Prudential Regulation Authority Rulebook

4.1

This chapter sets out the expectations of the PRA on treasury and financial risks management. As part of the implementation of the Capital Requirements Directive and Capital Requirements Regulation (known collectively as CRD IV) and the Markets in Financial Instruments Directive (MiFID II),^[9] provisions relating to a society's organisational and risk systems and controls have been included in the General Organisational Requirements, Compliance and Internal Audit and Risk Control Parts of the PRA Rulebook. This chapter generally explains the application of the PRA Rulebook in the context of financial risk management.

4.2

The chapter describes the key financial risks to which societies are exposed and also sets out the framework within which the PRA will supervise the treasury and financial risks management activities of societies.

4.3

The importance of financial risk modelling, the complexity of some financial instruments, and the size of individual transactions, combines to make treasury operations a high risk activity that needs particularly strong oversight. The impact of losses arising in the treasury area can be both significant and immediate.

4.4

Boards have ultimate responsibility for deciding the degree of risk taken by their societies, including all categories of treasury assets and risks arising from the management of treasury activities.

4.5

The key financial risks which societies are expected to manage and control are:

1. (a) liquidity risks: arising from maturity transformation (ie short-term borrowing financing long-term lending, creating a maturity mismatch that leaves the society at risk of deposit flight);
2. (b) funding risk: arising from the relative stability of different funding sources and reliance on new funding to replace outflows;
3. (c) wholesale counterparty credit risk: where a wholesale counterparty fails and cannot complete a transaction (eg cannot repay a term deposit placement by the society);
4. (d) currency risk: arising from the effects of changing exchange rates on unmatched assets and liabilities denominated in different currencies;
5. (e) interest rate risks to a society's earnings (most significantly to its interest margin) and to its economic value (the present value of future cash flows) arising from: repricing, yield curve and basis risks, and also from optionality effects, all of which may impact on its interest earnings or value of its assets and liabilities; or arising from the structural positioning of its balance sheet;
6. (f) product pricing risks: arising particularly where products are not immediately profitable and where longer term payback is dependent upon the achievement of specific cost and/or pricing assumptions (including assumptions for the performance of non-interest elements such as retail price index (RPI) or quoted share prices);
7. (g) settlement risk: the risk of losses arising from failure to settle transactions accurately, or on a timely basis; and
8. (h) operational risks in treasury and related activities: including failure of internal controls or procedures, and the risk arising from errors in legal documentation.

4.6

In order to meet the requirements in the PRA Rulebook, Risk Control 2.3, in the context of financial risk management, all areas of treasury activities should be governed by a board-approved policy statement^[10] that records the rationale and strategic framework for the policy, ie why and how treasury activities are expected to support the society's core business, the supervisory ‘approach’ category being followed, the conditions under which authority is delegated to a board sub-committee or to management, the operating limits and high level controls that will maintain exposures within levels consistent with the policy, and the procedures/controls on both existing positions and those that would arise from the introduction of new products or activities. The policy statement is expected to set out how the relevant financial risks described in paragraph 4.5 above will be measured, managed and monitored within a comprehensive and consistent risk framework.

4.7

Policy statements should be consistent with the type of business undertaken by the society and compliant with sections 7 and 9A of the 1986 Act. It should also be noted that, under section 5 of the 1986 Act, a society's principal purpose is that of making loans that are secured on residential property and are funded substantially by its members, not undertaking and trading in financial risk for profit.

4.8

Copies of the policy statements are expected to be made available to, and evidenced as read by, all personnel involved in treasury operations. They should also be provided to PRA supervisors on request, or when substantial changes to policy approaches or limits are made.

4.9

Policy limits are expected to confine risk positions within levels considered by the board and management to be prudent, given the size, complexity and capital needs of the society's business.

4.10

Where applicable, limits would normally also be applied to individual instrument types, asset/liability portfolios, and to separate business activities or subsidiary undertakings. Limits are expected to cover both the quantum and term/run-off of positions and to take due account of the intended impact on business flexibility and profitability – both in normal times and under stress.

4.11

The structure of limits should enable the board and management to monitor actual levels of sensitivity, under different pre-defined market, interest rate and exchange rate scenarios, against the policy specified maxima, to ensure that corrective action can be taken if required.

4.12

The number and type of limits to be applied will depend upon the relative sophistication of a society's treasury operations.

4.13

Limits should be set as part of the overall board policy, and these are expected to be treated as absolute. Any limit breaches should be treated as abnormal and escalated immediately, so the policy needs to make clear what action is expected of management in those circumstances. Breaches of board limits are expected to be reported to both the board and the society’s supervisor.

4.14

Operating limits, set by management within the overall board limit structure, are similarly expected to be subject to clear guidelines covering measurement, management and reporting.

4.15

The PRA expects all societies to put in place systems and controls that are appropriate and proportionate for the types of business that they intend to undertake. Operational arrangements for treasury activities are expected to ensure, as far as is practicable (given the relative size and complexity of the society), that there is functional segregation within the first line of defence between:

1. (a) staff whose duties involve initiating treasury deals with external counterparties (‘front office’ or ‘treasury dealers’);
2. (b) staff whose duties involve checking, confirming and settling such deals and applying the correct accounting for treasury instruments (‘back office’); and
3. (c) staff responsible for managing balance sheet positions, implementing agreed hedging strategies and providing treasury position reports to the governing body at board, committee and management committee levels (‘Asset and Liability Management’ (ALM)).

4.16

In all but the smallest societies, there would ideally be physical segregation between the front and back offices. Where physical segregation is not possible, steps would be taken to ensure that the same individual cannot both initiate a deal and then handle the settlement of that deal. Where possible, the reporting lines of front and back offices would be different.

