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Harnessing your Capacity - EBA Consultation on Recovery Capacity

The global financial crisis of 2008 originally highlighted the need for recovery plans and the UK’s regulatory approach to them has been evolving for nearly a decade. Firms now produce plans with the depth and flexibility to be used in a wide range of scenarios. SS9/17 requires UK deposit takers to demonstrate how their plans allow them to tackle multiple scenarios and the Prudential Regulation Authority (PRA) has placed additional emphasis on how firms should operationalise the recovery actions in a live scenario.

Firms are now able to assess the impact of the pandemic using a suite of early warning indicators and can gauge a potential response through a menu of recovery options. This framework can help keep key stakeholders, including the regulators, informed.

Despite unprecedented steps by the UK government to support the economy, the full economic effect of the current stress is still unknown. Forecasts range from a relatively short-term economic hiatus and v-shaped recovery, to a prolonged, multi-year recession. Nor is there any certainty about how any negative effects will materialise and it is impossible to dismiss a scenario in which default rates surge across a wide-range of products, leading to a severe capital and liquidity stress. To maintain financial resilience, firms will need to respond dynamically to the situation as it unfolds and understand vulnerabilities.

The largest UK deposit-takers have participated in the Bank of England’s concurrent stress testing exercise for a number of years and demonstrated their financial resilience via a variety of stress scenarios. Whilst medium and smaller firms have not been required to undertake the same depth of analysis, all undertake stress testing as part of their recovery planning. However, all firms, both large and small, will be considering how to navigate the financial challenges that may arise and the recovery plan is a major tool to help successfully achieve this.

Developing a scenario response plan

Recovery plans are designed to cope with a range of scenarios, providing a wide menu of options that can be combined to deal with events as they arise.

Recovery plans also have an inherent limitation – they do not address a specific situation and firms are now facing a very real and specific stress. This means that there is an opportunity to develop a tailored response to the current scenario, bringing in the most relevant and useful aspects of the current recovery plan.

Early warning indicators

All firms’ EWIs will have identified the stress, at the very least in their market stress indicators. However, the current stress can impact the firm in ways not anticipated during the development of the recovery plan and this is an opportunity to assess which EWIs are most relevant, but also where they need to be modified or additional ones added.

For example, a rise in missed loan or mortgage repayments might be seen as a traditional indicator of a crystallising stress event, but it is also important to recognise that the government has developed a temporary mortgage-holiday scheme which does not impact borrowers’ credit ratings. Also, those taking advantage of the holiday are hoped to have a much lower recidivism rate than we might have seen historically. As a result, a spike in this metric might not be as alarming as expected. Further analysis and configuration may be needed to draw out how this indicator would be of best use in a stress.

Whilst this is just one example, firms should give careful consideration to the ways in which the stress could crystallise and so amend or recalibrate existing indicators or consider the weighting they should be given. Firms should also consider developing completely new indicators to meet the challenges of this specific scenario.

Options and Playbooks

The regulator identified playbooks as a solution for firms with larger recovery plans that might not be easily useable in a stress event. There is an opportunity now for all firms to consider the advantages in developing playbooks for use in the current situation in order to highlight the best options available and what are the operational steps required to implement them, in a brief, easy-to-use format. Any firms that are currently undergoing stress should especially consider whether to undertake preparatory work on certain options to reduce time to full implementation, if needed.

Firms also need to monitor recovery capacity – for example, the market liquidity of a number of asset classes worsened early on in the stress, and if the situation deteriorates, it may be far harder to realise the full value of recovery options. It is advisable therefore to keep recovery capacity estimates up-to-date.

Testing capabilities

One of the innovations in SS9/17 was the requirement for firms to undertake ‘fire drills’ of their plans – scenario-based simulations in which senior management considers a scenario to test and improve their plans. Most often, these are hypothetical situations, often related to scenarios in the recovery plan.

Fire drills should never be a regulatory box-ticking exercise, but provide a valuable opportunity to identify ways in which the plan, and the execution of it, could be enhanced.

Now is an ideal opportunity to test the effectiveness of recovery planning capabilities based on a scenario that reflects the current environment and the unique nature of the stress. It is important to understand this scenario and ability to operationalise a range of responses, especially given the uncertainty as to how it could play out over the months or years ahead.

Firms have weathered the stress well so far, but we also know that things could potentially deteriorate further. It would be prudent to prepare for this and run tests around their ability to respond if events take a turn for the worse.

The benefits of testing capabilities to respond to a severe version of the current scenario are:

  • It will show whether there is sufficient recovery capacity available in a prolonged stress.
  • It can uncover operational issues with executing options during the pandemic.
  • Demonstrate to stakeholders that the threat of coronavirus is being considered from multiple angles and that mitigating actions have been prepared and rehearsed.

Given that we are experiencing one of the worst economic stresses in history and are in a scenario that is still unfolding and rapidly changing, firms should keep their recovery plans primed, updated, tested and ready for use at short-notice.