What does the future hold for the prudential regulation of smaller banks in the UK in the wake of SVB? Michael Raffan (Partner & Global head of the Financial Services Regulatory Practice, Corporate and M&A), Elisabeth Overland (Counsel, Corporate and M&A), Fran Kahr (Associate) and Brian Rance (Partner) at law firm Freshfields Bruckhaus Deringer consider the regulatory lie of the land.
As the dust settles on the failure of Silicon Valley Bank (SVB) and the resolution of its UK subsidiary, Silicon Valley Bank UK Limited (SVB UK), regulators will be reflecting on the broader significance of SVB’s failure for banking regulation in the UK.
Relevant questions will likely include:
- What does the future hold for the prudential regulation of smaller banks?
- Does the UK approach to bank resolution need to be revisited?
A simplified prudential regime for smaller banks
The Prudential Regulation Authority (PRA) has been working on plans to introduce a “strong and simple” prudential framework for smaller banks and building societies which it considers to be neither systemically important nor internationally active.
The PRA has, so far, consulted on proposed rules, on scope and non-capital related rules, under the most simplified layer of this framework for the smallest firms. It aims to increase the proportionality of prudential rules while maintaining firms’ resilience and the stability of the UK financial sector.
The PRA considered that these changes would enhance the attractiveness of the UK as a place for banking groups to do business, drawing inspiration from approaches taken in other jurisdictions, including the US (as referred to in the initial announcement by the PRA’s CEO, Sam Woods).
US and Dodd-Frank
In the US, legislation adopted in 2018 relaxed the regulation of US banking institutions with total assets below $250bn, revising the criteria for determining the applicability of the enhanced prudential standards originally implemented under Dodd-Frank. The 2018 legislation broadly increased the threshold above which US bank holding companies and intermediate holding companies are subject to the full set of enhanced prudential standards from $50bn in consolidated assets to $250bn in consolidated assets.
In addition, the legislation introduced a number of modifications for US bank holding companies and intermediate holding companies that have, broadly, between $100bn and $250bn in consolidated assets, including with respect to relaxation of capital requirements, disapplication or reductions in liquidity coverage requirements, disapplication of company run stress-tests, reduction in the frequency of supervisory stress testing and liquidity stress testing, as well as a reduction in the frequency of collateral position calculations and a disapplication of single counterparty credit limits.
As with most bank failures, SVB’s collapse followed a run on deposits caused by a loss in confidence, and in an age of digital banking that run happened rapidly. Whilst the primary cause of SVB’s collapse seems to be its poor management of interest rate risk and liquidity risks, we cannot say with certainty that these were not facilitated by relaxed prudential standards. While risky business models may to some extent be prevented by the imposition of appropriate regulatory standards and supervision, there is little that increased regulation can do to stave off failure following a loss of confidence, as not even the most stringent prudential requirements will save a bank in the event of a bank run (in particular, considering the rapid pace at which today’s technology enables a run to unfold). That is why a resolution regime designed to ensure an orderly failure is so important.
However, given the turmoil in the US banking system following the failure of SVB, the Federal Reserve is conducting a review of the regulatory framework applicable to mid-sized banks focusing on whether its supervision of SVB was appropriate for the rapid growth and vulnerabilities of the bank, including with respect to interest rate and liquidity risks, and whether the application of more stringent standards would have prompted SVB to better manage the risks that led to its failure. A group of US Democratic senators has recently proposed a bill to repeal the 2018 legislation in order to bring mid‑sized banks back in scope for the full set of Dodd-Frank enhanced requirements.
UK ‘Strong and Simple’ reforms
UK stakeholders have taken note of these developments. Almost immediately after SVB’s failure, warnings began to be sounded that the UK should be careful of going down a similar road as the US, potentially weakening regulation in order to enhance competition. This will no doubt involve a need for the PRA to reconsider certain elements of its “strong and simple” plans.
In the specific case of SVB UK, it is unclear whether the reforms proposed by the PRA would, in fact, have resulted in a different level of regulation. Based on the proposed rules for the most simplified regime, the general conditions may have been satisfied so that SVB UK would have fallen within the lighter touch regime; for example, SVB UK’s assets fell under the threshold of £15 billion (which is significantly lower than the threshold in the US), and SVB UK’s business seems to have been concentrated in the UK, such that it may not have had any significant credit exposures to non-UK obligors.
However, as part of a group based outside the UK, different considerations would have applied to SVB UK since the proposed definition of a ‘Simpler-regime Firm’ would not operate effectively beyond a UK consolidation level. However, the PRA intended that such firms would be able to apply for a waiver or modification to be treated in the same way as a Simpler-regime Firm if they met the scope criteria at the level of the UK consolidation group. In the waiver or modification assessment, the PRA would consider whether, in the specific circumstances, the size and activities of the group at a global level were consistent with the firm suffering from the complexity problem (i.e. where costs of understanding, interpreting and operationalising prudential requirements are higher in comparison to the contributions those requirements make to safety and soundness for smaller firms than for larger firms). Where that is the case, the firm would likely be able to access the simpler regime. SVB UK’s position could therefore have depended on the PRA’s specific analysis.
However, regardless of SVB UK’s particular position, the regulator may be expected to review its plans in light of recent events and the unfolding debate in both the UK and the US. Potential implications may include:
- a careful consideration of any easing of capital and liquidity requirements for smaller banks, which is expected to be considered in a PRA consultation due in the first half of 2024;
- a consideration of the inter-connectedness with foreign parents;
- a reluctance to extend any ‘simpler regime’ proposals beyond the smallest banks to mid-sized banks, with the result that the threshold for full compliance with international standards may be set at a higher level than previously anticipated.
It seems to us that there is no reason in principle to abandon altogether the “strong and simple” reforms, or significantly to amend those proposals for the smallest banks that have already been published, particularly given the threshold proposed by the PRA. Much of the substance of the regime is still undefined, enabling the regulator significantly to adjust its plans, if appropriate, without needing to go back on existing proposals.
Revisiting the approach to bank resolution
In addition to day-to-day banking regulation, it is also worth considering SVB’s failure in light of the UK approach to bank resolution.
The UK’s resolution regime, introduced after the financial crisis, recognises that insolvency or administration proceedings may not always be the most appropriate path for a failing bank. A “special resolution regime” may be applied by the Bank of England, as resolution authority, in certain circumstances, with available tools including a transfer of the bank to a private sector purchaser (as deployed in the case of SVB UK), the use of a bridge bank (with the bank being transferred to a company owned by the Bank of England pending a transfer to a private sector purchaser) and bail-in.
These powers are primarily aimed at large and systemically important banks and can only be exercised if certain conditions are met.
One of the conditions for the exercise of resolution powers is that resolution is in the public interest. The Bank of England’s “approach to resolution” document makes clear that this will be assessed based on factors including “the size and nature of the critical functions of the failed firm and conditions in the wider financial system at the point of failure”. The document also explains that the Bank of England must consider whether its resolution objectives would be met to the same extent by placing the firm into statutory insolvency, such as the bank insolvency procedure initially considered for SVB UK.
SVB UK’s successful resolution suggests that the current resolution framework is flexible enough to allow the Bank of England to react to specific cases which fall outside the parameters contemplated in the Bank of England’s approach document. Nevertheless, SVB UK’s case may have caused increased awareness among stakeholders of the breadth of factors that may be relevant, and that size and systemic importance to the financial system as a whole are not always a good proxy for the appropriate resolution strategy in any particular case. Other points, such as systemic importance to and concentration within a particular sector, may be just as central.
Silicon Valley Bank’s failure should not discourage UK banking deregulation