4.17

In addition to functional segregation in the front line, societies would also be expected to have an appropriately segregated second line of defence, delivering risk management oversight of all treasury activities undertaken. Within the second line, there would be:

1. (a) staff whose responsibility is treasury risk limit checking/monitoring and obtaining independent market valuations eg of high quality liquid asset holdings or derivatives (may be allocated to ‘middle office’ monitoring or to ‘back office’); and
2. (b) staff responsible for risk policy development who challenge and test treasury activities against risk appetite and who monitor the operation of the internal treasury control framework (‘middle office’ risk control).

4.18

The scale and breadth of the various functions are expected to reflect the scale and breadth of the activities that are undertaken by the society, and to keep pace with the development of the business. Some smaller societies with simple business models may not have sufficiently complex treasury operations to need a distinct ‘middle office’. In these cases, the checking and monitoring functions may be undertaken by the back office or finance function, supplemented by senior management oversight. However, all societies are expected to ensure that second line risk oversight is provided within the operational framework – where the business model and product set is simple, risk management may be performed by senior management (eg the CFO or CEO of the society) or a board committee. For these societies, the key objective would be to ensure that provision for challenge by individuals who are familiar with treasury risks is built into the decision-making process.

4.19

At board level, societies are expected to have individuals amongst their non-executives who are familiar with treasury issues and are able to provide appropriately robust challenge to management proposals relating to financial risks. These individuals may be expected to be members of appropriate board committees that cover risk management – typically a Risk Committee (possibly combined with Audit as an Audit & Risk Committee) or a more specialist board Assets and Liabilities Committee (ALCO). For larger and more sophisticated societies, a management ALCO (without non-executive attendees) may be used for day-to-day operations, with the most important decisions reserved to the board, but for smaller societies a single ALCO with both non-executive and executive attendees may be sufficient. It is for each society to determine what arrangements will give the most effective and efficient level of oversight.

4.20

4.21

This section relates to the PRA Rulebook Risk Control 2.1 and 2.2, specifically in the context of the treasury management activities carried out by back office and ALM.

4.22

A society is expected to have in place treasury information systems capable of logging transactions and reporting accurately on:

1. (a) all new transactions and/or cash flows which will affect calculations of structural risk exposures;
2. (b) the settlement timetable and processes for individual treasury instruments; and
3. (c) the current market values of high quality liquid assets, other marketable instruments and derivatives (including complex derivatives).

4.23

A society is expected to have in place treasury information systems that are capable of permitting ALM to report accurately and promptly, to management and to the board (and, if requested, to the PRA) on all the relevant risks for the society from those set out in paragraph 4.5 above, including specifically:

1. (a) the level of risk, funding risk, currency risk, and counterparty risk inherent in its balance sheet;
2. (b) the potential impact of interest rate changes on both its earnings and its economic value (including the effect of any standard interest rate shock as specified by the PRA);
3. (c) all material treasury risk positions including the information necessary to prepare an ICAAP and Internal Liquidity Adequacy Assessment Process (ILAAP), and the results of stress testing for liquidity, interest rate and structural risk in the banking book; and
4. (d) credit risk and settlement risk positions incurred with individual and groups of counterparties.

4.24

The scale and scope of the risk capture, measurement and reporting systems employed need to reflect the sophistication of a society's treasury operations. Those societies wishing to undertake more sophisticated activities require more complex models to capture different facets of risk, such as optionality. In particular, more sophisticated approaches will require methodologies and systems for quantifying behavioural aspects of customer balances, eg prepayment of fixed rate loans and the duration of non-maturity deposits (ie retail liabilities which contractually have short maturity but which have behaviourally proved to be both stable and rate insensitive), and for simulating the development of their balance sheets under multiple forward interest rate scenarios.

4.25

The risk measurement systems put in place should be able to evaluate the impact, on income and economic value as appropriate, of abnormal market conditions. The amount and type of stress testing required will depend upon the sophistication of treasury operations undertaken and the level of risk taken, but where required, is expected to be regular and systematic.

4.26

Within the range of scenarios tested, it is good practice for the scenario to reflect the events that would cause the society's business model to fail without any mitigating management action. Boards and management are expected to periodically review the extent of that stress testing to ensure that any ‘worst case’ scenarios remain valid. Contingency plans need to be in place to deal with the consequences should those scenarios become reality.

4.27

The PRA attaches considerable importance to the quality, timeliness, and frequency of the management information which the board uses to satisfy itself that treasury activities are being undertaken in accordance with its policies and guidelines. Information obtained by the board is expected to include the outcome of regular and systematic stress testing, as described above, which should be taken into account when policies and limits are established or reviewed.

4.28

This section relates to the PRA Rulebook, Compliance and Internal Audit section, paragraph 3.1 in the context of treasury management. Each board is expected to ensure that its society's internal audit function has the skills and resources available to undertake an audit of treasury activities.

4.29

Internal audit is expected to evaluate, on a continuing basis, the adequacy and integrity of the society's controls over maturity mismatch, over the level of structural risk taken and to assess the effectiveness of treasury management procedures.

4.30

Societies with complex treasuries or lacking internal auditors with treasury expertise could consider co-sourcing or outsourcing treasury internal audit to an audit firm with the appropriate expertise and experience. Where the whole internal function is outsourced to third parties, societies are expected to ensure that these have the requisite skills and knowledge for the role.

4.31

The work of outsourced internal audit needs to be fully integrated into a society's overall audit procedures and plans, with appropriate reporting lines into the audit committee. However, in order to avoid conflicts of interest, internal audit should not be contracted out to a society's own external auditors, even if the function were to be performed by a completely different branch of the audit firm.

