countries that are not members of CMGs but where U.K. banks and CCPs have a systemic presence. [BoE] (¶39, ¶52) — Medium term ### POLICY IMPLICATIONS AND PRIORITIES - Strengthen cross-sector surveillance and analytical capacity to monitor emerging interconnectedness and new market structures. - Review and strengthen internal models and the supervisory approach to less systemically important banks to avoid blind spots arising from supervisory concentration on the largest firms. - Complete resolvability reforms (ring-fencing, MREL) and develop operational funding principles for resolution; establish an insurance resolution regime for potentially systemic insurers. - Enhance the concurrent stress testing framework by extending coverage to large foreign subsidiaries and completing core data templates and analytical infrastructure. - Monitor BoE liquidity facility use carefully to mitigate moral hazard and regulatory arbitrage risks as access broadens. - Extend the FPC’s powers where necessary to address property-sector vulnerabilities (e.g., buy-to-let). *Source: IMF Financial Sector Assessment Program — United Kingdom, Executive Summary (PDF chapter).* ### 2. The banking sector is concentrated but competitive pressures have recently been ### _cr16167 - 2. The banking sector is concentrated but competitive pressures have recently been ### Banking sector concentration and competition - The seven largest U.K. banks represent over 75 percent of total system assets. - By this measure, concentration is higher than in Japan (71 percent), Switzerland (71 percent), Germany (48 percent), and the U.S. (48 percent), though lower than in France (91 percent). - Smaller “challenger” banks focusing on certain market segments (especially retail) are growing but still represent only about 5 percent of lending market share. ### Macroeconomic backdrop and bank fundamentals - The U.K. economy has continued to grow; the output gap is now almost closed and inflation is projected to rise gradually toward the 2 percent target. - Nonfinancial private sector indebtedness: below 160 percent of GDP at end-2014, down from almost 190 percent at end-2009. - Current account deficit: large and a source of concern; staff projections suggest a modest improvement under current policies over the medium-term. - Asset quality: average NPL ratio down to 1.4 percent. - Capital: Basel III Common Equity Tier 1 (CET1) capital stands at 12.6 percent of risk-weight assets (RWA). - Funding and efficiency: funding metrics have strengthened; efficiency ratios are improving. - Profitability: remains lackluster, reflecting low interest rates, balance sheet de-risking, declining trading income, and—mainly for the largest banks—high legacy conduct and litigation provisions, which may have dampened credit supply. Key statistics from Tables 2–3 (selected): - Real GDP changes: 2012 1.2; 2013 2.2; 2014 2.9; 2015 2.3; 2016 1.9; 2017 2.2 - CPI, end-period: 2012 2.7; 2013 2.0; 2014 0.9; 2015 0.1; 2016 1.3; 2017 1.9 - Unemployment rate (in percent): 2012 8.0; 2013 7.6; 2014 6.2; 2015 5.4; 2016 5.0; 2017 5.0 - Gross national saving (percent of GDP): 2012 12.9; 2013 12.1; 2014 12.3; 2015 12.0; 2016 13.2; 2017 14.0 - Current account balance (percent of GDP): 2012 -3.3; 2013 -4.5; 2014 -5.1; 2015 -5.2; 2016 -5.2; 2017 -4.7 - Basel III common equity Tier 1 capital ratio (2015): 12.6 - Simple leverage ratio (2015): 6.7 - Non-performing Loans to Total Gross Loans (2015): 1.4 - Non-performing Loans Net of Provisions to Capital (2015): 4.5 - Return on Assets (2015): 0.4 - Return on Equity (2015): 6.7 - Liquid Assets to Total Assets (Liquid Asset Ratio) (2015): 20.3 - Customer Deposits to Total (non-interbank) Loans (2015): 116.5 - Loan-to-deposit ratio (2015): 96.7 ### Key macrofinancial risks (FSAP assessment) - The FSAP identifies new/emerging tail risks broadly consistent with the BoE December 2015 Financial Stability Report. - Principal risks listed: - A sharp downturn in China and other emerging markets, leading to a dampening of global growth. - A sudden and sizeable increase in rates and steepening of the yield curve in the U.K. and globally—possibly triggered by an unexpected or larger-than-anticipated hike in policy rates in the U.S.—provoking abrupt asset price corrections and broad-based financial market dislocation. - A correction in the U.K. property markets, with buy-to-let and commercial real estate (CRE) segments appearing more vulnerable to price reversals, potentially spreading to other segments. Risk Assessment Matrix (selected entries): - British voters elect to leave the EU: Overall Level of Concern High; Likelihood of severe realization in 1–3 years High; expected impact: high volatility and potential contagion to financial markets. - A sharp downturn in China and other EMs: Overall Level of Concern Medium; Likelihood High; expected impact High, including adverse effects on bank earnings and creditworthiness, amplified by currency fluctuations and capital flow disruptions. - A premature and/or disorderly steepening of the yield curve in the U.K.: Overall Level of Concern High; Likelihood Medium; expected impact Medium, including erosion of bank earnings and capital through valuation losses and reduced market liquidity. - A large correction in the U.K. property markets (residential and CRE): Overall Level of Concern Medium; Likelihood Medium; expected impact Medium, including higher impairments and negative capital impact, and macroeconomic contraction. ### Box 2 — Recent developments in the U.K. property market (summary) - Overall: U.K. residential property prices reflect mostly long-standing supply-demand imbalances. Annual house-price growth slowed substantially between mid-2014 and mid-2015, then accelerated and outpaced nominal GDP growth. Little evidence of a credit-fueled boom: mortgage lending growth and number of housing transactions remain well below pre-crisis levels. - Buy-to-let segment: - Lending in the buy-to-let sector grew from 4 percent of mortgage stock in 2002 to 16 percent in mid-2015. - In response, the FPC requested powers of direction over this sector to level the regulatory playing field with the buy-to-own market. - Commercial real estate (CRE): - Annual price growth around 10 percent as of mid-2015, though it slowed somewhat in early 2016. - Prices of prime U.K. CRE—and especially prime London CRE—have grown rapidly since 2013; BoE analysis suggests overvaluation limited to certain prime locations. - Credit risks to domestic banks from a CRE price reversal are reduced relative to the 2008 run-up: U.K. banks have reduced CRE exposure, and international investors now account for more than half of CRE financing flows. - CRE poses macroeconomic risk because the majority of small and medium firms rely on CRE as collateral. Selected indicators noted in Box 2: - Outstanding mortgage balances (chart context): mortgage lending growth and residential transactions series shown; buy-to-let share highlighted as 16 percent in mid-2015. - U.K. commercial real estate prices: indices and prime-location growth since 2013. ### Cyber risk, Brexit uncertainties, and other vulnerabilities - Cyber risk: Authorities have identified cyber risk as a potential financial stability risk and are active in global initiatives to mitigate it. Cyber risk was not covered by the FSAP stress tests. - Brexit uncertainty: - A vote to leave the EU would create a transitional period of heightened macroeconomic uncertainty and financial market volatility during negotiations, potentially lasting years and imposing real economic costs. - The shape of any eventual exit deal is highly uncertain and critical for the long-term strength and global standing of the British financial sector. ### Financial sector resilience — stress tests and findings - Solvency stress tests: - Covered seven major banks and building societies included in the BoE concurrent stress test exercise on a global consolidated group basis, representing over 80 percent of PRA-regulated banks’ lending to the economy. - FSAP solvency stress test is based on end-2015 data and covers 2016–20. - BoE concurrent stress test (published December 2015) is based on end-2014 data and covers 2015–19. - Liquidity stress tests: - Covered ten U.K. firms (the seven in solvency tests plus three large subsidiaries of major foreign banks). - Based on end-December 2015 data; performed by the BoE using scenarios provided by the FSAP team. - Scenarios and focus: - The 2015 BoE scenario: synchronized global downturn and a correction in market risk appetite affecting mainly Asia and the euro area (followed the 2014 BoE stress tests that emphasized domestic property market risks). - The FSAP scenario: broad-based dislocation in financial markets, with jumps in yield curves and spillovers to vulnerable emerging markets, exploring valuation losses from shocks in credit spreads and term premia; could be triggered inter alia by faster-than-anticipated U.S. monetary policy normalization. - Both scenarios have major impacts on U.K. activity, employment, and asset prices; their triggers, persistence, and transmission channels differ and thus assess different facets of resilience. - Coverage and limitations: - The solvency exercises exclude Santander U.K. plc from consolidated home supervision as its parent is supervised by a foreign authority. - The risks to the financial sector from Brexit are significant but inherently difficult to quantify and were not incorporated into a specific stress test scenario. *International Monetary Fund — United Kingdom Financial Sector Assessment (excerpt).