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On the 31st October 2016 the consultation period closed on new proposals by the Prudential Regulatory Authority (PRA), which are highly likely to alter the internal ratings based (IRB) approach that deposit institutions (banks and building societies) with residential mortgage lending portfolios will need to adopt when calculating their risk-weighted assets (RWA).
This White Paper summarises some of the main assumptions of the PRA’s current Supervisory Statement (SS11/13) on internal ratings based approaches. It also examines the principal proposals in the consultation paper CP29/16 and explains the main implications for residential mortgage lenders (RMLs).
The purpose of the changes proposed in the PRA’s consultation is to address the material deficiencies in risk capture within residential mortgage models. Back in 2014, the Financial Policy Committee (FPC) raised concerns about excessive procyclicality and lack of comparability of UK banks’ residential mortgage risk weights, following that year’s Bank of England stress test. As a result, the PRA outlined proposed changes to SS11/13 on IRB approaches, to ensure consistency across all banks and building societies in calculating credit risk capital requirements.
If adopted, the changes will come into effect by 31st March 2019, with affected firms having to gain approval for their adjusted IRB residential mortgage models by 31st May 2018.
CP29/16: MAIN PROPOSALS
The overarching aim of the PRA’s proposed changes to SS11/13 is: “To address the material deficiencies in risk capture identified in respect of residential mortgage models. In doing this, the proposals seek to address the financial stability concerns identified by the [Bank of England’s] Financial Policy Committee (FPC).” They will also bring about a common basis for risk capture among RMLs that will enable them to be compared and aggregated more accurately in preparing sector overviews and setting supervisory measures.
The following are the main PRA proposals for amendments to SS11/13:
1. As there are potential weaknesses in both the point-of-time (PiT) + buffer approach and the through-the-cycle (TTC) method, the new guidance seeks for RMLs to move away from a heavy reliance on either. Instead, it is recommended that they use a hybrid model that falls somewhere between the two ends of a spectrum represented by the two approaches. The use of variable scalars will be prohibited.
2. The PRA believes that firms will need to recalibrate their probability of default (PD) models rather than develop new ones. The PRA will not prescribe what the model inputs will be. However, it will set an expectation as to how the models are calibrated.
3. In this regard, the PRA takes the view that the long-run average default rates should be included in the models. These should span good and bad periods in the economy, and should extend back to the recession period of the early 1990s. If firms do not possess data on default rates over this period, and the majority don’t, they should infer it from other sources.
4. However, the PRA proposes a 30% cap to the cyclicality when uplifting internal default data to a long-term average. This has the potential to add significant complexity to the process.
5. In terms of the capital requirements regulation (CRR), firms should be able to demonstrate that they have included the following in their monitoring: assessments of the accuracy of long-run average PDs; the cyclicality of their model; and the underlying risk ranking that they employ to categorise their residential mortgage assets.
6. In order to reach accurate PDs for products with a relatively short market history, such as buy-to-let, self-certification and sub-prime mortgages, lenders would be required to model how book default rates might have performed at various points in a representative economic cycle. This will also be true for portfolios where changes have occurred in portfolio mix/maturity or collection strategies. This is likely to be the biggest challenge facing institutions as part of the new requirements.
7. Firms will be expected to model LGD for residential mortgages in downturn conditions. This is already the case under SS11/13. In addition to the assumption of a 40% fall in property sale prices from the peak, they will now also need to assume at least a 25% fall in property values due to house price deflation.
THE IMPLICATIONS OF CP29/16
In the UK, CP29/16 will affect all RMLs that use IRB models to calculate the capital impact of their RWA.
Given that many RMLs currently adopt methodologies that rely on the point-of-time (PiT) + buffer approach or the through-the-cycle (TTC) method, we expect that these new proposed rules will impact the majority of the industry.
It is important to note that the proposed amendments represent a change to regulation, rather than a change in philosophy. However, some of the work required could be quite radical for some lenders, depending on how they currently structure their IRB models. As 4most’s Chief Operating Officer (COO) Mark Somers explains: “The task at hand should not be underestimated as being merely recalibration.”
4most is a specialist risk consultancy with extensive experience in delivering successful and cost effective projects for UK and international clients. Founded in 2011, we have grown rapidly to become the UK’s largest credit risk consultancy and a trusted brand with a wealth of experience. We pride ourselves on creating value for clients through long-term partnerships and by delivering results. We specialise in credit risk to support financial institutions to meet the growing complexity and demands of regulatory standards for risk modelling and data services. We have been involved in designing, developing, implementing and validating a full range of model suites and methodologies.
4most has considerable experience building capital and provision models, capital and impairment forecasting, and stress testing systems — critical components to an internal ratings based approach and IFRS 9. This collective experience enables us to bring an independent, analytical and balanced perspective to projects to deliver compliant models that are fit for our clients.
We take great pride in working collaboratively with our clients and to achieve this our engagements are delivered on site allowing comprehensive integration with in-house teams. All our consultants are permanent staff and we work hard to ensure we consistently deliver a high quality service.
In particular, 4most has leveraged its expertise to work with clients to ensure they are fully prepared for the implications of CP29/16. Most recently, we worked with an established IRB organisation which was looking to redevelop its mortgage model. Using our tools and methodologies, we worked with them to ensure that the new model put in place was equipped to meet with the demands of these proposals and acted upon insightful feedback from the PRA.
Our Broad Capabilities
Our firm has built a strong team of seasoned risk specialists who assist clients in developing tailored capabilities to better manage their exposure to risk. Our intention is to work with organisations, helping them better understand the impact of recent and ongoing regulatory and global accounting changes. In doing so, we leverage our many industry relationships to help you implement and deliver while minimising additional workload. Our consultants will add value to your team by leveraging their extensive experience, both in terms of scale and range, across different portfolios, and where appropriate facilitate skills transfer to your in-house analysts. Our client service model is rooted in the principles of objective advice, analytic rigour, and open knowledge exchange and we believe this sets us apart from the crowd.
PRA, Consultation Paper CP29/16: Residential Mortgage Risk Weights, July 2016. Available at: http://www.bankofengland.co.uk/pra/Documents/publications/cp/2016/cp2916.pdf. Accessed December 2016