4.32

This section sets out the expectations of the PRA for societies’ management of their treasury investments in compliance with the General Organisational Requirements, Skills, Knowledge and Expertise, Compliance and Internal Audit and Risk Control Parts of the PRA Rulebook^[12]. It outlines factors that the PRA will consider when assessing the adequacy of a society's ILAAP during a Liquidity Supervisory Risk Evaluation Process (L-SREP), and in reviewing liquidity risk management policies and capabilities.

4.33

Treasury investments may be held for a variety of purposes which broadly fall into three categories:

1. (a) High Quality Liquid Assets (HQLA) eligible for inclusion in a society's liquid assets buffer, held to meet the Liquidity Coverage Requirement (LCR);
2. (b) HQLA and other assets held operationally for matching and cash flow management purposes; and
3. (c) investment assets that management have decided to hold in order to generate income.

4.34

By nature, all societies specialise in long-term mortgage lending which is financed mainly by liabilities which are contractually short-term. This feature of societies' businesses creates maturity mismatches which can give rise to cash flow imbalances – and a risk that there could be insufficient cash resources to meet payment outflows when they fall due.

4.35

Specifically, maturity mismatch may give rise to liquidity and funding risks arising from:

1. (a) unexpected demand for deposit withdrawals;
2. (b) unexpected inability to refinance term wholesale borrowings on a roll-over date due to general market conditions (which may or may not be related to the position of the society itself);
3. (c) the bunching of roll-over dates for wholesale funding and/or maturities of term retail funding;
4. (d) concentration on a limited number of funding providers, giving rise to increased dependence, particularly on roll-over days;
5. (e) the uncertain timing of drawdown of mortgages, and inherent in the early withdrawal characteristics of certain retail savings products (ie behavioural as opposed to contractual maturity risks); and
6. (f) the potential reliance on receiving inward payments before being able to fund outgoing payments on the same day.

4.36

A society is required by Commission Delegated Regulation (EU) No 2015/61 of 10 October 2014 (supplementing Regulation (EU) No. 575/2013) to hold an adequate buffer of liquid assets to meet the LCR for credit institutions.

4.37

However, the LCR is intended to cover a generic scenario across all firms. It may not capture all the types of stress that could affect a society, and therefore does not give full assurance that a society would always be able to meet its obligations when they fall due. Societies are therefore expected to manage and mitigate the liquidity risks listed in paragraph 4.35 above by setting and adhering to their own overall liquidity adequacy requirement (‘OLAR’),^[13] based on their specific Liquidity Risk Appetite (LRA).

4.38

As set out in Rule 3 of the Individual Liquidity Adequacy Assessment Part, all societies should have board-approved liquidity policy statements, which, among other things, are expected to set out the strategies, policies, processes and systems in place to manage liquidity risk, and the liquidity risk tolerance to be accepted.

4.39

A liquidity policy statement ought to be consistent with the society's strategic plan and the related policy statements on funding and interest rate risk management. In the statement, the board is expected to establish its objectives for liquidity risk management, including:

1. (a) meeting obligations as they fall due (including any unexpected cash outflow that could arise under stress);
2. (b) smoothing out the effect of refinancing requirements; and
3. (c) maintaining public confidence.

4.40

A liquidity policy statement would establish the framework for operating limits within which liquidity would be maintained, the range of treasury investments in which the society can invest and the high level controls under which authority is exercised. The statement would have regard to the need to meet OLAR, LCR and any additional Pillar 2 requirements, and would cross-refer to the board's policy on counterparty credit assessment, ratings and exposure limits.

4.41

Where a society chooses to hold treasury investments other than for the purposes of meeting its LCR liquid assets buffer, the society's liquidity policy statement would include objectives, provisions, limits and requirements relating to such investments. The need to earn a return on treasury investments may also be recognised as an objective, although this would be expected to be secondary to the security of the assets.

4.42

A liquidity policy statement would be a working document, and personnel in the treasury and settlement areas would be expected to be familiar with its contents, as would members of relevant committees (eg the Asset and Liabilities Management Committees (ALCO) and/or the Finance Committee). When aspects of the policy or limits change, the policy document would need to be amended as frequently as necessary. The board is expected to agree all substantive changes.

4.43

Societies are expected to inform their supervisors of all material changes to their liquidity policy, and provide a marked-up version of their policy statement on request. Supervisors will review liquidity policies periodically as part of their assessment against the guidance in this Supervisory Statement, and in accordance with EBA/GL/2014/13 Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP), in particular as set out in paragraphs 401 – 419.

4.44

Societies are encouraged to cross-reference their ILAAP and their liquidity policy statement to the documentation required to satisfy the EU Directive 2014/59/EU Bank Recovery and Resolution Directive as relating to liquidity contingency plans.

4.45

A society’s liquidity policy statement is expected to include at least the following (this is not an exhaustive list, and societies ought to consider whether additional elements are required for their business model):

4.46

An introduction section that includes:

1. (a) background to the society's approach to liquidity risk management, including the setting of its risk appetite;
2. (b) the ratification process for obtaining board approval, including amendments to the policy statement as well as complete revisions; and
3. (c) arrangements for, and frequency of, review (which is expected to be conducted at least on an annual basis).

4.47

A background section setting out the society's business and operational characteristics, which impact on the amount and composition of liquidity and treasury investments.

4.48

A summary, setting out key policy limits, including the intended ranges and trigger values for the loans to customer deposit ratio and liquidity measures, both regulatory and business specific, and both gross and net of mortgage or other lending commitments.

