CP14/24 – Large Exposures Framework

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Responses are requested by Friday 17 January 2025.

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1: Overview

1.1 The prudential framework for large exposures (LE) complements the risk-weighted capital requirements by aiming to protect firms from large losses resulting from the sudden default of a single counterparty or groups of connected counterparties (GCC). As a result, it helps to maintain and enhance the safety and soundness of firms and the financial system within which they operate.

1.2 This consultation paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposals to implement the remaining Basel large exposures standards (LEX standards). The proposals include:

• removing the possibility for firms to use internal model (IM) methods to calculate exposure values to securities financing transactions (SFTs); and
• introducing a mandatory substitution approach to calculate the effect of the use of credit risk mitigation (CRM) techniques.

1.3 In this CP, the PRA is also proposing to amend the LE framework by:

• removing the option for firms to exceed LE limits for trading book exposures to third parties;
• allowing firms to exceed LE limits for trading book exposures to intragroup entities, and simplifying the calculation of the additional capital requirements;
• allowing firms to apply for higher LE limits to exposures to intragroup entities, and amend the conditions firms need to meet to mitigate the higher concentration risk;
• removing the exemption from LE limits to firms’ exposures to the UK deposit guarantee scheme (DGS);
• removing the option for firms to use immovable property as CRM; and
• remove the stricter requirements on exposures to certain French counterparties.

1.4 Lastly, this CP sets out proposals to merge the Large Exposures (CRR) and the Large Exposures Parts of the PRA rulebook to improve accessibility. The PRA also proposes to update supervisory statement (SS) 16/13 – ‘Large Exposures’ to amend the PRA’s expectations in light of these proposed changes set out in this CP.

1.5 The proposals set out in this CP would result in changes to the PRA’s policy material (PRA Rulebook Parts and SSs), as set out in the table below.

Table 1: Summary of changes to policy materials proposed by this CP

1.6 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [1]} This CP should be read in conjunction with CP 23/23 – Identification and management of step-in risk, shadow banking entities and groups of connected clients as well as CP11/24 – International firms: Updates to SS5/21 and branch reporting.

Background

1.7 The global financial crisis revealed that firms did not always consistently measure, aggregate and control LE. Based on the lessons learned during the crisis, the Basel Committee on Banking Supervision (BCBS) issued the Basel LEX standards. The LEX standards came into force on 1 January 2019. The PRA was involved in their development and the negotiations that have led to their agreement as a package.

1.8 Until recently, the LE framework in the UK consisted of requirements set out in Part Four of the Capital Requirements Regulation (CRR). The Financial Services Act 2021 (the FS Act) removed these requirements and empowered the PRA to apply LE standards in PRA rules. These rules were transferred into the Large Exposures (CRR) Part of the PRA rulebook in January 2022. Some rules were amended to implement Basel LEX standards as set out in policy statement (PS) 22/21 – Implementation of Basel standards: Final rules. The remainder of the rules were transferred without material modifications.

1.9 LE limits on exposures to intragroup entities have always been subject to national discretion and are not in scope of the Basel LEX standards. The PRA’s approach on the LE treatment of intragroup exposures is set out in the Large Exposures Part of the PRA Rulebook. This part contains rules for exempting intragroup exposures as well as rules for exempting sovereign exposures and a reciprocal measure that applied stricter requirements on exposures to certain French counterparties. The PRA’s expectations in relations to the requirements in this Part are set out in SS16/13 .

Structure of the CP

1.10 The topics are structured as follows:

• Chapter 2 sets out proposals relating to the modification of the calculation method for exposures to SFTs;
• Chapter 3 details the PRA proposals as regards amending the limits to trading book exposures, both for third-party exposures as well as for exposures to intragroup entities. This chapter also outlines the modifications to the permissions’ regime to allow for higher intragroup exposures and the calculation for additional capital;
• Chapter 4 sets out the PRA’s proposals to implementing the substitution approach to calculate the effect of the use of CRM techniques;
• Chapter 5 describes the PRA’s proposals to present exemptions to certain types of exposures from the LE framework, such as to the UK DGS, or the ability to use loans secured by immovable property for CRM purposes. It also outlines the proposals to delete the tighter LE requirements on specific French entities; and
• Chapter 6 provides the Cost Benefit Analysis (CBA) performed for these proposals, as well as providing the impact of these LE proposals on mutuals and equality and diversity.

Scope and accountability framework

1.11 This CP is relevant to PRA-authorised UK banks, building societies, PRA-designated investment firms, PRA-approved holding companies, PRA-designated holding companies and other CRR consolidation entities.

1.12 The PRA has a statutory duty to consult when introducing new rules (section 138J of FSMA), or new standards instruments (section 138S of FSMA). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. 

