5 min read
Natalie Barnes, Associate
There is concern emerging at the Bank of England (BoE) and the Prudential Regulation Authority (PRA) about how banks are assessing their overall exposure to private equity (PE) related financing activities.
- On Monday, 22 April, Nathanaël Benjamin (a member of the Financial Policy Committee (FPC) of the BoE) explained why he is concerned that banks could experience significant and correlated losses resulting from their exposure to the PE sector.
- On Tuesday, 23 April, Rebecca Jackson (an executive director at the PRA) set out her findings following the conclusion of a thematic review of banks’ PE related financing risk management frameworks.
- Later that day, the PRA published a Dear Chief Risk Officer letter (Dear CRO letter) written by Jackson along with her colleague Charlotte Gerken (also an executive director at the PRA) outlining their expectations of banks as a result of the thematic review.
Soon after, various media outlets picked up on this flurry of communications from the regulators – unsurprisingly so, as the regulators did not shy away from critiquing the approach being taken by banks (see for example, this article in the Financial Times titled “Lenders flying blind on private equity risk, Bank of England warns”).
You might like to refer to the summaries my colleagues prepared of the BoE and PRA publications referenced above. But in this post, I will set out some practical suggestions, from a legal perspective, about how to deal with the Dear CRO letter. In the Dear CRO letter, the PRA asks banks to analyse its findings and expectations arising from its thematic review, benchmark them against their own internal practices and then report back to the PRA once they have completed a gap analysis, which ultimately needs to be signed off on at board level.
So, where to start?
- Prompt engagement with the task at hand: The deadline to complete the review by Friday, 30 August 2024, on first blush, appears to be generous. But in reality, it underscores not only the PRA’s understanding of the complexity of the review it has asked banks to undertake but also the PRA’s expectations that the analysis submitted is high quality and has been robustly scrutinised by senior leaders. Simply put, CROs should treat this review as a priority regulatory matter and action it accordingly.
- Appreciating this is a firmwide exercise: It will be important for CROs to communicate the message early on that this review will need regular input from many colleagues across the bank, including at the most senior level. Data will need to be collected and analysed – maybe even for the first time – which will inevitably create logistical and operational challenges. Risk management frameworks will need to be adapted, as will stress testing procedures. Compliance officers and legal teams will need to be briefed. The board and relevant committees will need to dedicate time to considering these issues and board/committee packs will need to be prepared to ensure directors can engage meaningfully with the review at meetings. Management information and reporting procedures will also need to be updated. Nominating key stakeholders and appointing a project team should be seen as a ‘no regrets’ move.
- Assessing the responsibilities of senior leaders: The PRA has not minced its words – we know with absolute certainty that it expects board directors to be fully briefed on PE sector exposures, in all their guises. In addition, it is likely the PRA will be looking beyond the board and assessing the competencies of other key staff, in particular those exercising senior management functions (SMFs) under the Senior Managers and Certification Regime (SMCR). It would be sensible to think early on about how the SMFs are responsible for oversight of PE sector risks and potentially involve some SMFs in the review. ‘Statements of responsibilities’ and ‘management responsibilities maps’ as required under the SMCR may need to be updated.
In an interesting turn of events, on Thursday, 2 May, the Financial Times reported that Nikhil Rathi (the chief executive of the Financial Conduct Authority (FCA) and member of the FPC) holds a different view to the BoE and the PRA about the risks posed by the PE sector to the wider economy. Rathi is ‘not yet convinced’ that the PE sector poses a systemic risk and before going into ‘overkill regulatory mode’, more data and evidence was needed. The fact that the BoE, the PRA and the FCA do not appear to be fully aligned at this point in time highlights the need for banks to engage substantively with the Dear CRO letter - the data and internal reviews submitted by banks at the end of August will almost certainly be used to set and inform the regulatory policy agenda.
Overview of the PRA’s expectations arising from its thematic review of banks’ PE related financing risk management frameworks
In summary:
Data aggregation and risk management
- The PRA expects banks to flag all transaction and exposure data relating to the PE sector in their trade capture and risk management systems
- Banks must be able to monitor exposures to the PE sector overall, as well as exposures linked to individual financial sponsors and individual PE funds
Credit and counterparty risk interlinkages
- Credit due diligence procedures and management information processes should analyse the presence of overlapping credit exposures, collateral pledges, and financial claims across all PE related activities
Stress testing
- Banks should conduct routine stress testing of exposures to the PE sector as a whole, as well as PE exposures linked to individual financial sponsors
Board level reporting
- Boards should be informed of the exposures linked to the PE sector and consider the overall business strategy of the banking group in relation to PE linked activities
- Boards should satisfy themselves that the scale and composition of risk exposures linked to financial sponsor clients, and the PE sector in general, is appropriate in the context of the overall risk profile of the bank
By Friday, 30 August 2024, relevant banks must send the PRA their analysis and remediation plans, as approved by their boards