Banking – Q2 2023

Summary of SS1/23 – Model Risk Management

The PRA published its Supervisory Statement (SS1/23) on Model Risk Management (MRM) earlier this summer. The SS1/23 is broadly aligned with the PRA’s consultation on this matter (CP6/22) but is a lot more specific on the requirements that eligible firms – those with IRB permissions – should abide by. The four key takeaways are as follows:

Five principles

The PRA sets out a supervisory expectation that firms meet five model risk management principles which have been designed to cover all elements of the model lifecycle. These principles are as follows:

• Principle 1 – Model identification and model risk classification
• Principle 2 – Governance
• Principle 3 – Model development, implementation, and use
• Principle 4 – Independent Model Validation
• Principle 5 – Model risk mitigants

Model inventory

Based on the findings of recent Section 166 (s166) reviews on MRM, model inventories are closer to a living workflow management tool for the salient features of the model risk lifecycle, as opposed to a semi-static list of models with associated information. It is our understanding that the PRA expects inventories to:

• Document model objectives.
• Record the key considerations during the model development process.
• Record the status, results and remediation work undertaken during model testing.
• Evidence all governance controls.
• Track the results and remediation of model validation activities.

Governance, roles, and responsibilities

SS1/23 lays out clear responsibilities for the Board, model users, model testers and model developers. These are required to be clearly articulated across 8 mandatory MRM policies that the PRA requires firms to develop and implement. SS1/23 also indicates the main responsibilities of the 1^st, 2^nd and 3^rd line, including the key outcomes that their involvement is expected to achieve.

Proportionality

Whilst SS1/23 formally applies only to IRB firms, the PRA requires the management of non-IRB firms to "consider” these requirements. The SS doesn’t explicitly specify what these expectations are, but CP6/22 provides some intel. It states that all elements of Principle 1 and the subsequent elements of Principle 2 should be followed: board responsibilities and accountability, clearly drafted policies and procedures, and IA oversight.

The CP also states that where “material” models exist, non-IRB firms should also apply Principles 3, 4 and 5 in respect of those models specifically, as opposed to the entire MRM ecosystem.

Summary of CP 10/23 - solvent exit planning for non-systemic banks and building societies

CP10/23 includes a draft supervisory statement (SS) that details the Prudential Regulation Authority’s (PRA) expectations for non-systemic UK banks and building societies to prepare, as part of their business-as-usual (BAU) activities, for an orderly ‘solvent exit’.

The SS applies to all non-systemic UK banks and building societies, regardless of how unlikely or distant a potential solvent exit may seem to the firm.

This SS sets expectations for both the preparations for and execution of a solvent exit. This includes expectations on producing a ‘solvent exit analysis’ and ‘solvent exit execution plan’.

The SS complements the PRA’s guidance on Recovery Planning (SS9/17) and wind-down planning.

Solvent Exit Analysis

Firms must produce a ‘solvent exit analysis’ document that should include, at a minimum:

• Solvent exit actions and indicators.

• Potential barriers and risks to an orderly exit.

• Resources and costs required for an orderly exit.

• Communication plan during the solvent exit.

• Governance and decision-making with regard to a solvent exit.

• Assurance over the analysis.

Firms are encouraged to draw on and adapt existing work carried out under other (similar) existing regulatory requirements to perform this analysis. This may include leveraging recovery planning, resolution planning and wind-down planning.

Solvent Exit Execution Plan

The solvent exit execution plan should be an extremely up-to-date plan that is produced when a solvent exit becomes a reasonable prospect for a firm or when the firm is requested to by the PRA. As a starting point, the firm should use its ‘solvent exit analysis’ prepared during BAU for its ‘solvent exit execution plan’.

Similar to the expectations around Solvent Exit Analysis, this plan should set out actions and timelines, identify and detail plans to mitigate barriers and risks to execution. It should also provide a communication plan for stakeholders impacted, produce a detailed action plan, develop an assessment of required resources. Finally, it also needs to outline organisational structures, the operating model and other internal processes.

Summary of PS5/23 - Risks from Contingent Leverage

Following the publication of the consultation paper on the risks that may arise from contingent leverage, the PRA has released its policy statement on the issue. The aim is to provide guidance on contingent leverage and to provide a robust understanding of the risks associated with such positions. In this update, we have discussed the key elements of the policy statement.

• While the expectations of the PRA for firms undertaking the ICAAP begin immediately, the reporting requirement for LREQ firms comes to effect on January 1, 2024. The first reporting reference date is June 30, 2024.

• In response to feedback from firms, the PRA explained that the ICAAP expectations will not lead to additional capital requirements for PRA firms concerning contingent leverage risks. However, firms’ individual assessment of the risks associated with contingent leverage will be subject to the same level of supervisory review which applies to any part of the ICAAP.

• Further clarification has also been provided on the need for daily average reporting for on-balance sheet items and security financing transactions. In the PS, the PRA explained that relying on month-end values or periodic averages alone would be counterproductive and would not provide adequate information which is necessary for providing a better understanding of contingent leverage risks. It should be noted that the PRA allows ‘best estimates’ for daily averaged reporting as they are measured consistently and prudently.

• The PRA has included a new or revised definition for certain terms like internalisation and franchise clients. Furthermore, the PRA has modified the reporting instructions for the ‘internalised’ columns to avoid double-counting of certain internalisation activities.