* ### Box 3. Cyber Risk and Financial Stability in the U.K. ### Box 3. Cyber Risk and Financial Stability in the U.K. ### Cyber risk as a threat to financial stability - Cyber risks can threaten financial stability by disrupting the provision of critical functions from the financial system to the real economy. - Firms cannot protect against technological failures through capital and liquidity buffers, but require other lines of defense. - Several factors compound cyber and IT risks relative to other forms of operational risk: - The increasing reliance on IT systems and networks across the financial sector means that financial institutions face more potential points of operational failure. Firms may face significant increases in complexity arising from system incompatibilities or rapid obsolescence. - Cyber risks can be amplified by interconnectedness. A technological disruption at a large, interconnected firm or at a critical technology vendor can lead to disruption or financial losses for a large number of counterparties. - Cyber crime risks may be difficult to counter. Unlike some forms of operational risk, cyber attacks represent deliberate assaults on a firm’s infrastructure. Financial gain may not be the sole motivation: the goal may be to extract information, disrupt services, or serve as a means of protest. - Cyber attacks are rapidly evolving and readily scalable, detection is not easy, the capacity to recover may be threatened, and attacks may originate anywhere around the globe. ### Rising awareness and international context - At the international level, many institutions, including the Financial Stability Board (FSB), the Bank for International Settlements (BIS), and International Organization of Securities Commissions (IOSCO), view cyber security as a top financial stability concern. - In the U.K., the government has identified cyber attacks as a top priority for action. ### U.K. initiatives, diagnostics, and testing - Following an FPC recommendation in June 2013, two diagnostic exercises were conducted to assess the vulnerability of the U.K. financial sector to a cyber attack: - A cyber risk management questionnaire. - A bespoke voluntary vulnerability testing of firm’s defensive capabilities, called CBEST. The latter was intended to improve the authorities’ understanding of individual firms’ preparedness to address cyber security concerns by employing penetration testing. - In 2015, the FPC recommended that the BoE, the PRA, and the FCA work with firms at the core of the financial system to ensure that they complete CBEST tests and adopt individual cyber resilience action plans. - Such tests should become one component of regular cyber resilience assessment within the U.K. financial system. ### Work to promote recovery capabilities, governance, and international coordination - The FPC has recognized that more work is needed, including on promoting recovery capabilities and effective governance. - The FPC has therefore endorsed a work plan to develop a clear set of capabilities that will enhance cyber resilience of the U.K. financial system and improve the capability of the sector to recover from a major cyber attack. - The program will require coordination with international authorities. - In this context, in November 2015, U.K. and U.S. authorities conducted a joint exercise with major global financial firms to enhance their and the authorities’ cooperation and ability to respond to cyber attacks. *International Monetary Fund — Box 3. Cyber Risk and Financial Stability in the U.K.* ### 17. Going beyond this specific model, the FSAP discussed how structural market changes, ### 17. Going beyond this specific model, the FSAP discussed how structural market changes, some precipitated by regulatory changes, may affect the likelihood and channels of spillovers across sectors. ### Spillovers and structural market changes - Evidence of changing intermediation: - Some hedge funds are increasingly attempting to supplant functions thus far provided by banks in the repo market, reflecting banks’ diminished participation; distress in one hedge fund may spread network-wide. - Links between insurers and pension funds are growing through rising longevity swaps; new links between insurers, hedge funds, and pension funds are developing via participation in the Alternative Capital market. - Market-making and liquidity risks: - Liquidity in some dealer-intermediated markets, such as the corporate bond market, may have become more fragile due to regulatory constraints impacting market-making activity (Box 5). - The new regulatory regime may result in improved sectoral resilience but may also cause higher volatility; higher volatility per se does not represent increased systemic risk, but spikes in an environment of low liquidity could trigger adverse feedback loops. - The apparent resilience of the U.K. asset management sector, notably SCB funds, would in theory help limit such spillovers, but assessment is partial and tentative, underscoring the need for continuous monitoring of market liquidity and more in-depth analysis of behavior during stress. ### Market liquidity: structural shifts and potential risks (Box 5) - Key observations: - Regulation and technology can affect liquidity; regulation to safeguard core intermediaries has led to a rollback in market-making activities, impacting market liquidity. - Some metrics indicate stable liquidity in the SCB market despite declines in dealer inventories, but stable metrics do not guarantee liquidity during market stress. - Empirical points and figures preserved as in source: - Primary dealers’ inventories held on trading books declined from GBP 400 billion in mid-2008 to GBP 250 billion at end-2014 (FCA analysis). - Standard measures of liquidity (Amihud, round-trip costs, turnover ratio, magnitude of price reversals) have remained stable since end-2011; transaction volumes largely unaffected. - Higher-frequency analysis shows no meaningful reactions to global shocks such as the 2012 ‘taper tantrum’, but there is evidence markets are becoming increasingly sensitive to news, raising probability of more frequent volatility spikes. - Risk channel highlighted: - Volatility spikes in an environment of low liquidity could be amplified, leading to sharp corrections in liquidity premia and triggering large-scale redemptions from open-ended funds and other investors, creating negative feedback loops and rapid liquidity deterioration. - Policy tool and recommendation noted: - Comprehensive stress tests for the asset management sector planned by the authorities would be an important tool to assess and monitor these risks; BoE and FCA analysis suggesting SCB funds are resilient to sudden large redemptions is encouraging but needs expanded and improved analytical toolkit. ### Cross-border spillovers - Current assessment: - The likelihood of cross-border spillovers has declined, reflecting the reduction of foreign exposures of U.K. banks. - After elevated levels around the global financial crisis and the euro area crisis, the likelihood of distress spillovers is currently relatively subdued; macroeconomic linkages may still create cross-border spillovers with effects on the financial sector (Figure 8). - Policy spillovers: - Policies intended to safeguard U.K. financial sector resilience may have unintended consequences on other financial sectors; policy spillovers are hard to estimate and predict. - Appendix IV presents staff estimates of cross-border impact of changes in the U.K. countercyclical capital buffer (CCB); results suggest low policy spillovers may be concentrated in a small number of countries. - These estimates ignore the positive impact of measures on U.K. financial sector resilience and its benefits for the global system. - Coordination and reciprocity: - EU legislation sets formal co-ordination arrangements for the CCB starting in 2016; the FPC has already recognized foreign CCB rates ahead of schedule. - For tools other than the CCB, where reciprocity is voluntary, the FPC has stated intention to reciprocate foreign macroprudential capital actions where appropriate. ### Macroprudential policy framework - Institutional setup and mandates: - The BoE has been given a financial stability mandate, centered on the FPC; FPC’s mandate is to identify, monitor, and take action to mitigate systemic risk. - Legislation grants the FPC power to make recommendations (including to HMT) on the perimeter of regulation and the macroprudential toolkit; FPC has powers of direction over specific macroprudential tools prescribed by HMT (and approved by Parliament). - Information collection powers and data sharing provisions are adequate; accountability via communication tools, Treasury Committee inquiries, and Oversight Committee (BoE) reviews. - Heads of the PRA and the FCA are members of the FPC; these agencies’ mandates are aligned with the BoE’s stability goal. - Operational practices: - FPC conducts regular (quarterly) surveillance drawing on indicators, market intelligence, supervisory insights, and staff analysis; annual dedicated discussion on regulatory perimeter established. - Direction powers exist over tools targeting excessive leverage and credit growth (including tools beyond Basel III); FPC has requested powers of direction for buy-to-let lending and will reassess need for further tools as risks evolve. - For managing liquidity and structural risks, FPC relies mainly on broad powers of recommendation. - Implementation caveats: - Effectiveness depends on maintaining willingness to act as well as ability to act; fading crisis memories may increase external resistance to action and pressure on resources for financial stability work. - The Treasury Committee should watch for risks to “willingness to act”; authorities should continue efforts to promote public understanding of the FPC’s role and responsibilities. - Existing macroprudential tools (as stated in source note 10): - CCB under Basel III, sectoral capital requirements, loan-to-value ratios and debt-to-income ratios on owner-occupied mortgage lending, and the leverage ratio, including a countercyclical leverage ratio buffer and a leverage surcharge for systemically important institutions. ### Microprudential oversight — banking - Progress on post-crisis reforms: - U.K. authorities are advanced in implementing the international post-crisis reform agenda for banking regulation and have actively helped shape it. - As an EU member, the U.K. is implementing the ‘single rulebook’ under the 2013 Capital Requirements Directive and Regulation. - Preparing to adopt the FSB standard on Total Loss-Absorbing Capacity (TLAC) in the form of the European MREL. - Remuneration rules introduced in 2009 in response to FSB Principles & Standards on Sound Compensation practices came into effect in January 2010. - The U.K. has been assessed as Compliant or Largely Compliant with all Basle Core Principles for Effective Banking Supervision (BCP) in this FSAP (see Detailed Assessment Report). - Structural and governance reforms: - Ring-fencing (Box 6) and governance reforms aimed at reducing systemic risk, improving resolvability, and lowering taxpayer risk. - Senior Managers Regime (SMR) came into force in