BANK OF ENGLAND PRUDENTIAL REGULATION AUTHORITY

Mr Andrew Tyrie Andrew Bailey Chairman Deputy Governor Treasury Select Committee Prudential Regulation Authority House of Commons Bank of England Millbank T 020 7601 4293 SW1P3JA andrew.bailey@bankofengland.co.uk

6 January 2016

Dear Andrew,

I am writing to provide an update on the work we have been carrying out, with others in some cases, on three of the recommendations made in the final report of the Parliamentary Commission on Banking Standards (PCBS) Changing Banking for Good. The three recommendations were that:

• The PAA should examine the scope for extending bondholder influence over the standards, culture and behaviour of banks (paragraph 118 of volume I and paragraph 67 4 of Volume II).

• Banks should be required to prepare for the regulator an additional set of accounts that are more prudent than the statutory accounts prepared in accordance with International Financial Reporting Standards as adopted for use in the EU (IFRS accounts), that those additional accounts be audited, and, if there is sufficient interest in those accounts, they be published (paragraph 207 of volume I and paragraph 1039 of Volume II).

• Auditors' reports on banks' accounts should include specific commentary on subjective matters of valuation, risk and remuneration, amongst other key judgement areas (paragraph 208 of volume I and paragraph 1042 of Volume II)

Extending bondholder inffuence

Since the Commission's report significant progress has been made to ensure that bond holders are better incentivised to exercise discipline over banks. Advancements have been made on three fronts:

• Bail-in powers, • Enhancing the loss-absorbing capacity of firms in resolution, and • Increased disclosure and transparency.

Taking these in tum:

Bail-In: Legislative reform, specifically implementatlon of the Financial Services Act (Banking Reform) Act 2013, and transposition into UK law of the European Union Bank Recovery and Resolution Directive (BRRD) with ettect from 1 August 2014 and 1 January 2015 respectively, have given the Bank of England, as the UK's resolution authority, a bail-In tool as part of the UK's resolution regime. Ball-In allows the losses of a failed firm to be absorbed and the firm (or its successor) to be recapitalised using the firm's own resources. By putting unsecured creditors at risk of being written down or converted into equity to restore solvency, in a manner that respects the hierarchy of claims in Insolvency, the possibility of bail-in should provide a strong incentive for bondholders to exercise better scrutiny of firms.

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Loss-absorbing capacity: On 9 November, the Financial Stability Board issued the final Total Loss­Absorbing Capacity (TLAC) standard for global systemically important banks (G-SIBs) so that failing GSI.Bs will have sufficient loss absorbing and recapitalization capacity available in resolution. TLAC and the EU's Minimum Requirement for Own Funds and Eligible Liabilities (MREL), which applies to all banks and larger investment firms, will mean that bondholders rather than taxpayers are at risk if banks fail. These initiatives should provide powerful incentives for bond holders to assert greater influence over the standards, culture and behaviour of banks.

Disclosure and transparency: High-quality public reporting enhances transparency, which in turn facilitates more effective market discipline. At the global level we have worked through the FSB and the Basel Committee, seeking to encourage better quality voluntary disclosures by fim1s, while simultaneously sharpening regulatory guidance on the form that disclosure should take.

Under the auspices of the FSB, we continue to encourage industry's efforts to improve transparency and consistency in disclosure via the work of the Enhanced Disclosure Task Force (EDTF). The Financial Policy Committee (FPC) has sought to reinforce the EDTF's work by making it clear that it attaches considerable importance to high-quality implementation of its recommendations. The result has been a step change in the quality - comparability, accessibility and content - of risk disclosure, with UK banks leading the way internationally. UK banks complied with 98% of the EDTF recommendations at year::-end 2013 and 99% at end-year 2014 and 2015.

In parallel, revision to the Basel Pillar 3 reporting regime is underway, to provide better information for bank investors and thereby stimulate greater market discipline. Phase 1 of that work has been completed and is due to be implemented in respect of 2016 year-ends. This ought to enable market participants to compare banks' disclosures of risk-weighted assets more effectively. The revisions notably focus on improving the transparency of the internal model-based approaches that banks use to calculate minimum regulatory capital requirements. A consultative paper on phase 2 is scheduled-to be issued before the end of this year. Phase 2 will improve the comparability of disclosures in a number of areas, including liquidity and leverage, remuneration, market and operational risk and TLAC. The FSB TLAC standard specifically requires G-SIBs to disclose - on a legal entity basis - the amount, maturity and composition of their TLAC in issuance. The new style Pillar 3 reports will greatly enhance the prudential and ril?k information available to investors.

