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New Banks – the liquidity path to maturity

In a previous blog in our series on new banks, we discussed the regulator’s expectations around liquidity and considerations when going through an Internal Liquidity Adequacy Assessment Process (ILAAP). In CP9/20, the PRA provides some additional guidance around expectations for new and growing banks and in this blog we consider what this means for those going through the application process.

In the draft supervisory statement, the PRA gives its expectations around ILAAP development over the first five years of the business. These are:

Year 0

Year 3

Year 5

ILAAP in place but untested

ILAAP meets minimum standards and is fit for purpose

ILAAP is a robust document which is an integral part of the firm’s management process and decision making

While the guidance provided is very limited, it should be understood in the wider context of the draft supervisory statement and the PRA’s wider view and concerns about growing firms. There are two key themes driving this approach – one is proportionality i.e. ensuring that the controls and framework in place are proportionate for the size of the business. This ensures that firms in mobilisation are not excessively burdened with having to develop controls and testing capabilities that are excessive given the size and activities of the firm.

The other is ensuring that control and risk functions grow proportionately as the business does. The PRA has identified that quickly growing firms do not always successfully grow these functions at the same pace as the balance sheet, increasing the chance that the controls in place are insufficient for managing the risks to which the firm is exposed to.

Looking more closely at the three points the PRA highlights:

Year 0: the PRA understands that it is not proportionate, or even possible, to have detailed controls and testing in place prior to authorisation or during mobilisation. At this stage, the ILAAP should be appropriate to show that the firm’s liquidity strategy will support the launch of the business model, has identified the key liquidity risks it is exposed to and has strategies for managing them.

Year 3: by the third year post-authorisation, the business should be growing and on its path to profitability. The ILAAP should meet the minimum requirements, with a developed understanding of its liquidity risks, its risk appetite and how the risks would be mitigated if they were to crystallise. Both internal and regulatory reporting should be in place and the firm should be building its capabilities around stress testing. A new bank in its third year will have little to no systemic impact and the regulator accepts that the liquidity risk framework does not need to be fully developed.

The PRA notes that it has observed a theme of firms outgrowing their control functions however, and so at this stage a new bank should be investing in the control framework and stress testing capabilities it will need to manage the liquidity risks in the future – these capabilities should be in place before the risks grow – not as an afterthought.

Year 5: with the business model reaching maturity, there should be a fully developed liquidity risk management function and a comprehensive ILAAP document. This will align with the firm’s strategy and will support decision-making as the management of all liquidity risks that the firm faces. The PRA will undertake a “liquidity SREP” review this stage, if it has not already, and the ILAAP will be assessed and challenged from every angle. Where weaknesses are uncovered, a firm may face enhanced pillar 2 requirements and restrictions on its activities until the weaknesses are addressed. It is therefore essential that the ILAAP contains a robust assessment of risks, a rigorous stress testing framework, effective controls, and identified strategies for dealing with crystallised risks. A firm should also be able to evidence that controls are exercised through all three lines of defence and that the appropriate expertise is in place.

Governance is always a central focus of the PRA and it will be looking to senior management and the Board to have a plan in place to develop expertise and manage the journey from Year 0 to Year 5. That plan should be developed when the firm seeks authorisation and the board should have made itself comfortable that the appropriate resources and expertise would be in place at each point in its journey.

Often banks are focused on the ambition of becoming authorised and lose the longer term focus of becoming sustainable businesses or fail to appreciate the ongoing need to invest in systems and controls to ensure they remain commensurate with the evolving needs of the business