March 2016 to reinforce accountability of individuals in senior roles (Box 7). - Industry initiatives include the Banking Standards Board (created in 2014) to improve corporate culture, competence, and behavior. - Supervisory approach: - Authorities have adopted a more rigorous, hands-on, and systemic risk-focused supervisory approach: greater focus on assessing risks, capital and liquidity adequacy, and continuous direct engagement with the largest systemically-important firms. - Oversight of less systemically-important banks relies more on data monitoring, outlier analysis, and thematic reviews. ### Ring-fencing details (Box 6) - Legal and scope specifics: - Banking Reform Act of 2013 requires banks with core deposits greater than GBP 25 billion to create by 2019 a ring-fenced body (RFB) for all their U.K. “core activities and services” (core retail deposit-taking and related payment services). - Except for limited exemptions, remaining activities (notably investment banking) must be provided by separate entities. - RFB (or RFB sub-group) would be subject to a systemic risk buffer between 0 and 3 percent on top of other minimum requirements. - Objectives and implications: - Goal is to reduce likelihood of disruption to core activities due to risks in other business segments, facilitate orderly resolution, and further reduce implicit subsidy enjoyed by large systemic banks. - Six U.K. banks expected to be subject to ring-fencing: HSBC, Barclays, Lloyds, RBS, Santander U.K., and Co-op (as stated in source). - Implementation challenges: - Significant investment required by banks, particularly those with sizeable non-ring-fenced activities, possibly prompting re-evaluation of business models. - Requires preparation and follow-up by U.K. authorities across policy, supervision, central bank operations, reporting, and communication. - Complexity of Part VII transfer process and High Court verification introduces uncertainty given magnitude of transfers. *Source: IMF staff analysis and FSAP material as presented in the supplied content unit.* ### 27. This supervisory approach creates tradeoffs that need to be carefully monitored. It entails ### _cr16167 - 27. This supervisory approach creates tradeoffs that need to be carefully monitored. It entails ### Supervisory approach: tradeoffs and monitoring - The approach entails a relatively higher tolerance for risks arising from mid-size and small firms. - Failures of mid-size and small firms would have lesser systemic implications but may be: - Concentrated in particular regions or particular classes of customers; and - Correlated across institutions. - Dealing with the failure of a mid-size bank may be more challenging until the MREL is fully in place. - Offsite monitoring, thematic reviews, and data analysis can help detect risk build-up but cannot fully substitute for direct probing and validation. - Closer scrutiny of some critical activities of all banks is needed due to: - A persistent downward trend of the ratio of RWAs to total assets; and - Methodological inconsistencies across institutions. - The review of banks’ internal models should be intensified. ### Governance reforms (Box 7) - Reform came into force in March 2016, following the 2013 report of the U.K. Parliamentary Commission on Banking Standards. - Reforms include: - A new Senior Managers Regime (SMR) for individuals subject to regulatory approval (a Senior Insurer Managers Regime is also under discussion for insurers); - A Certification Regime requiring firms to assess the fitness and propriety of certain employees below senior manager who perform functions that could pose a risk of significant harm to the bank or any of its customers; and - New Conduct Rules applying to banks (and Solvency II to insurers) that establish the responsibility of senior managers for oversight of any delegated activities. - The SMR: - Identifies senior management functions relevant for managing one or more aspects of a firm’s affairs that may involve a risk of ‘serious consequences’ for the firm or for its business or other interests in the U.K. - Each regulator specifies which functions fall in this category in the entities they supervise. - Both regulators detail certain ‘Prescribed Senior Management Responsibilities’ (examples: safeguarding the independence and overseeing performance of internal audit; responsibility in relation to financial crime (for the FCA); responsibility for the firm’s proprietary trading activities (for the PRA)). - Certification Regime specifics: - Individuals under the Certification Regime are not subject to approval by the supervisor but will have their fitness and propriety assessed and “certified” by their firms at least annually. - A Senior Manager at the firm will be formally accountable for its Certification process. - Example functions for the PRA (as listed): Chairman; Senior Independent Directors; Chairs of the Audit, Risk and Remuneration Committee; Chief Executive Officer; Chief Finance Officer; Chief Risk Officer; Head of Internal Audit; Head of Key Business Areas; Group Entity Senior Manager; and Head of Overseas Branch. ### Cross-border supervision, AML/CFT, and corporate transparency - Effective cooperation and collaboration arrangements have been established with foreign supervisory and resolution authorities to enable information sharing and cooperation for cross-border banking groups. - Implementation of international post-crisis reform agenda and national initiatives may affect correspondent banking relationships and provision of services to certain customer categories (notably money transmitters and non-profit organizations). - Applying effective, proportionate, and dissuasive sanctions for misconduct, including for AML/CFT violations, should enhance compliance, promote financial integrity, and prevent unnecessary curtailment of legitimate financial activities. - Progress since the U.K.'s 2006 AML/CFT assessment is significant, but further improvements are needed. - Authorities are aligning with the revised 2012 FATF standard and the Fourth EU AML Directive, which must be transposed by June 2017. - The recently implemented AML/CFT supervisory framework for higher-risk banks (irrespective of size) seems adequate but is still relatively new. - The backstop for ensuring lower-risk firms effectively assess and manage ML risks appears limited; supervisors rely largely on thematic reviews and information from whistleblowers, media reports, law enforcement agencies, and international AML supervisors. - Authorities have adopted reforms to enhance corporate transparency, including establishing a register for individuals with significant control of U.K. companies and limited liability partnerships and abolishing bearer shares and corporate directors. - Additional steps should be taken to ensure availability of adequate information on ultimate beneficial ownerships, notably across additional forms of legal entities and arrangements present in the U.K. ### Insurance supervision - The FSAP insurance assessment targeted areas relevant for systemic stability: new PRA/FCA supervisory approach; level of implementation of Solvency II, including internal model approval, group supervision, and reporting requirements. - Key findings: - Insurance supervision is shared between the PRA and the FCA under robust cooperation arrangements. - The supervisory approach is forward-looking and risk-based, supported by comprehensive stress tests following international best practice. - Supervision focuses on the most systemic firms; smaller PRA-regulated firms and most FCA-regulated firms are supervised on a more reactive basis using thematic and outlier methodologies. - This approach requires granular high-frequency data that are not available for all activities. - Challenges under Solvency II group supervision: - Establishing a clear definition of responsibilities around joint decisions over group internal model applications and group model changes; - Capital transferability across jurisdictions; and - Reaching agreements on colleges for insurers with significant presence outside the EEA. - Supervisory arbitrage risk persists even within the EU; the U.K. should contribute to EU-wide coordination mechanisms to monitor potential supervisory arbitrage. ### Securities, fund management, and data gaps - The FSAP focused on fund management and equity trading platforms due to size and cross-border spillover potential. - Statistics and market structure: - Total authorized investment fund assets under management (AUM) by U.K. fund managers amount to some 95 percent of U.K. GDP; more than half of these assets belong to foreign-domiciled funds. - The U.K. hosts 11 U.K.-based exchanges and multilateral trading facilities (MTFs) that conduct almost half of all on-platform equity trading in Europe. - Eight U.K.-based “dark” trading platforms dominate European dark trading with a market share of about 85 percent. - Regulatory and supervisory observations: - The FPC and FCA have conducted timely work on liquidity risk management of corporate bond funds; U.K. fund managers may use a suite of tools to manage risk from large redemptions. - U.K. funds are subject to detailed valuation requirements and depositaries are responsible for monitoring compliance and reporting pricing errors to the FCA. - The FCA should ensure its supervision of investment funds’ compliance with valuation requirements is sufficient. - The FCA’s recently-adopted changes to its risk-based approach to supervision appear to strike the right balance between firm-specific and market-based supervision, but risks remain in authorizing new entrants and reacting to events among firms subject to market-based supervision. - Pending MiFID II application, the FCA should ensure that BCN activities are sufficiently monitored and supervised. - Data and international cooperation needs: - Authorities should extend, if legally possible, the scope of transparency reporting under the AIFMD and strive for enhanced international exchange of information to improve data on alternative investment funds and their managers operating cross-border. - Authorities should continue to contribute to international work on adoption of a globally harmonized calculation method for fund leverage. ### Financial Market Infrastructures (FMIs) - Supervision of FMIs has been significantly strengthened; the BoE is the lead supervisor for all FMIs enabling