1.13 In carrying out its policymaking functions, the PRA is required to comply with several legal obligations. The analysis in this CP explains how the proposals have had regard to the most significant matters, including an explanation of the ways in which having regard to these matters has affected the proposals. The Practitioner Panel and the Cost Benefit Analysis Panel were consulted during the production of this CP.

Implementation

1.14 The PRA proposes that the implementation date for the changes resulting from the proposals would, except for the proposal on SFTs (see paragraph 1.15), take effect shortly after publication of the final policy statement. As a result of the changes to rules 2.1 and 2.2 of the Large Exposures Part of the PRA Rulebook, any modifications granted in respect of these rules will no longer be effective. The PRA recognises that this may not leave sufficient time for affected firms to apply for a higher non-core large exposures group (NCLEG) permission. The PRA proposes therefore that affected firms be offered a modification by consent to maintain the current position until March 2026. The PRA considers that this will allow affected firms sufficient time to apply for the higher NCLEG permission. NCLEG non-trading book and trading book permissions that were granted by the PRA prior to the effective implementation date would remain in place. Firms would no longer be required to allocate the trading book exposures they have to their NCLEG in ascending order of specific-risk requirements.

1.15 The proposal to remove the possibility for firms to use IM methods to calculate exposure values to SFTs would take effect on 1 January 2026.

Responses and next steps

1.16 This consultation closes on Friday 17 January 2025. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP14_24@bankofengland.co.uk. Please indicate in your response if you believe any of the proposals in this CP are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

2: Calculation of Exposure Value – Securities Financing Transactions

2.1 In PS17/21, the PRA removed the option for firms to use IM methods to calculate exposure values to derivatives. However, for LE purposes, firms with permissions to use IM methods for counterparty credit risk can continue to use this method for calculating the exposure values to SFTs.

2.2 The PRA is proposing to remove the option for firms to use IM methods to calculate exposure values to SFTs. Firms can continue to use the financial collateral comprehensive method (FCCM) as set out in the revised credit risk framework. The credit risk framework was revised as part of the Basel 3.1 standards and the UK implementation was finalised on 12 September as set out in PS9/24 – Implementation of the Basel 3.1 standards near-final part 2. The FCCM was updated to make the volatility adjustments (to reflect possible future volatility in the value of the collateral) more risk-sensitive, and to introduce a revised formula for reflecting the effect of eligible master netting agreements (MNA) across multiple SFTs. These changes will have a consequential impact on the calculation of exposure values for LE purposes.

2.3 The PRA considers that, compared to IM methods, the FCCM provides better estimates of the maximum loss that a firm could suffer in the unforeseen event of a counterparty failing. This approach is better aligned with the objectives of the LE framework and international standards to maintain safety and soundness.

2.4 The PRA does not expect this proposal to have a material impact on firms. Firms with permissions to use IM methods to measure exposures to SFTs may see an increase in reported LE when calculating exposure values using the FCCM.

PRA objectives analysis

2.5 The PRA considers that the proposals set out in this chapter would advance its primary objectives of safety and soundness. Removing the use of IM methods for calculating exposure values for SFTs will ensure that firms use a more appropriate calculation method that will be better at capturing the maximum loss that a firm could suffer in the event of a sudden default of a counterparty or a GCC. It would also align with international standards and result in a more consistent approach being applied across all firms.

2.6 The proposals set out in this chapter may result in higher exposures being reported for firms with IM permissions, and the impact of the proposed changes will depend on the size of a firm’s SFTs book. The PRA considers that firms reporting higher exposure values will lead to greater oversight of potential losses that firms could suffer, which would help to ensure that exposures levels remain prudent, consistent with the PRA’s primary objective.

2.7 The PRA considers that the proposals set out in this chapter would advance the PRA’s secondary objective of facilitating effective competition. The proposals will lead to a consistent approach applied across all firms, regardless of whether firms have IM permissions in place.

‘Have regards’ analysis

2.8 In developing these proposals, the PRA has had regard to its framework of regulatory principles. The regulatory principles that the PRA considers are most material to the proposals include:

• Proportionality: The PRA considers that the proposals in this chapter are a proportionate response to the need for a more appropriate approach to measure SFT exposures, and to better reflect the risks that the LE framework is designed to capture. The proposed changes to remove the use of IM methods to calculate exposure values to SFTs may increase some firms’ operational costs, because these firms would have to calculate different exposure values for credit risk and LE purposes. The PRA expects the overall costs for these firms to implement the FCCM approach to be low because it is a simpler approach.
• Finance for the real economy: The PRA considers that its proposals relating to the removal of IM methods for calculating exposure values for SFTs would be unlikely to have a material impact on finance for the real economy. Based on recent regulatory reports and the PRA’s own assessments of the likely increase in exposure values, the impact on firms are not expected to be material.