4.49

A risk management section that includes:

1. (a) an overview of operational and settlement risk controls, including: the framework of board authorisation, delegations and operating limits (including dealer limits, transaction and day limits), deal authorisation, confirmation checking, segregation of duties;
2. (b) the policy in regard to use of repo and reverse repo facilities and the potential encumbrance of treasury investments held;
3. (c) procedures and criteria for authorisation of exceptional overrides in relation to dealing, operational rules, limits and settlement; and
4. (d) the policy for liquidity risk management information and reporting to the board.

4.50

A section setting out board expectations for the society’s funding maturity profile and for its capability (under a range of market conditions) to monetise its liquid assets. This would give a clear view of the maturity/realisability of different liquid asset types, and set limits governing the minimum/maximum proportions of liquidity that the board requires to be monetisable within a range of time bands.

4.51

A section covering permitted categories of assets and activities, setting out the society's policy for the acceptable level of holdings of:

1. (a) assets held in the liquid assets buffer to meet OLAR and LCR, including the risk appetite for concentration risk;
2. (b) inter-society and local authority deposits;
3. (c) repo/reverse repo (both gilt-edged stock and non-gilt-edged securities);
4. (d) mortgage backed securities and covered bonds;
5. (e) foreign currency securities and the handling of foreign currency exposures;
6. (f) commercial paper;
7. (g) bank deposits, certificates of deposit and other bank securities; and
8. (h) collateral eligible for use in the Bank of England's Sterling Monetary Framework.

4.52

The society's policy for membership and use of any central clearing counterparty for derivatives or repo activity would be set out clearly, including a section dealing with authorisation and operational controls. Liquidity implications arising from the role of standby facilities would be included in the policy statement.

4.53

If a society takes advice from, or makes arrangements with, an external advisor, its liquidity policy statement needs to contain a section on the role of external professional advisers in liquidity management, where applicable, setting out the basis on which advice is given and the adviser’s role in the execution of any transactions.

4.54

If a society has entered into an agreement involving the provision of advice, it needs to ensure that no transaction is undertaken without its prior consent. The society ought to ensure that it differentiates between advice and discretionary fund management, and to make certain that all transactions undertaken on a discretionary basis are within the terms of its liquidity policy statement.

4.55

If a society enters into an arrangement with a broker whereby its securities are held in custody by the broker’s custodian, the society needs to ensure that it retains legal ownership of, and unfettered access to the investments held in custody. Custody arrangements need to be clearly set out in a customer agreement between the broker and the society.

4.56

This section sets out the PRA’s expectations for societies’ management of their treasury counterparty relationships. Societies are expected to have in place wholesale counterparty credit risk policies that would include credit limits for all counterparties, both for making treasury investments and for transacting derivative contracts.

4.57

Such counterparty credit policy limits would cover:

1. (a) exposure policies, including controls and limits as appropriate, for countries, sectors and groups of connected counterparties, including exposure to brokers;
2. (b) acceptable risk exposure types (eg deposits or marketable instruments);
3. (c) valuation of market risk exposures (eg mark-to-market positive value of swaps, plus appropriate addition for potential future exposure increases arising from changes in market rates); and
4. (d) settlement risk exposures (eg currency deals where amounts are paid out before funds are received).

4.58

Boards are expected to determine the extent to which the authority to set counterparty limits is delegated to management, but delegation to a single individual ought not to be permitted. Personnel with dealing mandates should not be given authority to set new or increased counterparty limits. No dealings should take place with counterparties which do not have pre-approved limits.

4.59

Limits need to be established on the basis of a robust methodology, which should be fully documented and reviewed regularly. The methodology would be expected to cover:

1. (a) the use of credit ratings, including the minimum quality acceptable and procedures for ensuring credit ratings are up to date;
2. (b) other information such as market intelligence, which would be reviewed when considering limits on treasury investments; and
3. (c) the policy of assessment to be adopted towards counterparties and sectors that are non-rated.

4.60

For societies with more active treasury operations, a separate wholesale credit risk committee with responsibility for preparing a wholesale counterparty credit policy statement and counterparty list may be appropriate. Less active societies may incorporate a section on credit risk within their liquidity policy statements and ILAAP, with appropriate cross-references to other policy and procedures statements.

4.61

In all cases, the counterparty list and individual limits would be subject to formal credit review at least annually, with interim arrangements in place to add, amend or remove limits as appropriate.

4.62

Where credit ratings are used, if these are downgraded (or put on ‘watch’ with ‘negative implications’), or if a society becomes aware of information on a counterparty which might affect its perceived creditworthiness (whether or not this results in a rating change), it is expected to have systems for reviewing individual counterparty limits and, possibly, suspending or removing individual names from authorised lists in an expeditious manner.

4.63

Arrangements for obtaining information on counterparties, where this is in the public domain, would also be included in procedures manuals.

4.64

Exposures to counterparties are expected to be monitored on a consolidated basis, aggregating exposures of the society and any subsidiary undertakings (where applicable), and setting total exposure limits for groups of connected counterparties. Similarly, country, sector and market concentrations need to be monitored continuously against internally agreed limits.

4.65

Where the senior tranche(s) of Residential Mortgage Backed Securities (‘RMBS’) have been issued by a society in full to external (ie non-society or non-group) entities, amounts accumulated in the Securitisation Special Purpose Entity (‘SSPE’) bank account(s) pending disposition to external noteholders may be regarded as exposures of the SSPE rather than of the society in setting internal wholesale counterparty credit risk limits. However, where part or all of an RMBS issue has been taken up by the society (or another group entity) to be pre-positioned/repo’d with the Bank of England or a third party, the expectation is that SSPE bank account exposures will be aggregated with the relevant counterparty exposures.

