Brexit offers glimmer of hope for challenger banks
The UK’s challenger banks are stuck in a capital bind, forced to compete with each other on far worse terms than the big banks, but Brexit could offer a glimmer of hope.
The army of smaller institutions see Brexit as a small window of opportunity
While big banks operating in the UK fret over their future access to the European market for financial services in the wake of the country’s June 23 vote to leave the European Union (EU), the army of smaller institutions that are mainly focused on domestic clients – commonly dubbed challenger banks – could stand to benefit from any regulatory flexibility that might result from Brexit.
Euromoney understands that at least two of the bigger challenger banks are preparing to launch a residential mortgage offering before the end of this year as a result, and at least three banks are looking to transition to a similar capital calculation methodology as used by big banks.
Challenger banks argue they are unfairly disadvantaged in a number of ways, including by being effectively unable to take advantage of the internal ratings-based (IRB) methodology for risk-weighted capital calculations that big banks are able to use. IRB methodology was enabled via the Basel II capital framework in 2004.
Challenger banks must instead use the standardized approach under Basel II, which sets standard risk weights for their calculations. The effect of this is that they must set aside considerably more capital for certain risks – a residential mortgage, for instance – than a big bank might be required to under the IRB method.
The differential is most acute when considering retail exposures, a profitable area that challenger banks would like to expand into but generally avoid at the moment – other than more risky high loan-to-value mortgages – in favour of taking deposits and lending out to small and medium-sized businesses.
This is a particular issue within the EU, where the European Banking Authority (EBA) requires all national regulators within the EU to implement Basel standards on all banks, irrespective of their size, their business mix or the geographic scope of their services. “The key regulatory challenge that challenger banks face is the fact that the EU regime on capital and liquidity requirements has been very much developed in light of the post-crisis approach to large international banks,” says Robert Finney, partner at law firm Holman Fenwick Willan. “It doesn’t really take account of the smaller, domestic-focused banks.”
In the US, for example, regulators have only implemented Basel in full on those banks deemed to be of systemic importance, with much greater flexibility afforded to others.
The European capital requirements regulation, which governs the way in which Basel standards are implemented in respect of banks within the EU, dictates that institutions that wish to use IRB methodology must be able to satisfy their local regulator that they have sufficiently robust assessment methods for probability of default, loss given default and exposure at default, as well as possessing sufficient data to support those assessments.
This poses a severe problem for challenger banks, most of whom would lack the quantity of historical data necessary to satisfy regulators even if they were able to justify the considerable cost and workload in terms of analysis and reporting needed to implement an IRB approach.
Challenger banks have been lobbying UK regulators and policymakers for years over the issue, most recently in late June, when a group of seven of the most prominent wrote to Andrew Tyrie, chairman of the UK parliamentary Treasury Select Committee, to set out their hopes following the referendum vote.
In their letter to Tyrie, the banks set out a number of measures they argued should be adopted as recommendations by the Competition and Markets Authority (CMA) – a UK body that was at the time conducting an investigation into the competitive environment for UK banking.
Broadly, challengers banks’ preferred approach is to allow smaller banks access to a series of average risk weights that would be calculated on the basis of the 10 largest firms that are using the IRB approach. Such an approach, they argue, would be a simple solution that would continue to confer a capital advantage on those big banks taking risks that were more moderate than average.
The question, as the challenger banks freely admit, is whether such an approach could realistically be adopted even after the departure of the UK from the EU, and therefore having gained freedom from EBA requirements, given that it would mean departing from Basel standards.
Also complicating the issue is the fact that Basel is separately considering reworking its standard risk weights.
In any case, there remains a long time before the UK’s exit from the EU will be finalized — a two-year negotiation period is triggered only once the UK government has formally invoked Article 50 of the EU’s Lisbon Treaty, something it has said it is not minded to do before early 2017.
An interim solution, say the challengers, would be instead to create pooled datasets that banks lacking their own data history might use, thereby enabling them potentially to transition to an IRB approach themselves.
They argue the biggest banks in the UK should be required to share lending data from the past 10 to 20 years, a measure they concede would be likely to require legislation as it is unthinkable that competitors would volunteer such information. The data is currently reported by all institutions to the Bank of England (BoE), which could therefore coordinate the release of anonymized figures.
Euromoney understands that at least three of the most prominent challenger banks are preparing to move to IRB, but discussions with the BoE and Prudential Regulatory Authority (PRA) have slowed amid questions over the issue of data.
For the moment, the prospect of any substantial easing for challengers seems far off. The CMA duly released its final report on August 9, to a chorus of disappointment from the challenger sector when it became clear it had not adopted their recommendation to direct the UK Treasury and the PRA to put in place a platform for data sharing; neither had it put forward any substantial proposals with respect to capital – other than to acknowledge the ‘striking’ disparity in treatment.
However, all hope is not lost. The two banks that Euromoney understands are preparing to enter the residential mortgage market are doing so because they are sufficiently confident of the direction of travel – and of their belief that the PRA and the Treasury are sympathetic to the data approach.
The PRA has said it is committed to arguing for proportionality at a European level, suggesting it is aware of the disparity and keen to address it wherever possible. Brexit might just give it the flexibility to do that, eventually.