3: Limits to Large Exposures – Trading Book Exposures

Trading book exposures to third parties

3.1 The LE framework limits a firm’s exposure to a single counterparty or a GCC to 25% of its Tier 1 capital or £130 million, whichever is greater. The higher limit of £130 million applies to firms’ exposures to institutions where firms report Tier 1 capital of £520 million or less. For the purposes of this chapter, LE limits will refer to these limits. A firm can exceed these limits for exposures to each counterparty or GCC in the trading book by up to 500% of its Tier 1 capital. Any excesses to all counterparties or GCCs that have persisted for more than 10 days may not, in aggregate, exceed 600% of the firm’s Tier 1 capital. We refer to this allowance as the trading book excess allowance. This measure was introduced prior to 2008 to facilitate investment banks’ booking arrangements.

3.2 The trading book excess allowance is subject to a punitive capital requirement which increases incrementally as the excess over the LE limit increases. To calculate this additional capital requirement, firms must allocate their trading book exposures in ascending order by specific risk requirements. The PRA considers that this calculation method could be simplified.

3.3 Permitting a firm to exceed limits in the trading book exposes a firm to a significantly higher maximum loss in the unforeseen event of a failure of a single counterparty or a GCC which could hinder a firm’s ability to operate as a going concern. This is a particular concern for firms’ exposures to counterparties that are not within the same banking group, as it increases the size of contagion risk within the financial system. The additional capital that firms are required to maintain is likely to be small compared to the size of the maximum loss allowed and is unlikely to be sufficient to protect firms from large losses resulting from a sudden default of a counterparty. The PRA considers that this does not align with the objectives of the LE framework.

3.4 The PRA is proposing to remove the trading book excess allowance for firms’ trading book exposures to third parties, requiring firms to limit their exposures to these entities to 25% of Tier 1 capital or £130 million, whichever is higher. This would be a significant step towards promoting safety and soundness of PRA regulated firms and aligning with international standards.

3.5 The PRA is aware of a few instances where firms have reported using the trading book excess allowance for exposures to third parties in the past, none of which exceeded the LE limits by more than 7% of these firms’ Tier 1 capital. The PRA has not identified any firms using this allowance in the last two years. The PRA therefore considers that removing this trading book excess allowance for exposures to third parties is unlikely to have a material impact on firms.

Trading book exposures to intragroup entities

Background

3.6 A firm’s exposures to its own parent undertaking or to other subsidiaries within its group are treated the same as exposures to a third party, unless the firm has a permission granted by the PRA to exempt these exposures. As entities in the same consolidation group are together considered a GCC, members in the firm’s own group should also be considered a GCC, and LE limits would apply accordingly. This approach is designed to reduce contagion risk within a banking group.

3.7 When setting its prudential requirements and deciding whether to exempt firms’ exposures to entities in their own group from LE limits, the PRA considers the overall business model of a group as well as the strength of the relationships of the entities within that group. Several entities within a banking group may operate together as if they were a single entity to manage funding, liquidity, and risk more efficiently. In such situations, where group entities are strongly incentivised to support each other, the PRA may permit intragroup exposures to exceed the LE limits.

3.8 A firm can apply to the PRA, subject to CRR conditions being met, to assign a 0% risk weight to exposures to certain entities established in the United Kingdom within its consolidation group. These exposures are exempt from the LE limits and are also excluded from a firm’s leverage ratio. All the entities included in this permission are referred to as a firm’s core UK group (CUG). These permissions are not affected by proposals in this CP.

3.9 A firm can also apply to the PRA to increase its total exposures to certain cross-border group entities from 25% to 100% of Tier 1 capital. The PRA expects these entities to meet the same conditions as for CUG permissions except for the condition that such entities are established in the United Kingdom. These entities are referred to as the non-core LE group (NCLEG).

3.10 A firm’s exposures to members of its group that are not included in a CUG or an NCLEG, remain subject to a limit of 25% of the firm’s Tier 1 capital or £130 million, whichever is higher.

3.11 Trading book exposures to a firm’s NCLEG may exceed the 100% limit to its NCLEG. This excess will be added to exposures incurred by the firm to members of its group that are not included in a CUG or an NCLEG. The sum of these exposures will be limited to 25% of the firm’s Tier 1 capital or £130 million, whichever is higher. Firms can exceed this limit for exposures in the trading book using the trading book excess allowance.

3.12 The trading book exposure assigned to the excess amount depends on the specific risk requirements for position and settlement risk in the Market Risk framework. Firms must allocate exposures to its trading book exposure allocation in ascending order of exposures that attract the highest specific-risk requirements. This adds to the complexity of calculating the amount of intragroup exposures that can be exempt under PRA rules and the calculation of the additional capital requirement, if firms make use of the trading book excess allowance. For this reason, firms must apply separately for an ‘NCLEG non-trading book permission’ and an ‘NCLEG trading book permission.’