consistent PFMI implementation. - Improvements noted: - Governance improvements across all types of FMIs. - CCPs’ models for credit and liquidity risks have been upgraded and model validation procedures strengthened. - Largest retail payment systems have introduced prefunding to mitigate settlement risk. - Remaining priorities and risks: - Reduce FMIs’ dependence on bank services through de-tiering and settlement in central bank money for CCP-embedded payment systems. - Largest indirect participants of CHAPS and EUI have been transformed into direct participants; further scope exists to target other large banks still indirect participants. - CCPs should increase the number of transactions that settle entirely in central bank money using the U.K.’s High Value Payment System (HVPS). - The forthcoming strategic review of the Real-Time Gross Settlement System (RTGS) by the BoE should consider de-tiering and direct settlement of CCP transactions. - Shortcomings in HVPS supervision: - BoE supervises CHAPS, operated by CHAPS Co, which outsources infrastructure provision to the BoE via the RTGS. - CHAPS Co has limited powers to assess whether RTGS meets requirements or to induce change due to BoE’s unique position as provider of the infrastructure. - A BoE self-assessment of the RTGS infrastructure is underway; absence of formal RTGS oversight arrangements may weaken pressure to increase compliance. - The BoE recognizes these shortcomings and is considering alternative options. - International cooperation and crisis management: - BoE is leading international colleges for U.K. CCPs; MoUs governing these colleges contain escalation procedures but more is needed for effective crisis cooperation and coordination. - Crisis Management Groups (CMGs) for resolution purposes should establish information-sharing arrangements with authorities not represented in the college whose jurisdictions’ financial stability may be impacted by an FMI default. ### Bank of England concurrent stress testing framework - Launched in 2015 to support microprudential and macroprudential objectives. - Framework design: - Covers banks and building societies with retail deposits of GBP 50 billion or more and has a five-year horizon. - BoE issues scenarios, assesses banks’ projections, and uses tools to cross-check banks’ results and assess sensitivities. - Disclosure regime aims to promote market discipline and enhance credibility. - From 2016 onward, the annual stress scenario will be explicitly countercyclical and will be complemented by a biennial exploratory scenario. - Results will have a direct—though not mechanical—impact on setting buffers under the new capital framework. - Implementation challenges and BoE priorities: - Improving the analytical infrastructure: data, models, and processes require substantial additional efforts; the format of data submission (notably the Firm Data Submission Framework) and organization of stress test–relevant data elements (e.g., ICAAP submissions) need to be settled as soon as practicable. - Building supervisory model and analysis infrastructure: BoE employs three model types—(i) granular models using firm-submitted data; (ii) product- or sector-specific models using industry/other data; and (iii) “system-wide” models that examine interconnectedness and spillovers. Investment in these should be accelerated and BoE should develop its own TD supervisory stress testing models. - Coverage: Eight of the 15 biggest U.K. banks are foreign, mainly investment bank subsidiaries. Excluding these banks may hamper the contribution of the stress testing exercise to the FPC’s overall assessment of financial stability, notwithstanding that insights into these supervised entities would be partial. ### Liquidity framework and risks - The BoE has built a wide-ranging and flexible liquidity provision framework broadened in the wake of the crisis to cover CCPs and large broker dealers and to widen eligible collateral. - The framework encompasses tools for: - Monetary policy implementation; - Liquidity insurance (backstopping liquidity needs of individual institutions and the wider system); and - Providing emergency liquidity when needed. - Consists of two broad facility sets: the Sterling Markets Framework (SMF) and the largely unpublished Emergency Liquidity Assistance (ELA) framework. - The BoE maintains capacity to conduct covert ELA and has available foreign exchange from a number of sources for FX ELA. - Benefits and risks of the wide, flexible framework: - Major benefit: a larger and more vibrant financial sector better protected against shocks and able to continue operating under liquidity stress. - Risks: reduced incentives for firms with access to BoE facilities to self-insure; global liquidity arbitrage; and potential concentration of certain financial activities in the U.K. to take advantage of a more accommodating framework. - Mitigating factors and vigilance: - No evidence that these risks have materialized so far, largely reflecting safeguards in place. - BoE and PRA can monitor liquidity plans and risk management of entities with access to BoE liquidity, aiding assessment of counterparty creditworthiness and providing early warning of reduced self-insurance. - Risks of global liquidity arbitrage and over-reliance are managed via BoE’s close links with foreign supervisors, BoE discretion in providing liquidity, and the fact that the cost of liquidity increases with demand. - Nevertheless, these risks could potentially have serious consequences for the BoE, and increased vigilance is warranted. - Overview elements from Table 5 (Sterling Monetary Framework): - Objectives: Implement Monetary Policy Committee (MPC) decisions to meet inflation target; Reduce cost of disruption to key financial and payment services to the U.K. economy. - Governance: MPC; BoE; Chancellor and BoE Court. - Guiding principle: Maintain risk-free interest rates in line with MPC target; The market should be the first/prime source of liquidity. - Tools (selected): Level of Bank Rate; Remunerate reserves at Bank Rate; Operational Standing Facilities (OSF); Asset Purchase Facility; FX Intervention; Indexed Long Term Repos; Contingent Term Repos; Discount Window; Market Maker of Last Resort; Collateral swaps and/or secured loans; FX ELA. *UNITED KINGDOM — INTERNATIONAL MONETARY FUND* ### 45. Ongoing work on quantifying the implications of the liquidity framework on the BoE’s ### _cr16167 - 45. Ongoing work on quantifying the implications of the liquidity framework on the BoE’s ### Ongoing work on BoE balance sheet and capital - A new division is developing a deeper and more forward-looking capacity to evaluate the impact of a range of scenarios on the BoE’s balance sheet. - This work should be a priority and would be a key input to the Bank’s capital adequacy framework, which may in the future need adjustments to ensure the BoE’s operational independence (Box 8). ### Box 8 — The Bank of England’s Capital Framework: key findings and implications - Central banks typically need some level of capital for reasons different from banks; central banks can become balance sheet insolvent but cannot be wound up. - The appropriate level of central bank capital is not universal; it depends on the central bank’s policy mandate, the risks it faces, and the operational environment. - Policy solvency—where realized revenues, notably seignorage, exceed costs—is of greater importance for a central bank than balance-sheet capital per se. - Policy solvency allows the central bank to undertake its functions without recourse to HMT for funding. - Income from the proceeds of issuing currency (seignorage) usually covers operating and policy costs. - If net losses accrue they would be covered by capital, preserving credibility and independence. - Some central banks have operated with negative capital when they had sound prospects of being policy-solvent immediately or within a reasonable term. - The BoE’s specific context: - The BoE does not retain its seignorage revenue. - The BoE has a lower risk profile relative to many central banks: the U.K.’s foreign reserves are not held on the Bank’s balance sheet, and the monetary policy framework did not previously require a very large or risky balance sheet. - Many crisis-related operations, including Quantitative Easing (QE), were indemnified by the Crown, reducing the need for capital. - Changing environment and implications: - As the Bank exits from QE, the Crown indemnities that supported the expansion of the Bank’s risk profile since the financial crisis will wind down. - The financial system will likely have significant ongoing liquidity needs, implying that the part of the Bank’s balance sheet devoted to monetary policy implementation may continue to be large, potentially implying a higher ongoing risk profile. - The liquidity insurance framework may imply significant contingent balance sheet risks. - Design objectives for future operational and capital frameworks: - Ensure policy solvency. - Be capital efficient. - Provide the BoE sufficient capital buffers to cover a reasonable range of risks faced in pursuing its policy objectives. - Allow additional capital to be supplied expeditiously, if needed. - Risk coverage principles: - Risks from policies for which the Bank has independent authority should be covered first by prudent risk management and second by capital, up to a reasonable level of losses. - Other extraordinary-operation risks may not need capital but could be backed by Crown indemnities, as HMT ultimately assures the BoE’s capital adequacy. ### Financial safety nets and resolution framework — findings and recommendations - Current assessment: - The framework for effective bank resolution in the U.K. is robust. - The SRR introduced in 2009 has evolved, including the transposition of the EU Bank Recovery and Resolution Directive (BRRD) into U.K. law. - The resolution framework is broadly aligned with the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions (KAs). - The BoE is well positioned legally and operationally to carry out its resolution mandate and cooperates closely with HMT, the PRA, the FCA, and the FSCS. - A broad range of stabilization options—including bail-in—can be used to preserve financial stability while avoiding taxpayer bailouts. - Modified insolvency regimes can be used for resolving less systemic financial institutions. - Sufficient legal