Domestically, we have been working with the bigger UK banks through the BBA Code process to improve disclosure quality, in particular relating to conduct provisions and funding losses i.e. losses expected over the life. of an asset when the returns on the asset are expected to be lower than the cost of funding it.

In response to your report, a working group comprising representatives of the PAA, the FPC, the FRC, the Financial Conduct Authority (FCA), the Department of Business, Innovation and Skills (BIS) and HM Treasury (HMT) has been set up to consider the scope for bondholders to take a more active stewardship role in relation to banks. It is meeting with a wide range of interested parties to gather bondholders' views and considering what steps might be possible. We believe bondholders will see this as a higher priority as the implications of TLAC arid bail-in b~come clear, spo this work is continuing.

Prudent set of accounts for the regulator

The Commission raised a number of concerns about accounting standards, in particular their fitness far regulatory purposes and for long-term investors. Since the report's release, we believe the progress we have made on our capital adequacy framework, significant reforms to accounting standards and other changes in the public financial reporting of banks go a l?ng way to addressing these concerns.

Fitness for regulatory purposes

The key elements of our capital adequacy framework are:

• A common definition of capital resources focussed on genuine loss absorbency in a going concern .; Cammon Equity Tier 1;

• A framework for capital which comprises minimum capital requirements and capital buffers, with the buffers varying in size depending on a bank's systemic importance and the nature of its activities and risk, and varying through the cycle;

• Using a combination of different approaches to assessing capital adequacy- risk-based approaches, stress tests, and a leverage· ratio;

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• Within the risk-based approach, striking a balance which recognises the potential benefits of firms' internal models while guarding against their weaknesses and the incentive problems they create.

A major principle of our framework is that there is no single ''right" approach to assessing capital adequacy. Each approach - risk-based, stress tests, leverage ratio- has its strengths and weaknesses. Flaws, which may exist in any one approach, can be offset or compensated for elsewhere in our judgement-based framework. We can, for example, adjust capital requirements through:

• Stress testing and setting additional capital buffers where we think banks face losses in a stress scenario (not just expected losses) over the next five years, or through

• Pillar 2 - including requiring banks to hold capital through operational risk add-ons against prudent expectations of losses as a result of misconduct.

This is relevant in the context of the Commission's concerns about the suitability of accounting standards for regulatory purposes as decisions over capital adequacy are not solely reliant on one methodology, nor on one set of data such as the IFRS accounts. Regulatory rules, while often built on the foundations of accounting standards, have always required adjustments to accounting outcomes and additional regulatory data to ensure that prudential objectives are met. As accounting standards change, so our prudential adjustments and regulatory data needs are reviewed and amended. Regulatory returns are therefore in effect already an alternative "set of accounts" prepared for the regulator.

Examples of the kind of the adjustments made to accounting data for prudential capital requirements purposes include:

• Deductions from regulatory capital- under the EU's Capital Requirements Regulation (CAR). These capture goodwill and other intangible assets as well as preventing double counting of capital in the banking system through deduction of significant investments in other banks' capital.

• Use of stress testing to identify future losses in both base and stressed scenarios over the next five years. Where stress testing shows that regulatory capital ratios woufd decrease in a stress scenario, including because of loan losses, we set banks additional capital buffers.

• Deduction of the regulatory definition of one-year expected loss (EL) from capital (rather than accounting provisions based on incurred loss) for banks using internal mod.els.

• Prudent valuation adjustments (PVA) to the fair values used to measure trading book a.ssets.

PVA adjustments are a good example of our wider approach to adjusting accounting outcomes for prudential purposes. Since the Commission's report, we have developed a series of PVAs for prudential capital purposes that firms are required to make to their accounting fair values. Currently, these adjustments are made on the basis of PAA guidance, but the European Banking Authority is in the process of developing an EU-wide regulatory technical standard (RTS) on the subject.

Since the Commission's report, the information we receive from sources other than IFRS accounts has changed fundamentally through the implementation of the CRD IV regulatory reporting regime (comprising COAEP and FINREP). CAD IV provides a richer data set than was available to UK supervisors at the time of the Commission's work, although we still seek additional data from firms if and when needed. For example, in order ta take account of firms' stressed expected impairment losses, expected conduct issue provisions and funding losses as part of our concurrent stress testing exercises, we require firms to submit data that enables us to make assessments about these expected losses not covered by IFRS accounts or by CAD IV/CAR reporting.