Trading book excess allowance for intragroup exposures

3.13 SS5/21 – International banks: The PRA’s approach to branch and subsidiary supervision, sets out its approach to supervising international banks with activities in the UK. This includes the PRA’s expectations of firms’ booking arrangements. Firms have different booking and risk management structures, and the PRA is open to firms operating a diverse range of booking arrangements if there are effective systems and controls in place.

3.14 The PRA considers that removing the trading book excess allowance for firms’ exposures to members of its group could lead to fragmentation of risk management and undermine the effectiveness of existing risk management and controls.

3.15 Therefore, the PRA is proposing to keep the trading book excess allowance for firms’ exposures to members within its groups. The PRA proposes a more conservative excess allowance limit to balance the risk of excessive intragroup contagion risk with the benefits of effective risk management and control practices. The trading book excess allowance would remain subject to an additional capital requirement, but the PRA proposes to simplify the calculation of the additional capital requirement.

3.16 The PRA is proposing that firms should meet the following requirement to use the trading book excess allowance;

• firms' exposures to members of their own group in the non-trading book do not exceed 25% of firms’ Tier 1 capital or £130 million, whichever is higher;
• firms’ exposures to members of their own group in the trading book do not exceed 85% of firms’ Tier 1 capital; and
• firms meet an additional capital requirement on the part of the exposure that exceeds the LE limit, equal to 100% of the amount of the excess.

3.17 Based on historical regulatory data, the PRA considers that the proposed limits are sufficient to reduce excessive concentration risks to intragroup entities while allowing firms to maintain their current risk management and control practices. Introducing a simple calculation for the additional capital requirements means that firms would no longer have to allocate their trading book exposures in order of ascending risk requirements as described in paragraph 3.12. Simplifying this calculation means that firms would no longer have to apply for two separate NCLEG permissions. The PRA is therefore proposing amendments to allow firms to apply for a single ‘NCLEG permission.’ This permission would exempt firms’ exposures to intragroup entities within the NCLEG on both non-trading and trading book. The PRA is not proposing to make any changes to the conditions that firms must meet in order to gain NCLEG permissions.

3.18 The PRA considers that these proposals would allow firms to maintain their current booking arrangements without disrupting effective risk management and control practices, while promoting the safety and soundness of firms by introducing more prudent limits to reduce intragroup contagion risk. As firms are expected to benefit from the simplicity of the rules and the additional clarity provided, the PRA does not expect any firm to be materially impacted by these proposals.

Changes to NCLEG limits for Intragroup Exposures

3.19 In PS17/21, the PRA implemented a requirement that firms could continue to use the method for determining the exposure values to derivatives that they are using for risk-based capital requirements but are not allowed to use IM methods for LE purposes.

3.20 The PRA assessed the impact of the standardised approach for counterparty credit risk (SA-CCR) on firms’ LE to third parties and found it not to be material. However, the PRA found that the impact of moving from IM methods to SA-CCR had a material impact on several firms’ intragroup exposures and subsequent additional capital requirements for LE in the trading book. As a result, the PRA stated that in cases where the impact of applying SA-CCR for LE purposes had a significant impact on a firm’s LE to its NCLEG, the PRA would consider applications to modify the relevant NCLEG limits to offset the impact of applying SA-CCR rather than IM methods. These modifications meant that firms with IM permissions did not have to make changes to their booking arrangements and they allowed the PRA time to review its approach on intragroup trading book exposures in the LE framework.

3.21 SS5/21 sets out the PRA’s approach to supervising international banks with activities in the UK, in line with its principle of responsible openness towards international business.^{footnote [2]} The PRA is open to hosting highly integrated international banking operations, recognising the efficiency benefits these can bring, and in line with its secondary objective to facilitate the international competitiveness and growth of the UK economy.

3.22 In May 2022, the PRA also published SS1/22 – Trading activity wind-down which sets out the PRA’s expectation in respect of firms engagement in trading activities that may affect the financial stability of the UK. The PRA expects such firms to have a set of capabilities that will allow them to execute a full or partial wind-down of any trading activities in an orderly fashion (hereinafter referred to as trading activity wind-down, or TWD). Firms will be expected to meet the expectations in SS1/22 by March 2025. The enhanced set of capabilities will provide a firm with more information and procedures to address and control concentration risk to intragroup trading book exposures, which is one of the conditions for granting an NCLEG permission. It will also enhance supervisory oversight of the risks in a firm’s trading book.

3.23 The PRA is proposing to allow all firms (not just those with IM permission) to apply for a higher NCLEG permission. The PRA proposes that the higher NCLEG would permit those firms meeting the requirements set out in SS1/22 to apply for an NCLEG limit up to 250% of a firm’s Tier 1 capital. The proposed enhanced risk management and control requirements will be in addition to the current conditions that firms must meet when applying for an NCLEG permission. Firms should note that the PRA would still need to make a wider judgement on whether it is appropriate to grant this treatment even where the conditions are met.

