Non-Performing Exposures – The start of a trend?

A few weeks ago the PRA (Prudential Regulation Authority) announced a change to the capital rules for consultation (PRA CP 06/23).  At present, non-performing exposures are deducted from Capital, subject to various factors and adjustments.  The proposed change removes this rule entirely from Q4 this year.  Non-performing exposures (NPE) no longer get their own line in the Capital+ and CA1 returns, and the three NPE returns are to be removed entirely.  This means that rather than being ineligible for capital by virtue of being NPEs, NPEs are instead assessed according to standard accounting criteria, allowing them to contribute to the Capital position of the firm.

As a change to the reporting process this is minor news.  It’s not hard to achieve, and the end of year timeline gives plenty of time for implementation.  But the implications of this move are more interesting.

On the business side, it seems unlikely the consultation period will draw many objections.  Moreover, as a quick change that will likely flatter banks’ figures, this announcement seems tailor-made to fit in with the government’s demand for ‘nimble’ regulatory changes that will improve the country’s competitiveness.  It’s natural to speculate that someone went looking for ‘quick wins’, and found one.  And given the sheer size of some of these piles of distressed assets still remaining, allowing them to provide any kind of value may have a noticeable impact.

But if that speculation is correct, are we likely to see more such changes?  On major issues the European regulatory bodies and the Bank of England have been following each other, a change in one being followed at a discreet distance by a change in the other.  Both are following principles that are being discussed and implemented globally.  By reacting to each other’s text, they reduce what could have been a dramatic divergence between the EU (European Union) and the UK (United Kingdom) down to a gentle drift.

But the NPE change is not driven by a shift of international consensus, but rather by national interest.  And it is far less likely to be copied.  Allowing NPEs to count towards capital benefits those who trade assets more than those who merely hold them, while taking the stricter line of deducting them from capital does more for those seeking foreign capital and inward investment.  The market-dominated UK is more likely to welcome such a change than European countries seeking to avoid the perception of risk.

It is going to be on these smaller scale issues, on the national level, rather than grand matters of principle that see similar rules adopted around the world, that will determine how quickly and how far the UK and EU regulations diverge.  The more changes of this style we see, the greater the divergence.

And this divergence will have an impact.  Any company with distressed but still productive assets may, in the wake this change, see it as more useful to hold those assets in the UK, reducing their capital as appropriate.  That in turn may boost income for the UK firm, in turn attracting more speculators and more activities with a high tolerance of risk.  Meanwhile more sober and long-term investment may drift more towards the continent.

This in turn may trigger a change in the product mix being reported on either side of the Channel, leading to a flurry of new product assessments falling on the regulatory team around January 2024, when resources may already be committed to the Basel 3.1 changes to Credit and Market risk, not to mention what for many firms is year-end.  A bit of forward planning might get some changes done in Quarter four instead, preventing a potential crunch.

However, as companies decide whether it is worth moving distressed but still potentially valuable NPEs to the UK, is it worth considering whether this is really the one-off exercise that it might appear?  If successful, we will surely see more changes like this one, leading to greater divergence.  It seems unlikely that we’re going to return to the levels of regulatory arbitrage common before the financial crisis of 2008, but it also stretches credibility that financial markets and groups that operate on both sides of the Channel are likely to ignore regulatory differences, particularly in a landscape that is becoming more varied as time goes on.

We have several factors coming into play.  The EBA’s (European Banking Authority’s) present line that the pace of Basel 3.1 changes will be set country by country via differing transitional provisions.  The deliberate introduction of rules to differentiate once country from another.  The usual idiosyncratic reaction of individual regulators to global rules proposals, such as ESG (Environmental, Social and Governance) compounded by additional regulators joining a consensus rules set they hadn’t previously followed as we can see in East Asia and the US.  And of course the rapidly rising cost of capital and liquidity.

All of these combine to give us the perfect conditions for two changes.  Companies shifting assets to take advantage of local regulations, and markets anticipating these shifts, changing market behaviour.  When telling people in your firm about upcoming changes for NPEs in the UK, it might worth considering how to communicate these changes in future.  The changes will keep on coming, how quickly the company reacts is likely to only get more critical over time.

Hanbury Hampden-Turner

Regulatory Product Functional Authority