PRA 'Dear CEO' Letter to Fast Growing Firms

On 12 June 2019 the PRA published a new ‘Dear CEO’ letter summarising the regulator’s findings from a review of 20 non-systemic deposit taking firms that it has undertaken over the past year. The firms reviewed are mostly growing faster than the market as a whole, so the PRA refers to them as ‘fast growing firms’ (or ‘FGFs’) in the letter. The review included firms with different business models and activities so the expectations expressed in the letter may well apply to a range of challenger banks and disruptor businesses in the finance sector including the growing number of FinTech businesses with full banking permissions in the UK.

The letter summarises the main findings of the review, which covered three main areas: stress testing, asset quality reviews and funding and lending analysis. Overall the PRA is reassured about the resilience of the sector but identifies areas for improvement in individual FGFs’ risk management practices. The PRA will be providing further feedback on the review at its conference session for Chairs and Non-Executive Directors of non-systemic UK Banks and Building Societies in July and affected firms can expect their supervisory teams to discuss the points raised in this letter with them as part of the PRA’s ongoing supervisory engagement.

In its stress-testing review, the PRA’s overall concern was that FGFs could be underestimating the potential losses in stressed scenarios. It thinks this may reflect the fact that many FGFs have only existed during relatively benign credit conditions and have not experienced a downturn. The PRA expects firms to be adopting several specific measures in relation to stress-testing, including:

• effective engagement and challenge by senior management and boards, with stress testing integrated into the business;
• using Bank of England annual stress test results for the UK major banks as a reference point and cross-checking for an assessment of the risk profile of a particular loan book and how it might behave under stress;
• ensuring risk concentration is taken into account in their provisioning and stress models; and
• ensuring that the management actions proposed in ICAAP stress test are consistent with the stress scenario used.

The PRA also warns that it does not consider it appropriate for FGF to assume that significant growth would be available in generally falling markets.

In relation to asset quality, the PRA notes that FGFs tend to operate in higher credit risk segments of the lending market and it is concerned that some FGFs are not demonstrating that they have appropriate credit expertise and control frameworks. The PRA’s key action points for firms to improve here are to broaden the range of risk metrics and enhance data quality and risk information packs for management as and when individual portfolios become more material in size. Firms should also bring forbearance practices into line with industry standards so as not to mask the level of arrears, delay appropriate recovery action in a downturn.

The PRA again emphasised that not having experienced adverse credit conditions in the past should not allow FGFs to think they can afford not to be prepared to react quickly if conditions change and said that better firms had adequately resourced risk functions with experienced staff.

In both the asset quality review and the funding and lending analysis the PRA appears to be warning FGFs against pressurised growth targets which could lead to taking on unplanned higher levels of risk, commenting that firms should ‘guard against’ such pressures and noting that most FGFs’ pursuit of ‘aggressive balance sheet growth targets’ by maximising assets could increase execution and refinance risks. The PRA expects firms to take into account various market pressures as well as their own ability to differentiate pricing on both sides of the balance sheet in both their baseline and stress testing projections.

Although the Dear CEO letter is broadly positive about fast growing firms’ financial resilience, challenger banks and FinTech businesses that take customer deposits should be aware of the regulator’s expectation that their prudential governance policies are as robust as those of the major UK banks.

The letter can be read in full here.