Fitness for long-term investors

Since the report's publication the global accounting standard-setter (the rnternational Accounting Standards Board {IASB)) has - with the support of the PRA, the FRC and other regulators - issued a new accounting standard (IFRS 9). IFRS 9 replaces the incurred loss provisioning model that the Commission criticised with an expected credit loss approach that requires at least 12 months of expected losses to be provided on all loans, with loans showing a "significant increase in credit risk" since origination subject to lifetime expected credit loss provisions. The IASB has given finns until 201 B year-ends to implement the standard. We have been working to ensure that this timetable does not slip and to encourage banks to implement the new impairment accounting in a high-quality way.

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Improvements have been made to public disclosures to help investors understand and deal with measurement uncertainty, an issue that lies behind concerns about recognising unrealised gains in capital and profit. For example, the total value of PVAs made is now being publicly disclosed by the bigger UK banks in their reconciliations of accounting capital to regulatory capital. As at end-2014, this totalled £4.0bn for the major eight UK banks. We are currently considering whether it would be useful to enhance that disclosure further.

We have also been looking at other ways of improving the published information on measurement uncertainty more generally, as fair values are not the only accounting values that gives rise to measurement uncertain,ty. In particular we have been:

• Encouraging the EDTF to develop a comprehensive set of harmonised disclosures on the measurement uncertainty underlying the new IFRS 9 expected credit loss numbers; and

• Discussing with the major UK banks ways in which to enhance the disclosures that are currently provided about conduct issue provisions in ways that will not encourage litigants or regufators to seek a higher settlement than they would otherwise have done.

We continue to seek other improvements to financial reporting disclosures that will enhance market discipline. For example, we are currently exploring with investors and other analysts the value of asking banks to provide a templated disclosure that would show the deductions and other adjustments made to accounting numbers for regulatory purposes in the form of an adjusted IFRS balance sheet. We expect to be able to draw some conclusions on this work shortly.

In addition, changes to risk disclosure as a result of the EDTF's recommendations - which, as explained earlier, the FPC and PAA put their weight behind - have also significantly enhanced the published stewardship infonnation, as will the changes that are being made to the Pillar 3 public reporting regime. The result overall is that the public financial reporting of banks will in the future provide a more holistic and prudent picture of a bank's financial position - taking more fully into account expected losses, measurement uncertainty and significant risks - than it did at the time of the PCBS's work.

Auditors' reports

The Commission felt that certain issues - subjective matters of valuation, risk and remuneratron - are sufficiently important to an investor's understanding of a bank's business model that an independent opinion on those issues from the external auditor would be beneficial. Subsequently important changes have been made to audit reports and to 'going concern' reporting, including the introduction of so-called 'extended' audit reports. Audit committee reporting has also improved as a consequence. Some auditors have begun issuing audit reports that describe the major risks of material misstatement and how these have affected the focus of the audit. along with the results of the audit work. Such reports typically cover the areas identified by the Commission. Looking ahead, banks will provide viability statements for the first time at end-2015, which ought to alleviate some of the concerns that the PCBS has expressed about 'going concern' reporting.This Is a positive start, but there is further to go and we intend to continue to play our part in encouraging better practices to evolve.

For example, since the Commission's report we have consulted on a rule to require the external auditors of the largest UK banks to provide written reports to the PAA as part of the statutory audit cycle. These written reports will help supervisors to understand the risks in banks' financial reporting. Once finalised, this approach will give them better information on which to base their dialogue with auditors.

Where auditors and actuaries fail to provide us with the information that we need to supervise firms effectively, we now have disciplinary powers which allow us to take action to rectify this. At the PRA's request, HM Treasury has laid regulations ta commence the PRA's disciplinary powers over actuaries and external auditors. The range of disciplinary powers that the PAA can use includes fines, public censures or disqualification from working in financial services. Disciplinary action could be taken against the "personn who is formally appointed to undertake the audit or actuarial work. This may be an individual or a firm, depending on the terms of appointment. We have consulted on how we will use these powers and how we will co-operate with other regulators when using them.

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Taken as a whole, we believe considerabfe progress has been made to address these three recommendations of the PCBS. We will continue to press for further improvements in future.

We would of course be happy to meet to discuss these issues further.

Andrew Bailey