Prudential Regulation Authority Rulebook

2.1

As set out in ‘The PRA’s approach to banking supervision’, the PRA expects the most significant part of a firm’s capital to be ordinary shares and reserves. These are the highest-quality form of capital, as they allow firms to absorb losses unambiguously on a going concern basis.

2.2

When assessing firms, the PRA will be mindful of the fact that quality of capital is not purely about whether a firm meets each sub-tier of the capital rules. For example, even if two firms have identical Common Equity Tier 1 (CET1) positions, the PRA may view the quality of their capital differently due to the nature of the items underlying their CET1 position.

2.3

As set out in ‘The PRA’s approach to banking supervision’, the PRA also expects firms to comply with the clearly stated internationally agreed criteria around the definition of capital, in spirit as well as to the letter, when structuring capital instruments. CRR II (Article 79a) requires that institutions have regard to the substantial features of instruments and consider all arrangements related to the instruments to determine that the combined economic effects of such arrangements are compliant with the objective of the relevant provisions. Additionally, the PRA expects firms to consider any such arrangement that the firm is aware of, including the use of side agreements,^[3] regardless of whether the firm is a party to such an arrangement.

2.4

With that purpose in mind, the PRA’s preference is for firms to adopt simple, plain vanilla CET1 share structures consisting of only one class of share that is fully subordinated to all other capital and debt, that has full voting rights and equal rights across all shares with respect to dividends and rights in liquidation. The PRA expects firms to refrain from features that may be ineffective (or less effective) in absorbing losses. For the avoidance of doubt, this expectation also applies to Additional Tier 1 (AT1) and Tier 2 capital instruments. For example, the PRA would expect firms to refrain from complex CET1 share structures, including transactions involving several legs or side agreements, where the same prudential objective can be achieved more simply. Complex features and structures complicate the prudential assessment and may also undermine instruments’ loss-absorbing properties and CRR compliance. Complexity can arise, for instance, when CET1 shareholders have different rights and entitlements, including preferential realisation provisions or other features that guarantee a distribution to CET1 shareholders. Multiple classes of shares, whereby some are classed as CET1 instruments and others are not, could result in the entirety of the CET1 instruments becoming ineligible as regulatory capital. Some instruments may include preferential realisation provisions which grant priority or higher amounts to certain shareholders when allocating the proceeds from share sales, or other preferential terms such as anti-dilution clauses. These arrangements may represent barriers to recapitalisation, especially in a stressed environment, as they could deter new investors from investing in the firm unless they receive similar preferential or superior rights as other shareholders. This results in uncertainty regarding the ability of the firm to raise capital quickly when needed, which in turn undermines the firm’s primary recovery option of recapitalisation. The PRA notes the prudential risks arising from such features and expects firms to avoid them.

2.5

The PRA expects the relevant Senior Management Function (SMF) to take responsibility for ensuring the quality of the capital structure overall. This includes being accountable for the quality of notifications to the PRA under Definition of Capital 7A to 7D, acknowledging that the act of signing and submitting any notification form may be delegated. In a relatively rare case where it may be necessary for a firm to include complex feature(s) in its CET1 instruments, the PRA expects the relevant SMF to inform the firm’s board in advance of the issuance, evidencing why the instrument cannot be issued without the proposed complex feature(s) and that, notwithstanding the proposed complexity, they consider the instrument compliant with the objective of the CRR. For the purpose of this paragraph and paragraph 2.6, the relevant SMF means the individual with:

1. (a) responsibility for managing the allocation and maintenance of the firm’s capital, funding and liquidity (Allocation of Responsibilities 4.1(7) – PR O); or
2. (b) responsibility for managing the firm’s financial resources (Allocation of Responsibilities 5.2(5) – PR CC) (small firms only).

2.6

The PRA expects the SMF’s proposal, in turn, to be subject to appropriate board-level review and discussion and the board should consider and suggest ways to minimise any proposed complexity. In cases where the board does adopt the SMF’s proposal and complex features are included in CET1 instruments, notwithstanding the PRA’s preference for simplicity (paragraph 2.4), the PRA expects the board to discuss whether the continued inclusion of the complex features within the share structure is necessary, at least annually as part of its Internal Capital Adequacy Assessment Process (ICAAP).^[4] The PRA also expects firms to try to simplify the structure where possible.