3.24 The PRA considers that allowing firms to apply for a higher NCLEG limit would allow the PRA to consider the benefits of risk efficiencies in firms’ current booking arrangements versus higher intragroup concentration risk, thereby promoting safety and soundness. An NCLEG permission would not be needed if the higher NCLEG permission were granted.

3.25 The PRA proposes that firms applying for the higher NCLEG permission are required to demonstrate that they meet the same set of conditions as applying for the NCLEG permission. The PRA also proposes the following additional conditions to be met, which is specified in the updated SS16/13:

• the purpose of the higher limit is to facilitate booking arrangements and ensure that firms meet PRA expectations in SS5/21; and
• firms must demonstrate that they have robust plans in place to ensure a solvent wind-down and that they meet all the expectations in SS1/22.

PRA objectives analysis

3.26 The PRA considers that these proposals would allow firms to maintain their current booking arrangements without disrupting effective risk management and control practices. Although firms can increase their exposures to intragroup entities, the PRA considered that the additional expectations regarding risk management and control and robust solvent wind down plans will mitigate the higher concentration risk without impacting on the PRA’s safety and soundness objectives. As firms are expected to benefit from the simplicity of the rules and the additional clarity provided, the PRA does not expect any firm to be materially impacted by these proposals.

3.27 The proposals in this chapter of the CP are expected to promote the safety and soundness of firms. Removing the use of the trading book excess allowance for exposures to third parties would help to ensure that firms limit their exposures to third parties in a prudent manner. Simplifying the calculation of additional capital requirements for firms’ LE in the trading book will also improve consistency and comparability across firms.

3.28 The proposals to amend the rules on firms’ exposures to intragroup entities are expected to promote the safety and soundness of firms. The proposals are also underpinned by the PRA’s expectations of firms’ booking arrangements. The PRA is also proposing to introduce a more consistent and transparent approach for firms applying for higher intragroup permissions. This proposal is also likely to provide incentive for firms to meet the solvent wind-down requirements.

3.29 The PRA considers that the proposals set out in this chapter would enhance the PRA’s secondary objective of facilitating effective competition and growth. Removing the trading book excess allowance for exposures to third parties would not lead to firms having to make changes to their existing booking arrangements and would not have an impact on competitiveness. The PRA considers that the proposal to remove the trading book excess allowance for firms’ exposures to third parties is aligned with the Basel LEX standards. Although firms made very limited use of this allowance, the potential to greatly exceed LE limits for exposures in the trading book could weaken the LE framework. Proposals on intragroup exposures are outside of the scope of the Basel LEX standards.

‘Have regards’ analysis

3.30 In developing these proposals, the PRA has had regard to its framework of regulatory principles. The regulatory principles that the PRA considers are most material to the proposals include:

• Sustainable growth: The PRA considers that the proposals set out in this chapter, would support sustainable growth. The proposals would enhance the safety and soundness of firms and simplify the treatment of trading book exposures without changing the status quo in terms of firms booking models and therefore the UK’s status as an international financial hub.
• Transparency: The PRA considers that its proposals in this chapter would contribute to the transparency of regulatory activities. Simplifying the application of the trading book excess allowance and associated additional capital requirement calculations are likely to improve transparency.
• Proportionality: The PRA considers that the proposals in this chapter are a proportionate response to the need to strengthen the LE framework and to ensure firms’ safety and soundness. Proportionality is demonstrated in particular in the PRA’s proposals to simplify the LE framework, while allowing firms higher intragroup exposure limits in order to maintain their current booking arrangements.
• Encouraging economic growth in the interests of consumers and businesses and promoting competitiveness: Please refer to the discussion of how the proposed approach facilitates competitiveness and growth in the section ‘PRA objectives analysis’ above.

4: Calculating the effect of the use of credit risk mitigation techniques

4.1 The LE framework requires firms to limit their exposures to a counterparty or a group of connected counterparties after taking into account the effect of CRM. Eligible CRM can take the form of:

• funded credit protection (FCP): a type of CRM that reflects financial or non-financial collateral held against an exposure, which the firm can retain or liquidate in case of the default of a borrower or counterparty. It also includes the use of on-balance sheet netting and MNAs; and
• unfunded credit protection (UFCP): a type of CRM that reflects the promise from a third party to pay when a borrower or counterparty defaults.

4.2 While CRM can be used to reduce exposures for LE purposes, the resulting indirect exposures to collateral issuers of FCP and protection providers of UFCP are not captured. Reducing exposures in this way when applying LE limits, without recognising these indirect exposures means that firms could potentially have large concentrations to collateral issuers and protection providers. To address this risk, the Basel LEX standards require mandatory substitution to apply to all exposures reduced by eligible CRM. This means that when a firm reduces an exposure to a counterparty using eligible CRM, it must reassign the portion of the exposure that is reduced to the collateral issuer or the protection provider as the counterparty for LE purposes.