4.66

Regardless of the operation of internal credit limit structures, societies are expected to remain within the Large Exposures Framework of CRDIV and CRR, subject to the exemptions that apply to smaller firms.

4.67

This section sets out the PRA’s expectations for societies’ management of their retail and non-retail funding (business deposits and wholesale funding) activities. Societies' core business (set out in statutory ‘nature’ limits)^[14] of financing long-term residential mortgages mainly with short-term personal savings necessarily involves a high degree of maturity transformation, and this creates major funding risks that all societies need to manage.

4.68

Retail deposits from individuals have historically proved to be a good source of stable funding, but the extent of that stability differs by product type. Much retail funding from individuals is contractually withdrawable on demand, but in practice has tended in aggregate to remain stable even when markets are under stress or showing acute instability – although the extent of this stability depends significantly on the extent to which such accounts are remunerated: those targeted at rate-sensitive depositors via best buy tables will inevitably show less stability than lower balance transactional accounts where interest earnings may not be the prime motivation for the depositor. However, the threat that loss of confidence could lead to a deposit ‘run’ is one of the main reasons for holding precautionary levels of liquidity.

4.69

In order to reduce the risk of a run, and to provide additional certainty about the availability of funding over an extended period, societies have introduced retail deposit types with one or a combination of withdrawal restrictions such as:

1. (a) limiting the number or size of withdrawals during a given period;
2. (b) requiring customers to give a period of notice if they wish to withdraw money; and
3. (c) offering deposits with fixed maturities (normally also with fixed interest rates).

4.70

Although such restrictions can be effective in improving stability for a period, some can also have the effect of incentivising deposit outflows once the restriction period ends. Thus, a product with limited withdrawals may exhibit larger outflows as the remaining number of permitted withdrawals reduces (and depositors take action to maintain access to their money). Similarly, depositors may give precautionary notice of withdrawal, even if none is actually intended. A retail bond with a fixed term provides funding up to the maturity date, but implicitly forces the depositor into a decision about where to redeposit the money at term: the extent to which such funding rolls-over is therefore dependent upon the rates offered for follow-on products, and their relative competitiveness in the market. Thus, although the fixed-term funding is available for a specific period, as it approaches maturity the risk of withdrawal increases significantly, and retaining the deposit may require paying rates that are damaging to the net interest margin. For all these reasons, societies are expected to undertake appropriate behavioural and cash flow modelling to understand the funding risks, and to ensure that they use a variety of different retail funding products to manage vulnerabilities arising, and to avoid over-concentration.^[15]

4.71

Together with basis risk policies and liquidity optimisation policies, retail funding policies would be expected to shape the society’s target liability structure over the corporate plan horizon.

4.72

In addition to deposits from individuals, societies may seek to attract deposits from local businesses and professional firms (eg solicitors). Such funding may be covered by Financial Services Compensation Scheme (FSCS) arrangements, improving its stability, and may also be treated as ‘retail funding’ for the purposes of the 1986 Act funding restriction.^[16]

4.73

However, although similar to retail funding from individuals, funding from such sources may have some different behavioural characteristics and societies are expected to take steps to understand these in determining how much reliance to place on this source. In particular, professional firms depositing client money may be particularly sensitive to anything indicating a lack of creditworthiness or a change of reputation for the society, and there is potential for groups of such depositors to act simultaneously.

4.74

Therefore, boards are expected to set limits on the size of individual deposits and the total volume of such non-retail deposits as a proportion of their funding base.

4.75

Wholesale markets may provide funding that carries a more definite maturity than retail deposit funding, but the size of wholesale tranches may concentrate the refinancing risks societies face, and wholesale tenors may still be less than those of any mortgages thus funded – except where those mortgages are held within securitisation or similar ‘pass-through’ structures where amortisation of the assets is used to reduce the outstanding funding. Exposure to refinancing risk needs careful management, and avoidance of over-reliance on an assumption of continued access to the wholesale market.

4.76

To access the wholesale markets, some societies have been credit rated by external agencies. Carrying such a rating is often essential to enable a society to access wholesale funding markets, but does expose it to the danger of a change in market view of the sector or the society, so the process of obtaining and continuing management of the rating therefore needs careful consideration and monitoring.

4.77

Societies using wholesale funding are expected to manage their wholesale maturity profile so that it does not cause excessive volatility in their liquid assets buffer. In particular, societies are expected to manage their wholesale funding in a way that ensures stability of supply and availability over time. This implies that, the greater the volume of non-pass-through wholesale funding used as a proportion of funding liabilities, the longer the maturity profile of that funding needs to be. Societies are expected to consider their realistic levels of access to market funds, including in stressed circumstances.

4.78

Societies are expected to measure and project refinancing risk arising from all types of funding relied upon. Such projections would cover the corporate plan horizon, and include internal policy limits for combined retail and non-retail refinance/withdrawal risk to ensure that aggregate gross and net retail plus non-retail outflows are not over-concentrated by rolling quarter.

4.79

Refinancing risk concentrations may reflect the behavioural nature of the funding to be refinanced in any rolling period – typically three months. Therefore, the rolling exposure measured against the limit may include 100% of bullet repayment wholesale maturities but a smaller proportion of stressed retail maturities (based on behavioural analysis). In this way, long term refinance risk monitoring will align with medium and shorter term OLAR and LCR forecasts, and be consistent with the ILAAP stress methodology.

4.80

Where wholesale funding has been raised through secured pass-through structures in which the repayment of funds is generated from the cashflows of the collateral (eg RMBS pass-throughs), the resulting positive impact on a society’s refinance risk may be reflected in the methodology. Only the ultimate clean-up call value of the bond specified in the offer documentation and any other features that give rise to cash demands on the society would need to be reflected in the refinance risk profile.