safeguards balance the public interest against rights of shareholders and creditors. - Resolution policies and recovery and resolution planning are well developed and transparently explained in many important areas. - Scope expansion recommended: - The current resolution framework covers banks, building societies, investment firms, holding companies, and CCPs. - Authorities should work with international partners to develop an effective resolution framework for insurance companies that could be systemically important at the point of failure. - The BoE should be provided with an explicit power to depart from pari-passu treatment where necessary, in the interest of preserving financial stability, regardless of which stabilization option is used. - System-wide contingency planning should be expanded to include the FCA and the FSCS, both in the Crisis Management MoU and in regular high-level discussions. - Implementation progress and specific measures: - Ring-fencing reforms are producing operational transformations aimed at insulating critical retail functions from riskier parts of the group by 2019. - MREL implementation timelines: phased in from 2016 to 2019 for the G-SIBs and to 2020 for other banks. - The BoE estimates that the MREL implementation will require long-term restructuring of liabilities of around GBP 223 billion. - Cross-border cooperation: - For all U.K. G-SIBs, Recovery and Resolution Plans have been shared and discussed within the relevant CMGs. - A first round of resolvability assessments was completed in 2015. - Cooperation Agreements have been discussed within CMGs for all U.K. G-SIBs. - The legal framework enables information-sharing and cooperation in resolution; there is automatic and mutual recognition of resolution actions undertaken by EU home authorities. - The BoE has power to recognize and give effect to resolution actions of home jurisdictions of non-EU bank branches operating in the U.K., except in specified circumstances, such as when the stability of the U.K.’s financial system is at risk. - Ongoing challenges and operational recommendations: - Ensuring resolvability is a continuous journey requiring domestic and international efforts to detect and address barriers in an evolving market environment. - Domestically, the BoE must balance setting MREL proportional to firms’ risk profile and resolvability, manage the transition, and closely supervise medium-size firms. - Cross-border coordination is required on internal MREL/TLAC amounts and forms, and mechanisms for triggering and executing bail-in in each jurisdiction. - The MREL/TLAC will need periodic reassessment. - Operational principles for funding in resolution need further development: - Terms and conditions for access to FSCS funds and notional “resolution fund” need full operational elaboration. - The HMT/BoE MoU should be updated to reflect common understanding on the use of a resolution fund. - When ELA is provided to support the liquidity of a solvent firm in resolution (e.g., to a recapitalized institution post bail-in), authorities should consider providing an indemnity to the BoE if there are concerns about the length of support, exit strategy, collateral, or scale of the liquidity need. - Authorities should work closely with foreign counterparts to establish and coordinate resolution funding plans for a G-SIB. - Firms’ liquidity risk management information systems must be capable of producing accurate and timely information. - International engagement: - Maintaining and expanding engagement with international counterparts requires continuous effort. - Significant variations in resolution regimes, approaches to valuations, and creditor hierarchies can hamper cross-border resolution. - Lack of recognition of U.K. resolution actions outside the EU could impede orderly resolution of a G-SIB. - Authorities should finalize the framework for contractual recognition of bail-in governed by third-party jurisdiction laws, and the regime for independently resolving U.K. branches of non-EEA firms. - Over the medium term, establish practical and appropriately tailored cooperation and communication arrangements for engaging with non-CMG hosts where U.K. G-SIBs have a systemic presence. ### Brexit and the U.K. financial system — key observations and risks - Importance and current scale: - The financial services industry accounts for about 8 percent of U.K. GDP and 3½ percent of employment. - EU countries account for about a third of the U.K.’s financial services surplus. - Roughly half of the largest financial institutions in the world have their European headquarters in the U.K. - Short-term effects of a vote to leave: - During negotiations (which could take years) the impact on the financial sector would be mostly indirect. - A vote to leave would likely heighten volatility in financial and foreign exchange markets and lower business investment due to increased uncertainty. - Markets may anticipate longer-term economic effects, provoking adverse reactions that bring forward long-term costs. - British banks would face higher impairment losses, lower profitability, and higher funding costs, potentially curtailing credit extension. - Valuation losses would affect insurers and investors. - While the U.K. remains a member of the EU during negotiations, U.K.-based financial firms would not face direct obstacles to accessing EU markets, but may restructure in anticipation of future changes. - Long-term effects and conditional factors: - The long-term impact depends critically on whether the U.K. maintains EEA membership and “passporting” rights post-exit. - Loss of “passporting” rights would likely lead U.K. banks to exit some EEA markets, subsidiarize local branches (implying higher funding costs), or shift activities to subsidiaries, increasing costs and reducing business. - Global banks may continue a U.K. presence, but those with European headquarters in London would probably relocate. - Replacing many banking regulations formerly embodied in EU legislation with domestic laws and rule-making would cause regulatory upheaval and could shrink the banking industry and diminish London’s importance as a global banking hub. - Uncertainty: - Given unknowns about post-exit adjustments, quantifying the overall impact is not possible; effects will be differentiated across industry segments and hinge on the eventual shape of the U.K.–EU relationship. *Source: IMF staff report content as provided in the supplied PDF excerpt.* ### 57. The asset management industry, which is more mobile, would also be negatively affected ### 57. The asset management industry, which is more mobile, would also be negatively affected ### Asset management and fund domiciliation - U.K.-based funds classified as Undertakings for Collective Investment in Transferable Securities (UCITS) by EU regulations would need to be converted to nationally-regulated funds, since UCITS funds can only be domiciled in the EEA. - From the perspective of other EEA countries, these funds would become non-EEA alternative investment funds (AIFs) that do not benefit from the “product passport” when marketed to EEA investors, including professional investors. - The same would apply to all other U.K. AIFs, including hedge funds and private equity funds. - Marketing non-EEA AIFs to EEA investors would require using the National Private Placement Regime (if any) of each EEA member country, which may not provide sufficiently easy access to the EEA investor base. - Given these difficulties, a British exit without immediate EEA membership (assuming that, by that point, all relevant EU legislation is incorporated into the EEA Agreement) would lead asset managers to relocate the funds targeted to EEA investors within the EEA. - U.K.-based asset managers may also need to set up subsidiaries in EEA countries to continue to manage EEA-domiciled investment funds in an efficient manner. ### Insurance sector - U.K. insurance companies would be relatively insulated from the effects of Brexit, even in the case of exit from the EEA. - Many U.K. insurers already operate in other EU countries via subsidiaries, with the notable exception of Lloyd’s. - Even if the U.K. did not obtain EEA membership, insurers would not incur costs of subsidiarizing branch networks or be significantly affected by loss of “passporting,” although they would be impacted by the regulatory uncertainty post-exit. - The impact on Lloyd’s and the London insurance market could be significant absent cross-border supervisory recognition. ### Central counterparty clearing houses (CCPs) - Exit could have a major impact on U.K. CCPs because EU regulations governing access would no longer apply, and decisions on alternative access arrangements depend solely on EU authorities and may not be taken on time. - Present relations between U.K. CCPs and EU CCPs and banks are governed by the EMIR. - Post-exit, unless the U.K. became a member of the EEA and EMIR was incorporated into the EEA Agreement, EMIR would treat the U.K. as a “third country,” whose regulatory regime for CCPs would need to be recognized as “equivalent.” - In the absence of such equivalence—or until such determination is made by the EU—EU banks would need to maintain higher capital buffers or, in the worst case, not be permitted to use U.K.-based CCPs. - Existing interoperability arrangements between U.K. and EU CCPs may have to be halted until the relevant U.K. CCPs have been recognized under EMIR, disturbing current clearing arrangements and increasing market inefficiencies. - Regardless of the final shape of these arrangements, euro-denominated business may over time shift to the euro area. ### Payment and settlement systems - U.K.