4.3 The PRA considers the mandatory substitution approach an important enhancement to the LE framework and consulted the industry on implementing this approach in February 2021. Several respondents asked for further clarifications and guidance on the application of the proposed rules. The PRA considered industry feedback and conducted further policy analysis and an impact assessment in 2022 and 2023.

4.4 The PRA proposes that firms apply the mandatory substitution approach as consulted on in 2021, and with the following additional proposals to provide further clarifications.

4.5 The PRA proposes to clarify that where a firm reduces an exposure to a client using an eligible CRM technique, the firm must treat the reduced part of the exposure (the recognised amount) as having been incurred to the collateral issuer or the protection provider. The recognised amount assigned to the collateral issuer or protection provider will be (a) the exposure value before taking into account the effect of CRM, where applicable, minus (b) the exposure value, after taking into account the effect of the CRM. This recognised amount will be:

• in the case of UFCP, the value of the protected portion of the exposure;
• the market value of the portion of claim collateralised by the recognised financial collateral when the firm uses the financial collateral simple method;
• the value of the collateral as recognised in the calculation of the counterparty credit risk exposure value for any instruments with counterparty credit risk; and
• the market value of collateral adjusted after applying the required haircuts, in the case of financial collateral when the bank applies the financial collateral comprehensive method.

4.6 For exposures that are over-collateralised, firms would not need to assign an exposure to a collateral provider that exceeds the amount by which the original exposure is reduced. Where the collateral includes multiple financial instruments, firms can decide which amounts to be assigned to which collateral issuer.

4.7 When the PRA previously consulted on implementing the substitution approach, four respondents suggested that sovereign exposures should not fall within the scope of mandatory substitution requirements, as the framework should not constrain the use of government bonds as eligible collateral. Sovereign exposures are exempt from LE limits if the sovereign is assigned a 0% risk weight for credit risk purposes. The PRA considers that the existing treatment is prudent for LE purposes. In this consultation we are proposing to maintain the PRA’s existing policy that exposures to sovereigns are exempt from LE limits where they receive a 0% risk weight for the purpose of calculating credit risk capital requirements.

4.8 The PRA’s impact assessments suggest that, to implement this proposal, some firms may need to consider reducing exposures to certain collateral issuers or protection providers, but the overall impact is unlikely to be material. The PRA considers the mandatory substitution approach an effective tool in reducing firms’ concentration risk and advancing the safety and soundness of PRA regulated firms. Based on that, the PRA considers that the expected firm impact is justified and would act to control prudential risks appropriately, as intended.

PRA objectives analysis

4.9 The PRA considers that implementing the mandatory substitution approach, as set out in CP5/21 would facilitate the safety and soundness of firms. The PRA’s additional proposals in this CP aim to provide further clarity on the application of the substitution approach, which would help firms monitor, control and report their indirect exposures.

4.10 The proposals in this chapter will not impact on the competitiveness of UK firms given that many jurisdictions have already aligned with the Basel LEX standards in this regard, rather it will contribute to levelling the playing-field between UK firms and firms in other jurisdictions.

‘Have regards’ analysis

4.11 In developing these proposals, the PRA has had regard to its framework of regulatory principles. The regulatory principles that the PRA considers are most material to the proposals include:

• Sustainable growth: The PRA considers that the application of the substitution approach as set out in this chapter would support sustainable growth. Providing greater clarity and certainty on how indirect exposures from recognising eligible CRM are reassigned to collateral issuers and protection providers would reduce firms’ potential exposures to these counterparties and prevent the build-up of excessive concentration risk in the wider economy. This would promote financial stability and support sustainable growth.
• Transparency: The PRA considers that its proposals to clarify the use of when the substitution method applies and specifying that it must be used when either the FCCM or FCSM methods are used will contribute to the transparency of regulatory activities. The proposals make it clear that firms must report exposures to collateral providers, which should prevent firms from failing to report indirect exposures. Providing greater clarity on the use of the substitution approach should make it easier for firms and other stakeholders to understand and apply the LE framework.
• Proportionality: The PRA considers that the proposals set out in this chapter would be a proportionate response to the need to enhance the approach to calculate the effect of CRM and capture the concentration risk to collateral issuers and protection providers. The PRA considers its proposals to be proportionate as they impose the same requirements to firms using collateral for CRM purposes, whether they operate using FCCM or FCSM without penalising any specific group of firms.

5: Exceptions, Exemptions and Reciprocation

Exposures arising from mortgage lending

5.1 In the credit risk framework, a number of CRM techniques, such as immovable property and certain physical collateral, are allowed to be used to reduce exposures under the internal ratings-based (IRB) approach, but not under the standardised approach.