4.81

A focus on aggregate refinance risk will allow greater holistic planning and control of outflows; however, societies are also expected to consider potential wholesale funding concentrations within the refinance risk profile to determine whether concentrations within any one rolling quarter meet their risk appetite. A wholesale funding maturity ladder may be required where reliance on wholesale funding is higher and maturities therefore need to be spread over a longer period. As a guide, maturing wholesale funding (excluding pass-through) exceeding 5% of shares, deposits and loans (SDL) in any one rolling quarter or exceeding 10% SDL in any rolling twelve month period could be regarded as material.

4.82

The Basel Committee has developed a funding stability control metric, the Net Stable Funding Ratio (NSFR),^[17] which focuses on exposure to outflows of volatile funding over the ensuing 12 months of operation. Societies are expected to manage their funding in accordance with any future EU or PRA policy on NSFR once enacted. Specifically, societies need to ensure that their funding liabilities have sufficient stability to finance their particular asset mix, which will include a high proportion of long term, residential mortgages.

4.83

Undue dependence on individual funding sources that account for a large proportion of a society's overall liabilities could cause liquidity problems should those funds be withdrawn or not be available for rollover. These potential problems apply whether the funds in question are raised from the retail or the wholesale markets.

4.84

A small society is relatively more exposed to this type of risk, and is expected therefore to consider the implications of concentration on individual shareholders or depositors when assessing its funding approach, bearing in mind the consequences for liquidity levels and the potential need for committed facilities. In the management of large retail investment accounts, a society would normally avoid:

1. (a) obtaining funding from a single shareholder or depositor which exceeds 1% of SDL; and
2. (b) allowing the aggregate total of funding, from those single shareholders or depositors which individually represent more than one-quarter of 1% of funding liabilities, to exceed 5% of funding liabilities.

4.85

The statutory funding limit (section 7 of the 1986 Act) sets a ‘nature limit’ of a minimum of 50% share account funding as a percentage of total funding liabilities.^[18]

4.86

For prudential monitoring purposes, societies are expected to set an internal policy limit based on a maximum level of funds raised by means other than the issue of shares (ie an inversion of the ‘nature limit’). To avoid any possibility of an inadvertent breach of the 1986 Act, these internal policy limits would generally be set at levels below the 50% statutory maximum.

4.87

In undertaking their corporate planning process and under the CRD IV liquidity regime, societies are required to develop a funding plan covering all expected funding needs over the period of the corporate plan, and use this to set funding limits. The plan would assess sensitivities and their impact on funding levels but, while contingencies would be catered for, agreed funding limits would not be set at levels where usage is either unplanned or highly unlikely.

4.88

Wholesale funding can be divided into three broad types originating from different sources:

1. (a) offshore/overseas retail deposits upstreamed to the society;
2. (b) business deposits from non-financial /non-individuals (sub-divided between SME funding within the statutory limit, and other business funding); and
3. (c) wholesale funding from the financial markets and central banks (excluding asset swaps) sub-divided into unsecured debt and secured debt.

4.89

Boards are expected to set policy sub-limits for each of these sources as well as an overall limit (eg a society might set an overall deposit liabilities limit of 30%, with sub-limits of 25% for wholesale funding, 10% for business deposits and 10% for offshore/overseas funding, the total of the sub-limits exceeding the overall limit only on the basis that all could not be used to their full extent simultaneously or only to the extent that some of the funding is both wholesale and offshore/overseas).

4.90

Certain types of funding (eg covered bonds, non-recourse finance such as securitisations, and repurchase agreements - repo) involve pledging assets as security for loans. In addition, collateral may be pledged in respect of ‘out of the money’ derivative positions, either under credit support annex arrangements or as initial/variation margin. Such pledged assets are referred to as ‘encumbered’. Encumbrance can be short term (eg overnight repo) or long term (eg covered bonds).

4.91

Typically the assets pledged will be subject to a ‘haircut’, ie more collateral will be required than the value of the funding, and the extent of such over-collateralisation will reflect the credit quality and liquidity of the pledged assets. Hence, availability of secured funding (both secured (covered) bonds and through repo) is limited by the availability and quality of collateral. Consequently, societies involved in all types of secured funding markets are expected to measure, monitor and control their collateral generation and usage, to ensure that they have an appropriate forward view of collateral availability and that a spread of suitable assets will be available to raise secured funds as required. In planning future secured fundraising, societies will need a considered strategy for pledging different qualities of collateral for different periods in a way that will deliver market consistency and reliable funding results: pledging progressively declining collateral quality will result in rising haircuts, to a point where secured funding becomes unavailable, uneconomic, or both. Moreover, as the level of encumbrance increases, the position of senior creditors of the societies is weakened, and the availability of unsecured funding will reduce – or its price will increase – to a point where it too becomes unavailable or uneconomic.

4.92

Societies that wish to operate in secured funding markets, including central bank facilities, are expected to therefore have in place robust systems for identifying and monitoring collateral (available for future use, pre-positioned, currently pledged and received), and to set internal limits to control the level of encumbrance in normal times and the risks associated with it to within their risk appetite. Societies’ management of risks associated with asset encumbrance should be in line with the PRA’s Supervisory Statements 24/15 ‘The PRA’s approach to supervising liquidity and funding risks’^[19] and 9/17 ‘Recovery planning’.^[20]

4.93

A society’s board is also expected to set encumbrance limits if appropriate to ensure that funding secured on the society’s assets is undertaken in a controlled way that limits the risk to members and retains balance sheet management flexibility, including under stress. The wholesale funding policy needs to set out the board’s overall risk appetite for:

1. (a) Assets encumbered under securitisation/repo funding arrangements with financial markets counterparties, including amounts encumbered under central bank facilities in return for HQLA which are then re-hypothecated to market counterparties;
2. (b) Amounts encumbered for derivatives margining purposes; and
3. (c) Assets encumbered under central bank liquidity facilities.