-authorized payment service providers currently have “passport” rights under the EU Payment Services Directive that allow free access to EU markets provided they meet the Directive’s requirements. - Depending on whether the U.K. retained membership of the EEA, exit could mean providers that are not authorized credit institutions in the EU would need to establish a separate legal entity within the EU, likely with significant cost impact. - Exit could also impact the central securities depository business, albeit to a lesser extent, since EU legislation is not yet fully in place. ### Legal environment and contract law - Brexit could have a deep long-term impact on the legal environment for cross-border dealings. - Mutual recognition of judgments and complex cross-border resolution cases may become challenges. - The U.K. would lose access to the European Court of Justice to challenge any perceived discriminatory behavior by EU institutions. - The International Swaps and Derivatives Association has questioned whether the widespread choice of English law for derivatives contracts between two non-U.K. counterparts in the EU would still be accepted by local courts post-exit in disputes or bankruptcies. ### Banking Sector: Solvency Test — scope and data - Institutional perimeter: Seven major banks and building societies: Barclays plc, HSBC Holdings plc, Lloyds Banking Group plc, Nationwide Building Society, The Royal Bank of Scotland Group plc, Santander U.K. plc, and Standard Chartered plc. - Market share: Approximately 80 percent of PRA-regulated banks’ lending to the UK real economy. - Data effective dates: - Effective date: end-December 2014. - Effective date for market risk: February 20, 2015. - Later: Effective date: end-December 2015. - Effective date for market risk: end-December 2015. - Data sources: Stress testing templates and associated documents submitted by participating banks for the 2015 Stress Test; firm-by-firm confidential data at the cut-off date; BoE data on aggregate write-off rates for UK exposures; publicly available data including Pillar 3 disclosures, Bloomberg, Datastream, Markit, 2015 EU-wide transparency exercise, Haver Analytics, Mortgage Lenders and Administrators Statistics, Moody’s KMV, Bankscope, SNL, International Financial Statistics (IFS), IMF Global Assumptions (GAS), and IMF WEO. - Scope of consolidation: global consolidated group basis, except for Santander U.K. plc, whose parent is supervised by a foreign authority. Perimeter of the banking group (CRD IV). Insurance activities are excluded but firms must assess scenario impact on insurance activities and model the impact on dividends, holdings or minority interests, capital deductions, and risk weightings. ### Stress testing process and methodologies - Hybrid process combining BoE-designed scenarios approved by the FPC and PRA Board, bank bottom-up (BU) stress tests, BoE in-house challenger models, and aggregation/adjustments by BoE. - FSAP team conducted top-down (TD) macroprudential stress tests based on IMF-generated scenarios. - For IRB exposures: separate credit risk model calibrated for 5 Basel asset classes and 15 geographies. - For STA exposures: stressed NPL ratios, stressed coverage ratios, and transition matrix for performing exposures projected. - Market risk: stress to 22 sovereign issuers and major corporate indexes modeled separately. - Detailed stress test of the UK mortgage book by LTV vintage using a structural Merton-based approach. - FSAP used its own credit risk models to project stressed credit risk parameters based on the 2015 BoE scenario and compared FSAP projections against banks’ BU projections. - Sensitivity tests included a range of stressed UK residential house prices and shocks to the swap curve. ### Channels of risk propagation and models - Risks projected using banks’ internal models and BoE/PRA supervisory models. - Banks model traded risk elements, valuation adjustments (FVO, CVA, PVA and bid/offer reserve), prescribed counterparty defaults, funding cost impacts and pass-through to customers. - BoE in-house suite challenges banks’ projections and provides system-wide risk view. - Over 75 credit risk models and 900 econometric specifications for PDs were developed for the 2016 U.K. FSAP, using VAR, PCA, quantile-based regressions, and a structural Merton-based approach for LGDs. - Lending rates linked to shocks to deposit rates projected in line with the macro scenario, banks-specific solvency ratios, and funding stress in peer banks; add-on funding shock related to funding shock in H1 2012 with disallowed pass-through. - Marked-to-market losses from full revaluation of sovereign securities (22 jurisdictions), and corporate fixed income debt securities, excluding hedges, under each scenario. ### Tail shocks and scenarios (selected calibrations) - Global recession scenario: - U.K. real GDP growth contracts by 2.3 percent year-on-year from Q4 2014 to Q4 2015, and reaches a peak deviation from baseline in 2017 at -7.7 percent. - Unemployment rises by 3.5 pps by 2017/Q3. - Equity prices decline by 36 percent peak-to-trough. - Residential property prices fall by 20 percent. - Euro area year-on-year real GDP growth troughs at -2.1 percent in 2016/Q1. - China year-on-year real GDP growth falls to 1.7 percent in 2015/Q4. - Peak-to-trough fall in real GDP: about 7 percent in Brazil and 4 percent in South Africa. - VIX peaks at 46 pps in 2015, the oil price troughs at USD 38, the renminbi depreciates 10 percent against the USD by end-2015, and the euro depreciates by about 25 percent against the USD and by 15 percent against sterling in 2015. - Disorderly U.S. monetary normalization scenario (2.1 standard deviation move in two-year cumulative real GDP growth rate for 2016–17): - U.K. GDP growth contracts by 1.6 percent in 2016, and reaches a peak deviation from baseline in 2017 at -6.9 percent. - Real house prices fall by 40 percent in 2016 and 2017. - Real equity price falls by 40 percent during 2016. - Banks’ lending rates rise by 1.1 pps by 2017; bank credit falls by 6.7 percent. - Output falls by 11.9 percent in the fragile three (Brazil, South Africa, and Turkey), and by 1.3 percent in other emerging economies. - Scenario includes an additional idiosyncratic and system-wide funding risk shock linked to banks’ capital ratios under stress. ### Sensitivity analysis and risk factors - Projections for stressed misconduct costs. - Shocks to UK residential house prices affecting stressed LGDs. - Shocks to swap curve. ### Risks, buffers, calibration, and behavioral adjustments - Credit risk: estimated according to Basel III framework under IRB advanced, IRB foundation, and Standardized approaches; positions include cross-border loan exposures, covered bonds, securitization exposures, and off-balance sheet exposures using baseline and stressed Credit Conversion Factors (CCFs). - Sovereign risk: issuer risk from shocks to yield curves across material advanced and emerging economies; mark-to-market valuation of trading book and AFS/FVO securities linked to macro scenario. - Market risk: shocks to asset prices in FX markets, corporate spreads, commodities, and money markets; counterparty credit risk losses and shocks to PVA for own funding costs in BoE stress test. - Profits: income from investment banking activities; interest income declines from defaulted loans; interest income from non-defaulting loans estimated according to satellite models (IMF stress test); interest expenses increase due to rising funding costs with empirically estimated pass-through and add-on funding stress. - Behavioral adjustments and dynamic balance sheets: - Balance sheets evolve under stress per each bank’s corporate plan, adjusted for the scenario. - BoE scenario includes paths for UK lending to individuals and PNFCs; guidance that individual banks’ market share of lending should not decline under stress. - Non-UK lending size/composition allowed to vary with constraints. - Dividend payout in stress aligned with publicly disclosed policies; further cuts possible as strategic actions. - Banks may propose strategic management actions; BoE assesses timing and benefits and accepts only realistic actions expected to be part of recovery and resolution plans. - Under IMF TD framework: credit supply effects are disallowed; EAD under stress from off balance sheet exposures increases about 5 percent on average. - Dividends: under positive profits, payout set at 30 percent; otherwise no dividend payout assumed. - Losses recognized in the same year that a shock hits. - If banks’ capital ratio falls below regulatory minimum during stress horizon, no prompt corrective action is assumed. ### Calibration of risk parameters and regulatory standards - PDs and LGDs: - Banks project PDs and LGDs across the stress scenario for both expected loan losses (impairment charges) and capital requirements. - PiT PDs and LGDs for both expected and unexpected losses. - PDs are blended PDs by asset class and geography; PDs and LGDs projected by asset class and geography for defaulted and non-defaulted exposures. - For IRB exposures, changes in PDs proxied by shocks to write-off rates for U.K. exposures, Moody’s EDFs for cross-border exposures, and banks’ computed PDs in historical stressed episodes. - Shocks to LGDs projected using a Merton-based approach for mortgage exposures, shocks to unemployment for retail unsecured exposures, and shocks to GDP for corporate exposures. - For STA exposures, inflows into NPL categories based on panel regression including risk migration for performing exposures. - Regulatory standards: - Capital definition according to Basel III/CRD IV/PRA rulebook, including CET1, Tier 1, and total CAR. - CET1 ratio computed using CRD IV end-point definition; PRA decision not to use transitional provisions for CET1. Unrealized gains/losses in AFS and equities and reserves from revaluation of property are recognized since January 2015. - Capital components no longer eligible for additional Tier 1 and Tier 2 follow CRD IV transitional path. - CET1 ratio hurdle rates: 4.5% of RWAs in stress and 7% in the baseline (BoE stress test). Hurdle rates follow Basel III (including Capital Conservation Buffer under the baseline) (IMF stress test). - Leverage ratio (3 percent hurdle rate met with Tier 1 capital) using two definitions: - (i) the leverage ratio set out by the PRA in SS3/13 (BoE stress test): Tier 1 (end point definition as set out in CRR); Leverage exposure (CRR delegated act definition). - (ii) a Tier 1 (CET1 end point definition and Additional Tier 1 transitional definition) ratio relative to interest-bearing assets (IMF stress test). *Source: _cr16167 - 57. The asset management industry, which is more mobile, would also be negatively affected (UNITED KINGDOM, INTERNATIONAL MONETARY FUND).