Harnessing your Capacity - EBA Consultation on Recovery Capacity

In December 2022, the European Banking Authority (EBA) published its consultation paper (EBA/CP/2022/15) on guidance for calculating “recovery capacity”. Whilst the requirement for calculating recovery capacity was established by the EBA in 2014, this consultation provides further articulation of regulatory expectations around it. This paper follows a survey carried out by the EBA that showed that regulatory assessments of recovery capacity were not consistent across regulators.

An important feature of the consultation is guidance on how regulators will actually go about reviewing banks’ self-assessed recovery capacity, grading them, and where necessary, adjusting them. This interesting development is the focus of this blog.

The UK Prudential Regulation Authority (PRA) previously published its own expectations of recovery capacity, but even with this guidance, some banks have struggled to provide a clear picture of their own recovery capacity. This draft guidance will therefore be helpful for all firms when preparing the annual refresh of recovery plans in 2023.

The EBA draft guidelines provide more detail on how to tackle recovery capacity than the UK’s guidance and there are some areas firms should consider include:

• Suggestions on how to approach calculations of “overall recovery capacity” (ORC) in practice, including tables and charts.
• Although these do not need to be followed precisely, they are consistent with examples of good practice that we have seen from various banks and will be helpful for banks in considering how to describe their overall recovery capacity.
• Clarity on the minimum timeframes over which capacity should be estimated (12 months for capital, 6 months for liquidity).
• More detailed explanation as to how recovery capacity should be linked to recovery plan stress scenarios.
• Details of the regulatory approach to reviewing estimations of capacity, the grading system to be used, and the implications for banks with limited capacity (further details below)
• Expectations as to the indicators that should be tracked – in addition to CET1, Leverage Ratio and LCR, which are required in the UK, it also includes Total Capital Ratio and NSFR.
• Expectations around the type and severity of recovery plan stresses; and for firms that do not have scenarios that are sufficiently severe enough to threaten failure, the requirement to provide detailed justification as to why, or re-work the scenario.

Competent authorities’ assessment of ORC

The guidance on regulators’ approach to assessing ORC is helpful for understanding both how to approach calculating recovery capacity and interpreting subsequent feedback, so is worth unpacking in further detail.

Firstly, it is important to understand the purpose of recovery capacity from the regulatory perspective – how much total recovery “ammunition” (for want of a better word) is available to support a firm’s recovery from different types of stress? In an actual stress, regulators will need to know the bank’s realistic chances of surviving and making a full recovery, or whether and when resolution or wind-down activities need to commence.

This goes beyond demonstrating that a firm can recover from certain specific scenarios, but lays out the total capacity that could be utilised in a stress, over and above the minimum required to recover from a hypothetical recovery plan scenario.

The draft guidance lays out the approach and criteria:

An important take-away is that the regulator will take a detailed look at each firm’s scenarios and capacity and provide a rating, and the approach is likely to lead to a more standardised approach between firms and even between different regulators. It will also mean regulators coming to a view on certain subjective areas, such as haircuts, operational capabilities and timeframes. Due to the highly subjective nature of these assessments, and the fact that regulators do not always have as clear an insight into firms’ capabilities as the firms themselves do, or the same objectives, this may lead to differing views of recovery capacity. Regulators may seek to balance this utilising peer comparisons.

Implications

The use of “adjusted ORC” will result in regulators quantifying their assessments of recovery plans, and moving beyond the largely qualitative assessments that have been common over the past decade. This will provide a quantitative liquidity and capital value by which each bank either meets or falls short of the requirement implied by the stress scenarios.

Where the ORC score is not satisfactory, the bank will need to take appropriate steps to close the gap, although mitigating points may be taken into account, such as the headroom above recovery thresholds. And while not stated explicitly, it could be inferred from this that a bank that falls short would be expected to hold additional buffers to make up for a quantitative gap between the adjusted ORC and the recovery threshold.

This is probably an unsurprising extension to the regulatory tool-kit and is present elsewhere – for certain FCA-regulated firms in the UK, there is already an explicit requirement that the costs of absorbing a stress and a subsequent solvent wind-down should form the minimum financial resources that a firm should hold. For banks with limited recovery options, the EBA’s recovery capacity requirements may therefore lead to firms being required to hold additional financial resources if the adjusted ORC is insufficient to recover from a severe but plausible stress.

Conclusion

The EBA’s draft Guidelines make it clear that recovery capacity is an important area of regulatory assessment in judging the effectiveness of recovery plans. Through the inclusion of a grading system, and the quantification of shortfalls in capacity, the EBA is creating a much more structured framework for reviewing plans, facilitating greater consistency between banks and countries, as well as providing an approach to measuring shortfalls in recovery capacity. It will also place added responsibilities on regulators to make a correct assessment of each option and to do this consistently across banks, which could prove challenging given the subjective nature of calculating the value of recovery options.

Where shortfalls are identified by regulators, firms will need to improve the credibility of existing options, generate new ones, or potentially hold increased financial resources.

The consultation closes on 14 March.