5.2 In the LE framework, firms are not allowed to use CRM techniques that are only available under the IRB approach, except for exposures that are partially or fully secured by residential or commercial immovable property if certain conditions are met. The exposure amount that can be reduced is capped at 50% of the market value, or 60% of the mortgage lending value of the property.^{footnote [3]}

5.3 The PRA is proposing to remove this allowance. Immovable property can be illiquid, especially in stress scenarios, therefore is unlikely to be an effective mitigant in preventing a firm from experiencing financial difficulties or failing due to a counterparty default. The PRA considers that this would reduce prudential risks appropriately as well as facilitate competition between firms that use the standardised approach and firms that use the IRB approach.

5.4 Some firms are currently using immovable property to reduce exposures to clients although, based on recent regulatory reports, it would not result in firms breaching LE limits if the allowance were removed.

Exempting exposures to the UK deposit guarantee scheme

5.5 Firms’ exposures arising from the funding of the UK’s DGS, the Financial Services Compensation Scheme (FSCS),^{footnote [4]} are currently exempt from LE limits.

5.6 The PRA does not consider an exposure to the UK’s DGS as an exposure to a sovereign and therefore exempting these exposures from LE limits does not align with international standards. The PRA is therefore proposing to delete this exemption although the PRA does not have prudential concerns regarding firms’ exposures to the UK’s DGS. Firms are currently reporting very small exposures to the FSCS relative to their Tier 1 capital and this proposal is unlikely to have a material impact on firms.

Stricter requirements for exposures of G-SIIs and O-SIIs to certain French counterparties

5.7 In 2018, The European Systemic Risk Board (ESRB) recommended European Economic Area (EEA)-wide reciprocation of a macroprudential measure imposed by the Haut Conseil de Stabilité Financière (HCSF) in France (‘the HCSF measure’).

5.8 The HCSF measure lowered the LE limit for French Global Systemically Important Institutions (G-SIIs) and French Other Systemically Important Institutions (O-SIIs) in respect of their exposures to French non-financial corporations (NFCs) that are ‘highly indebted.’ The limit was reduced from 25% to 5% of these institutions’ Tier 1 capital.

5.9 In PS24/19 – Large exposures: Reciprocation of French measure, the PRA implemented policy changes to reciprocate the French measure in October 2019, following a request from HM Treasury and the Financial Policy Committee’s (FPC) review of the ESRB recommendation. The measure tightened the LE limit for systemically important banks for exposures to highly indebted French NFCs to 5% of a firm’s eligible capital.^{footnote [5]} This measure came into effect from 1 January 2020.

5.10 Following the withdrawal of the HCSF measure in 2023, the PRA proposes to remove this stricter requirement in the PRA LE Rulebook.^{footnote [6]} As this is a small market segment, and there is no indication that UK firms have appetite to substantially increase their exposures to these highly-indebted French NFCs, the PRA expects that the impact of removing this macroprudential measure to be minimal for UK’s financial stability. The PRA also considers that this removal would not have adverse impact on the PRA’s primary objective to promote the safety and soundness of firms, or secondary objectives of facilitating effective competition in the markets for services provided by firms and UK’s international competitiveness and growth.

PRA objectives analysis

5.11 The PRA considers that removing the exception to allow immovable property as eligible CRM will promote the safety and soundness of firms. This is because immovable property is likely to be illiquid, especially during a period of stress, which would lead to firms underestimating their expected losses if a counterparty were to fail. The proposal to remove the exemption of exposures to the UK DGS and the removal of the stricter measure applied to certain French counterparties are unlikely to impact on the PRA’s objective to promote the safety and soundness of firms.

5.12 These proposed measures would align the PRA’s LE framework with international standards facilitating a robust regulatory framework leading to greater confidence in the financial soundness of banks, thereby promoting competitiveness and growth.

‘Have regards’ analysis

5.13 In developing these proposals, the PRA has had regard to its framework of regulatory principles. The regulatory principles that the PRA considers are most material to the proposals include:

• Efficient and economic use of PRA resources: The PRA considers that the proposals are in line with efficient use of PRA resources given that less time will be spent monitoring compliance with these requirements.

5.14 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for this proposal, it is because the PRA considers that ‘have regard’ to not be a significant factor for this proposal.

6: Cost Benefit Analysis (including equality and diversity implications)

Cost benefit analysis (CBA)

6.1 In developing the proposals set out in this CP, the PRA has had regard to its objectives and a range of factors that contribute to the CBA. The baseline for the CBA is the current LE rules as set out in the PRA Rulebook.

6.2 Where proposals introduce changes to existing policy, the PRA has considered the additional costs and benefits. Overall, relative to the baseline of current rules, the PRA considers that the benefits of these proposals exceed the costs involved.

6.3 We amended this CBA following consultation with the CBA Panel. The two most significant changes were to: address the potential impacts of the proposed changes in stress scenarios; and highlight that there is some uncertainty around the operational costs associated with the mandatory substitution approach.