* ### 6. Reporting Format for Results ### 6. Reporting Format for Results ### Output presentation (solvency stress tests) - Minimum stressed CET1, Tier 1, CAR and leverage ratio by bank. - Evolution of stressed CET1 and leverage ratio for aggregate of all 7 banks (BoE stress test). - Evolution of CET1, Tier 1, CAR, and leverage ratio, for the aggregate banking system and type of bank, i.e., major U.K. international banks and major U.K. domestic banks (IMF stress test). - Contribution of key drivers to aggregate net profits and aggregate CET1 capital ratios. - Cumulative impairment charges by bank for the UK and specific other countries impacted by the scenario (BoE stress test). - Number of banks and share of total assets below hurdle rates (IMF stress test). ### Liquidity Stress Testing Matrix — Institutional perimeter and data - Institutions: - Number of firms: 10, consisting of 7 major banks and building societies, and the 3-largest subsidiaries of foreign investment banks. - Selection criteria: The sample firms have been selected to provide 80 percent coverage of total U.K. banking assets as measured by the PRA048 liquidity returns. - Market share: - About 80 percent of banking sector total assets. - Data and base date: - The LCR Liquidity Stress Test is based on the data as of December 31, 2015 received by the PRA as Interim LCR reporting from U.K. firms on an all-currency basis. This PRA return is based on the EU Delegated Act (Commission Delegated Regulation (EU) no 2015/61) which implements LCR in the United Kingdom. - The cash flow liquidity stress test relies on the PRA048 return as of January 1, 2016. ### Channels of risk propagation — Methodology - Basel III measures of liquidity risk — the LCR on three scenarios. - Two implied cash flow tests: 5 days (cumulative) and 30 days (noncumulative). - A general maturity mismatch analysis by maturity bucket. - A single currency analysis based on PRA’s ILG regime. ### Risks and buffers - Risks: - Funding liquidity risk, rollover risk, and market liquidity risk. - Buffers: - HQLA securities assessed at market values net of haircut on a security-by-security basis. ### Tail shocks — Size of the shock (range of adverse scenarios) - LCR Scenario under standard assumptions calibrated by BCBS. - LCR ‘U.K. retail stress’ scenario: - Calibration replicates the peak stress during the 2007 Northern Rock run, with run-off rates for retail deposits of up to 15 percent and for corporate deposits of 60 percent, and with liquidity risk from committed but undrawn liquidity facilities of 50 percent. - LCR ‘U.K. wholesale stress’ scenario: - Replicates liquidity stress observed during the global financial crisis. Characterized by: - (i) a freeze of wholesale funding on the interbank market, secured funding market via repo and covered bonds, and the commercial paper market (with run-off rate for operational deposits of 75 percent and for not-fully covered corporate deposits of 100 percent), and - (ii) liquidity risk from sizable margin calls related to secured funding, derivatives and foreign currency funding due to market liquidity shocks, derivative assignments, and unwinds and disruptions in the FX swap market (with rollover of secured funding backed by other than Level 1 and Level 2A assets of up to 0 percent). - Implied cash-flow assumptions include: - haircuts of up to 60 percent for securities and bank loans that can be mobilized in repos, - no issuance of new unsecured funding and freeze of securitization markets, - call-back rates of up to 100 percent, - cash outflows of up to 75 percent. ### Regulatory standards - Counterbalancing capacity above net cash outflows under stress scenario. - The PRA’s transitional arrangement for the LCR ratio which is more front-loaded than that prescribed by the CRR (Art. 460). It is set at 80 percent on October 2015 above the 60 percent threshold under the CRR). ### Reporting format for results (liquidity) - Changes in average liquidity position and counterbalancing capacity for each scenario. - Distribution of banks’ liquidity position for each scenario. - Number of banks with counterbalancing capacity below net cash-outflows. - Banks post-shock net liquidity position. ### Spillovers from U.K. CCB adjustments (Global Macrofinancial Model findings) - Model: - Analysis based on the Global Macrofinancial Model (GFM), a structural macroeconometric model disaggregated into forty national economies. - Transmission channels: - Spillovers transmitted via trade, financial, and commodity price linkages. - Financial linkages include cross-border bank lending, private sector borrowing, portfolio debt and equity exposures, and capital market contagion effects. - The most important channel for CCB adjustments is private sector borrowing exposures, given some economies’ relatively high dependence on U.K. bank loans. - Quantitative effect: - A one percentage point increase in the CCB in the U.K. would reduce U.K. output by 0.1 percent and output in the other economies covered by the analysis by less than that. - Distribution of impact: - Macrofinancial spillovers are small but concentrated among selected advanced and, to a lesser extent, emerging economies, broadly in line with their exposures. - Impact could be larger in some very small economies with large exposures to the U.K. not included in the sample. ### Report on Basel Core Principles (BCP) — Main findings and supervisory developments - Assessment context: - Assessment used the revised BCPs issued by the BCBS in September 2012; U.K. authorities agreed to be assessed against both Essential Criteria (EC) and Additional Criteria (AC). - Assessment is qualitative and based on assessors’ judgment; U.K. authorities were deemed compliant or largely compliant with all BCPs. - Institutional reforms and changes noted: - Financial Services Act of 2012 replaced the Financial Services Authority with the PRA (a subsidiary of the BoE) and the FCA; responsibility for financial stability assigned to a new statutory subcommittee of the BoE’s Court of Directors, the FPC. - Subsequent changes highlighted during assessment: - Further revisions: The BoE and Financial Services Act, approved in May 2016, merges the PRA into the BoE, creating a Prudential Regulatory Committee (PRC) and preserving the operational independence of the prudential supervisor while increasing integration with the BoE. - Ring-fencing: Banks preparing plans to implement ring-fencing of retail banking operations by 2019; expected effects include reduced systemic risk, improved resolvability, lower risk to the taxpayer, and potential increases in capital base. - Governance improvements: In March 2016, a new Senior Managers Regime (SMR) replaced previous supervisory approvals, reinforcing accountability of senior individuals; SMR was introduced very recently and its implementation was not reflected in the BCP assessment. - Supervisory approach and emphasis: - U.K. supervisors have shifted to a more rigorous, hands-on, and systemically focused approach since 2011, especially emphasizing assessment of risks and adequacy of capital and liquidity for the largest, most systemically important firms. - Stress testing has become a critical supervisory tool, encouraging forward-looking balance sheet assessment and strengthening firms’ internal analytical and risk-management capabilities. - Observations on tradeoffs: - Prioritization of systemic resilience concentrates attention and resources on largest firms but reduces probing and validation for mid-size and small firms, creating tradeoffs and risks that should be considered in supervisory objectives. *Source: _cr16167 - 6. Reporting Format for Results* ### 80. Supervisors continue to rely substantially on the practice of setting out supervisory ### _cr16167 - 80. Supervisors continue to rely substantially on the practice of setting out supervisory ### Supervisory approach and expectations - Supervisors rely substantially on setting out supervisory expectations for firms—articulated in the “Threshold Conditions” and in the PRA’s “Fundamental Rules” and FCA’s “Principles for Business”—and then depend on firms to report shortfalls from these standards. - This approach: holds firms and senior management accountable for compliance and for conducting business in a prudent, safe, and sound manner. - Given recent concerns about weaknesses in conduct and culture, supervisors should probe firms’ compliance, safety, and soundness more carefully and intensely than before the crisis. - There is room for deeper testing and probing even in the largest firms; offsite monitoring remains the primary means of supervision for less systemically important firms. ### Supervision of mid-sized and smaller institutions - The assumptions supervisors make about the scale and depth of challenges from mid-sized and smaller, non-systemically significant institutions should be re-examined. - Characteristics and risks: - Such institutions may serve particular regions or customer classes underserved by larger firms. - Risks across these banks are more likely to be correlated than across large ones. - They constitute the majority of supervised firms by number, though not by risk exposure. - Current supervisory practices and gaps: - Supervisors rely heavily on automated monitoring for small to mid-sized banks; it is unclear if this yields sufficient insight into management, operations, and risks. - Failure of any one smaller firm may not threaten financial stability, but frequent or concurrent failures may present reputational risk for the supervisor. - Evaluating and monitoring risks across firms requires comparable, relevant, reliable, and timely data. - Recent improvements in data collection noted (many stemming from changes in the EU reporting framework); the creation of a PRA data governance group is improving data decisions. - Still, there is room to develop better data on credit exposures and performance to: - Enhance monitoring and interpretation of credit trends across the industry. - Develop techniques for more detailed offsite analysis of loan portfolios’ performance. - Improve efficiency in monitoring credit conditions and banks’ asset quality. - Recommendation: - Consider expanding Asset Quality Reviews (AQR) and supervisory guidance on credit risk for smaller firms. ### Review of internal models and large-bank supervision - Concern that the supervisors’ “continuous assessment” of major players may leave insufficient time and resources for regular review of internal models used to calculate capital requirements. - Inadequate review of internal models could weaken scrutiny of banks’ capitalization. - The current model change review policy does not ensure that reliability of internal