4.93A

Societies should ensure that they have capacity to raise sufficient liquidity resources in stress, including through encumbrance.

4.94

In the case of re-hypothecation, where collateral / securities are pledged to the Bank of England (or other central bank) in return for Treasury Bills/gilts (or equivalent government bonds) which are then repo’d with a wholesale market repo counterparty in exchange for cash, the internal encumbrance limit would normally include the original amount of collateral encumbered only, rather than double-counting. Therefore, where the Treasury Bills (T-Bills)/gilts/other government bonds received are then themselves repo’d, there would be no need to include this additional encumbrance in the overall internal limit.

4.95

A society with high levels of maturing funding, or vulnerable to withdrawal of individual deposits, may consider arranging committed facilities. However, it should be noted that drawdown capacity theoretically available to firms under such facilities is not allowable as an inflow for LCR purposes, nor is it expected that societies would include committed drawdown inflows for OLAR purposes. Consequently, these facilities will be valuable only insofar as they help societies to manage day-to-day operating cashflows.

4.96

In arranging committed facilities, a society is expected to consider:

1. (a) the credit standing and capacity of the provider of the facility;
2. (b) the documented basis of the commitment (ie is it an unconditional commitment or a ‘best endeavours’ arrangement); and
3. (c) the cost/fee structure compared to alternatives.

4.97

In extreme cases, there remains a risk that a provider may renege on a contractual commitment to provide funding, or purport to rely on widely drawn ‘events of default’ or ‘material adverse change’ clauses in the funding facility documentation, ie they may risk the legal consequences (if any) of refusing drawdown rather than lend money to a society in difficulties.

4.98

Societies should not, therefore, become over reliant on committed facilities to meet unexpected short term cash outflows.

4.99

In order to exercise proper control over combined retail and wholesale funding risks, each society is expected to put in place a board-approved statement of funding policy, setting out the key attributes of the society’s approach, including limits and control structures, and cross-reference this to their ILAAP and liquidity contingency plan. The policy would cover, holistically:

1. (a) retail and business deposits product limits, eg for:

• fixed term investment bonds (where limits would also be in place governing the volume of such deposits that can reach term within a given month/quarter);
• instant access, internet-only deposits; and/or
• fixed term/rate Individual Savings Accounts (ISAs) (since all are treated as withdrawable within 30 days for LCR calculation purposes)

1. (b) aggregate retail and non-retail (business deposits and wholesale) funding refinance risk limits;
2. (c) large shareholdings and deposits limits;
3. (d) total wholesale funding, instrument, sector and tenor limits;
4. (e) encumbrance limits; and
5. (f) the purpose and maximum permitted usage of committed funding facilities

4.100

The funding policy would be a working document. Personnel in the Marketing/Product Management, Treasury and Settlement areas would be expected to be familiar with its contents, as would members of relevant committees (eg the Asset and Liabilities Management Committees (ALCO) and/or the Finance Committee). The board would be expected to agree substantive changes and be informed of all other changes. The policy would need to be kept up-to-date and subject to strict version control. All users could be expected to sign to attest that they have read and understood the latest version of the policy within an ALCO specified period, following any changes.

4.101

Societies are expected to inform their supervisors of all material changes to their funding policy, and provide a marked-up version of the policy statement on request. Supervisors will review policies periodically as part of their assessment against the guidance set out in EBA/GL/2014/13 Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP).

4.102

Societies are expected to aim to eliminate, as far as is practicable, all exposures to risk arising from movements in currency exchange rates. Societies are precluded by section 9A of the 1986 Act from acting as a market maker or trading in currencies (subject to some de minimis exemptions).

4.103

The PRA expects that only larger societies with more complex business models will wish to consider originating foreign currency assets or liabilities, given the additional operational and risk management overheads that are necessary to manage such activity.

4.104

If a society decides to raise wholesale funding in currency to support its sterling operations, it would be expected to enter into a cross-currency swap to neutralise exchange risk, both at maturity and in respect of coupon payments. Similarly, if a society decides to acquire treasury investment assets denominated in foreign currency, it would normally be expected to swap out the exchange risks. Matching of treasury assets and liabilities in terms of currency and tenor could also be an effective risk mitigant.

4.105

If a society decides to raise retail deposits in a foreign currency, the PRA would expect the currency risk to be hedged by holding assets (including liquid assets) in the same currency. If a society decides to originate or purchase retail assets denominated in foreign currency, the PRA would expect these to be match funded in terms of currency and tenor.

4.106

Any society proposing to operate in foreign currencies is expected to inform its supervisor before entering into any transactions. The PRA will expect such societies to be able to demonstrate that they have the appropriate knowledge, skills and controls in place to be able to transact such business prudently.

4.107

To comply with the General Organisational Requirements and Risk Control Parts of the PRA Rulebook in the context of financial risk management, a society should have an adequate system for managing and containing financial risks to the net worth of its business, and risks to its net income, whether arising from fluctuations in interest or exchange rates or from other factors.

