The Prudential Regulation Authority publishes Policy Statement updating its Supervisory Statement on Credit Risk Mitigation

By Hannah Fearn, Geoffrey Wynne and Marian Boyle

Today the Prudential Regulation Authority (PRA) has published a Policy Statement (PS 8/19) and updated Supervisory Statement (17/13 “Credit Risk Mitigation”, which will come into force on 13 September 2019) in relation to the use of different types of guarantees as unfunded credit risk mitigation (CRM) for the purposes of calculating capital requirements under the Capital Requirements Regulation (575/2013) (CRR).

Last year, the PRA published a consultation paper on this subject, setting out certain draft proposals which caused serious concern in the market. Key issues arising out of the consultation paper included:

• The PRA’s expectations that the provider of the credit protection must be obliged to pay the beneficiary bank “without delay and within days, but not weeks or months” of the counterparty’s default, conflicted with the typical waiting periods agreed in credit insurance policies and export credit agency guarantees.

• There was a lack of clarity as to whether credit insurance policies containing market standard exclusions, such as an exclusion for nuclear-related events, would be considered eligible where the operation of such exclusions is outside the strict control of the insured.

The PRA received a number of responses to the consultation paper, and has made a number of significant changes to its proposals in direct response to that feedback.

In respect of the timeliness requirement, the PRA has decided not to implement its proposal and acknowledges that there may be difficulties in applying a single measure of timeliness to all the different products that may be used as guarantees. This is positive news for banks using credit insurance and ECA guarantees, as the standard waiting periods for these instruments will not automatically render them ineligible as CRM.

In the case of the nuclear exclusion often found in credit insurance policies, the PRA advises that this may be contrary to the CRR requirements unless “in all circumstances the clause is immaterial to the guaranteed exposure and the risk of an obligor default under that exposure”. This means that a policy containing this exclusion can be eligible as CRM, where the bank can demonstrate that it meets this condition. However, there will still be cases where exclusions cannot be considered eligible and an assessment will still need to be made as to whether an exclusion is within the insured’s control.

Notwithstanding the positive changes noted above, the PRA considers that in some cases the use of guarantees as CRM has actually proved to be less effective than expected, resulting in residual risks. This assessment is based on the PRA’s observations in supervisory cases and evidence it has received of claim pay out rates. It notes that it has observed situations where credit insurance has not paid out for a long time due to disputes between the insurer and the insured. It also has concerns about the residual risks created by instruments that contain and “broad or vague terms”, which it believes includes duties of disclosure usually found in credit insurance policies.

In some circumstances the PRA will expect a bank to hold additional capital to account for these “residual risks”, even where an instrument meets the CRR criteria for CRM (meaning that the firm has substituted the risk weighting of the guarantor to reduce the amount of capital required). As such, the impact of the PRA’s new expectations here might still mean that credit insurance is treated less favourably than other types of “guarantees” in terms of overall capital requirements.

On balance, however, the amended position is very positive and addresses the serious concerns that arose out of last year’s consultation paper.