model banks’ capital requirement calculations is adequately scrutinized. ### Consolidated and cross-border supervision (CP 12-13) - Effective supervision requires oversight of consolidated operations at home and abroad. - Financial Services Act 2012 granted PRA and FCA two new powers over parent organizations that are not authorized entities: - (i) the power to give directions to the parent organization to undertake or refrain from certain undertakings; - (ii) the power to require the parent organization to provide information. - PRA and FCA are engaged in oversight of U.K. firms’ overseas operations and cooperate with supervisors abroad; both can share/exchange relevant information and participate in supervisory colleges. ### Corporate governance (CP 14) - Excessive pre-crisis risk build-up partly due to weak or poor internal governance and gaps in supervisors’ ability to hold key individuals accountable. - The Senior Managers Regime (SMR), implemented in March 2016, is expected to address these weaknesses and reinforce supervisors’ abilities to hold individuals accountable. - Due to timing, the assessors could not evaluate SMR implementation in practice. ### Risk-management and capital adequacy (CP 15-25) - U.K. authorities maintain a comprehensive and well-articulated framework for supervision of risk management and capital adequacy, especially for systemically important firms. - Persistent issues: - Difficulty keeping pace with reviews of internal models (see above). - Need for improved guidance on supervision of credit risk (no explicit supervisory guidance on credit risk management is provided to the majority of banks). - AQRs at nonsystemic banks are too sporadic to ensure adequate scrutiny of asset classification and provisioning. - Recommendation: - Continue promoting closer alignment of the EU regulatory framework with international standards. ### Controls, audit, accounting, disclosure, and abuse of financial services (CP 26-29) - Evolved approach to encourage greater dialogue with internal and external auditors. - Increased oversight of banks’ internal audit functions so supervisors can rely more on internal auditors’ work. - Discussions with external auditors now extend into governance matters. - More could be done to promote greater consistency in how supervisors engage with auditors. - Disclosure: - Supervisors should find ways to publish non-confidential, firm-level prudential returns to assist comparative analysis of firms’ condition and performance. - Greater release of comparable, relevant, reliable, and timely data on balance sheets, income and losses, and off-balance sheet exposures may improve market understanding of firm risk profiles and promote greater scrutiny. - Anti-money laundering and abuse supervision: - Procedures leave large numbers of firms monitored and supervised on a thematic and “responsive” basis. - Reviews of the majority of firms subject to AML regulation are limited to periodic thematic work. - FCA thematic reviews identified problems with compliance and internal controls in smaller firms. - Recommendation: Strengthen the “backstop” against abuse for firms thought to be of lower risk. ### Summary of compliance with Basel Core Principles (selected findings) - Responsibilities, objectives, and powers: - New regulatory architecture addresses most previous FSAP findings (including lack of powers over parent undertakings). - Independence, accountability, resourcing: - Supervisory resources in current configuration might be overstretched given U.K. system size and complexity. - Supervisory approach and techniques: - Important progress toward a more rigorous, “hands-on” approach for systemically important firms. - Offsite monitoring remains primary for less systemically important firms; reliance on skilled persons and “deep dives” does not substitute for onsite transaction testing. - Supervisory reporting: - Wide range of data collected (partly via EU reporting framework); opportunities remain to develop better data on credit exposures and performance. - Corrective and sanctioning powers: - PRA created a proactive intervention framework with five explicitly defined stages, providing a formal early intervention process. - Consolidated supervision and home-host relationships: - U.K. authorities supervise groups on a consolidated basis and routinely analyze consolidated and solo information; they regularly share information with foreign authorities. - Corporate governance: - SMR may address weaknesses in Approved Persons Regime; governance reviews have focused on largest firms (“Category 1”), though PRA released guidance to evaluate governance across all supervised firms. - Risk management and capital adequacy: - Comprehensive framework exists, but smaller institutions receive less attention and internal model reviews remain an issue. - Credit risk and problem assets: - No explicit supervisory guidance on credit risk for the majority of banks; AQRs for nonsystemic banks are too sporadic. - Large exposures and concentration risk: - EU framework for large exposures not aligned with Basel standard (alignment due to take effect from January 2019); U.K. framework is robust for credit risk concentration under Pillar 2. - Internal control, audit, and disclosure: - Supervisors strengthened engagement with control functions and auditors for largest firms; fewer supervisory touch points in smaller firms. - Lack of formal powers to access external auditors’ working papers is mitigated by close PRA collaboration with the Financial Reporting Council. *Source: IMF staff assessment contained in the provided content.* ### 29. Abuse of financial ### 29. Abuse of financial services ### Key findings - Testing of the management and control of exposure to financial crime and the abuse of financial services is limited and raises questions of whether supervisors engage in sufficient testing to ensure that these risks are well managed. - The prior assessment’s concerns remain that “pockets of financial activities...receive less than adequate supervision.” ### Recommended actions (selected from Table 2) - For Reference Principle 29 (Abuse of financial services): - Propose stronger and more proactive backstops for evaluating banks in the lowest risk categories more frequently to assess the quality of their controls and risk-management to avoid exposures to financial crime. - Related supervisory recommendations that reinforce AML/CFT and control testing: - Reference Principle 8 (Supervisory approach): Evaluate adequacy of supervision, especially of less systemically important firms, and whether current arrangements provide sufficient testing to ensure that all firms are operating safely and soundly and in compliance with laws, regulations, and supervisory expectations. - Reference Principle 9 (Supervisory techniques and tools): Seek more ways to validate and probe statements in banks. Evaluate whether “deep-dives” provide sufficient, ongoing insight into major firms, and whether key skills need to be developed within staff. - Reference Principle 14 (Corporate governance): Promote efforts to make managers in financial institutions more accountable. Ensure that corporate governance is appropriately supervised in firms beyond the largest and most systemically important, including through the implementation of recently released supervisory guidance. - Reference Principle 25 (Operational risk): Evaluate assumptions underlying the deployment of supervisory risk specialists (SRS) with regard to operational risk to ensure that all firms, and not solely systemically important ones, are managing this risk appropriately. ### Authorities’ response (paragraphs 91–97) - The U.K. authorities: - Welcome and support the IMF’s comprehensive review and the acknowledgement of significant progress since the last FSAP in 2011 through adoption of a more rigorous, hands-on and systemically focused approach to banking supervision (paragraph 91). - State the ambition for the U.K. financial services sector to be the best regulated in the world, aligning competitive and innovative markets of unquestioned integrity with the highest standards of conduct (paragraph 92). - Cite steps taken including: - continuing to be a leading advocate for tough capital and leverage requirements and liquidity standards; - introducing a robust resolution regime and adopting total loss absorbency standards, a bail in tool and structural reform of the banking system; - putting in place the Senior Managers and Certification Regime to ensure strong governance, better accountability of senior executives and higher standards of conduct in the banking sector; - ensuring better alignment of financial incentives of senior risk takers with the longer term financial soundness of their firms; - prioritizing a high degree of protection for consumers of financial services, improving standards across the industry and taking tough enforcement action against those who do not meet them (paragraph 93). - Emphasize a forward looking, judgment-based prudential and conduct regulation that does not seek to operate a ‘zero failure’ regime, but seeks to ensure that firm failures do not cause significant disruption to critical financial services or a material negative impact on consumers; resources are devoted to areas with the greatest risk to financial stability and the current level of scrutiny for smaller firms is considered appropriate, proportionate and in line with statutory objectives (paragraph 94). - Welcome the IMF’s findings regarding the effectiveness of AML/CFT supervision and recognition of positive and significant progress since the last FSAP in 2011 in expanding and strengthening supervisory activities in this area (paragraph 95). - Describe the FCA’s AML supervision as risk-based and outcome focused, targeting resources at banks and activities giving rise to high money laundering risk, and considering supervision of lower risk banks through thematic reviews, event-driven supervision and alerts from other domestic and overseas law enforcement/supervisory authorities to be proportionate and effective (paragraph 96). - Reiterate support for the role of the FSAP in improving supervisory practices and commit to continued dialogue with the IMF and global counterparts (paragraph 97). *International Monetary Fund — _cr16167 - 29. Abuse of financial services_* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16167.pdf_