Costs

Costs to PRA

6.4 The proposed policy changes would not affect the PRA’s approach to the supervision of the UK firms. The proposed measures would not require substantial new resources from the PRA to supervise firms or to review the regulatory returns. Simplifying the calculation of the additional capital requirement for firms’ intragroup exposures in the trading book will make it easier to supervise and require less resources.

Costs to firms

6.5 There may be limited costs in applying the mandatory substitution approach for some firms who have exposures collateralised by government bonds and where those governments are not exempt from LE limits. The PRA’s impact assessments suggests that one firm might have to decrease exposures to two counterparties, none of which would breach LE limits by more than 5% of Tier 1 capital. We therefore expect cost to firms would be minor. Given that these costs will not be material, we do not anticipate that there will be a negative impact on liquidity in the rest of the repurchase agreement (repo) market.

6.6 The PRA also expects that there would be some costs to reporting indirect exposures to collateral providers. The mandatory substitution approach is only a requirement if firms use the collateral for calculating capital requirements under the credit risk framework, meaning that firms will already be monitoring these data and they should be readily available. The PRA’s reporting form will not change, so the PRA expects this cost to be of minimal significance. However, there may be additional costs associated with reporting these data and we welcome feedback from firms on these costs.

6.7 We do not anticipate that the proposal to remove the trading book excess allowance for firms’ exposures to third parties will increase costs to firms. That is because firms are not currently using this allowance. Similarly, reducing the trading book excess allowance limit for firms’ intragroup exposures in the trading book is unlikely to increase the costs as this limit was calibrated to ensure that no firm would have to make changes to their booking models to align with the new proposals.

6.8 The PRA expects that the costs to firms from the other measures proposed in this CP would be minimal in that they impose few additional constraints on firms. Based on recent regulatory data, no firm will breach LE limits as a result of the changes proposed in this CP that would impact on firms’ exposures to the UK DGS, and mortgages secured by immovable property. Based on current data, only one firm may be affected by the change relating to SFTs. UK firms currently have no significant exposures to entities that were subject to the French reciprocity measure and the PRA considers that there would be no impact on firms if this measure was withdrawn.

6.9 While these rule changes will have a limited impact given firms current practices, they limit firms’ ability to increase exposures of the affected types in future. This cost is, however, limited because in exceptional cases where firms do breach LE limits, firms may apply to the PRA which may, where the circumstances warrant it, allow a firm a limited period of time in which to comply with the limit.^{footnote [7]}

Benefits

6.10 Relative to the baseline of current rules, the proposals in this CP would strengthen the LE framework and lead to some improved efficiency and clarity for firms, by:

• clarifying the use of the substitution approach and how exposures to collateral can be valued and assigned to collateral issuers and providers of unfunded credit protection. The substitution approach will make it easier to monitor exposures to collateral issuers. This will reduce compliance costs to firms;
• simplifying the use and application of the trading book excess allowance, allowing it only for intragroup exposures, and simplifying the risk weights assigned to trading book excesses, making easier for firms to use and report the use of the allowance, again reducing compliance costs;
• removing the exemption to exposures secured by immovable property, the UK DGS, and SFTs would further the safety of UK firms, allowing firms to calculate exposures and appraise risk in a more prudent way; and
• by merging the Large Exposures Part of the PRA Rulebook with the Large Exposures (CRR) Part, the PRA Rulebook would be made more accessible and have greater clarity as to their obligations. Again, reducing costs to firms.

6.11 Furthermore, aligning the LE Parts of the PRA Rulebook with international standards would also contribute to the level playing field and, at the margin, support confidence in and compliance with international standards. Compliance with these standards supports financial stability and competition between firms leading to higher UK economic output in the medium to long term.

6.12 As noted above, the proposed changes have a limited impact on firms because firms currently manage their exposures to third parties within the large exposure limits and, other than a few exceptional cases, have sufficient headroom to absorb the impact of the proposed changes. The proposed changes would ensure that over the medium-to-long term and in potential future stress scenarios, firms do not build up excessive exposures to counterparties or GCCs which could help reduce the risk of disorderly firm failures and, potentially, mitigate risks to financial stability.

Conclusion

6.13 The PRA considers that the costs of these proposals are likely to be proportionate to the benefits of the proposals, given their relatively limited costs and the potential benefits which flow from complying with international standards, and providing firms’ additional clarity which can reduce their compliance costs.

Impact on mutuals

6.14 The PRA considers that the impact of these policy proposals on mutuals is expected to be no different from the impact on other firms. The calculation of LE is as important to mutuals as it is for other firms, so mutuals are expected to benefit as much as other firms from the clarifications and simplification of the PRA rules proposed in this CP. Moreover, mutuals are less likely to be impacted by the main proposals on SFTs, or the Trading Book and substitution approach, due to their generally smaller trading book exposures.

Equality and diversity

6.15 The PRA considers that the proposals do not give rise to equality and diversity implications.