4.108

Most societies are susceptible to interest rate risks (commonly called ‘interest rate risk in the banking book’ or ‘IRRBB’) arising not only as a result of changes (or potential changes) in the general level of interest rates, but also from:

1. (a) repricing mismatches, eg where, in a rising interest rate environment, liabilities reprice earlier than the assets which they are funding; or, in a falling rate environment, assets reprice earlier than the liabilities funding them (in both cases leaving the society with a reduction in future income). Repricing risk is inherent in fixed rate instruments, the market value of which will change inversely with interest rate movements (eg gilts), and in unhedged fixed rate retail products (eg unhedged fixed rate mortgages funded by variable rate liabilities would yield less margin should the cost of the liabilities increase due to rises in market rates before the end of the fixed rate period);
2. (b) yield curve risk, where unanticipated changes to the shape or slope of the yield curve will cause mismatched assets and liabilities to reprice differently relative to each other, possibly exposing positions which were hedged against a parallel shift in rates only;
3. (c) interest basis risk, arising from the imperfect correlation of rates on floating rate assets funded by floating rate liabilities eg between:
   1. (i) SONIA/base rate and mortgage rates (the former being driven by monetary policy and unsecured wholesale markets, the latter by the general level of rates and competition amongst lenders);
   2. (ii) SONIA/base rate and administered rates paid on deposits (the latter being driven by general market rates and competition for funding more generally);
   3. (iii) SONIA and reference gilt rates or other indices;
   4. (iv) overnight and term reference rates; and
   5. (v) legacy market rates and other policy and market rates.
4. (d) spread risk, which can arise where the underlying market driver is the same for matching assets and liabilities, but the margin paid relative to the offer rate diverges from the margin received relative to the bid rate - for example due to supply/demand/credit dynamics;
5. (e) optionality risk, arising from both explicit/contracted option contracts, such as ‘caps’, ‘collars’ and ‘floors’, which confer the right, but not the obligation, to fix an interest rate for an agreed amount and for an agreed period; and from embedded/implied options included within products, such as early withdrawal or redemption entitlements. Optionality can magnify the effect of other interest rate risks. In particular, societies may be subject to implied optionality in respect of retail savings rates (for which a minimum rate payable –a ‘floor’ – above 0% may need to be assumed), and from prepayment of mortgages/pre-withdrawal of deposits (where the customer may effectively have an ‘option’ which may not be adequately ‘hedged’ by way of early repayment charges;
6. (f) structural risk, which arises when the mix of interest rate basis characteristics of assets and liabilities are such as to constrain the society’s ability to manage its future interest margin. A society that holds higher balance sheet totals at administered rates that can be adjusted to deliver a required margin usually carries lower structural risk than a society whose net margin is largely locked in as a spread to market rates over which it has no control; and
7. (g) margin compression risk, which is typically driven by asymmetric competition in societies’ core retail funding and lending markets, resulting in pricing pressure that cannot be compensated for by adjusting rates on the other side of the balance sheet. This is described more fully in the next section.

4.109

Societies are expected to adopt a risk-averse approach to maturity mismatch and to structural risk management. A degree of maturity mismatch and structural risk is inherent in normal society operations, but boards of societies are expected to adopt policies that either:

1. (a) ensure that, as far as possible, exposures to changes in interest rates are measured and managed within the agreed risk appetite; or
2. (b) where interest rate positions are to be taken, restrict potential reductions in income or economic value, estimated under robust stress testing scenarios, to levels that would not compromise the current or future viability of their societies.

4.110

Societies are expected especially to have regard to the specific structural and margin compression risks created by originating a large proportion of assets and/or liabilities over which they have no rate setting control (either fixed rate, or contractually linked to interest rates set by market indices or by the central bank). Significant exposure to such assets and liabilities reduces the ability of a society to manage its net interest margin through movement of its own administered rates. This can give rise to prudentially dangerous margin compression and thus to potential for an unexpected shock to income. In the event of a fall in market interest rates, structural imbalances may crystallise as a risk: it may not be possible to decrease administered savings rates in line with decreases in money market rates or Bank Rate without losing the funding (or because deposit rates/fees cannot realistically/practically fall much below 0%), resulting in a serious margin squeeze where lending rates are market-linked. Similarly, in the event of a rise in rates, margin compression may arise from the inability to raise rates on fixed rate assets, at a time of price competition for floating/administered rate assets and rising funding costs.

4.111

The PRA expects societies to manage their balance sheet in such a way as to retain the ability to flex interest margin management within a reasonably short time in order to deal with such asymmetric shocks. This is a fundamental tenet of financial risk management for societies and needs to be reflected with high importance and visibility in their approach to management of financial risks. The board is expected to focus closely on achieving a reasonable balance between assets and liabilities carrying similar interest rate characteristics, with any divergence away from the corporate plan agreed target balance sheet structure prompting action – because the timescales required to repair any significant mismatches that have arisen may be long. Where such mismatches exist, the board should agree in the corporate plan a target structure that meets its risk appetite, to be achieved over a specified time horizon. It is expected that the board would view this as a high priority strategic objective.

4.112

Structural risks can also arise from the approach taken by societies to manage the variability of net interest income arising from assets financed by reserves and/or non-maturity deposits (NMDs).^[21] More sophisticated societies may wish to manage earnings risk by treating reserves and NMD liabilities as fixed rate with a defined (and behaviourally modelled) term profile that can be matched with fixed rate assets (or derivatives). The resultant fixed rate positions can pose economic value (EV) risk – were capital to be eroded or NMD balances decline), so the trade-off between managing risks to net interest income and EV needs to be carefully managed. The PRA generally expects that only those societies with skilled resource and more sophisticated risk management systems will be capable of modelling and managing these structural risks, and that boards of such societies will set prudent duration assumptions that are treated as inputs to longer term corporate planning rather than as parameters that can be adjusted tactically based on changes in market sentiment. Less sophisticated societies would normally treat capital as having no fixed repricing date and would not model NMDs.

4.113

The arrangements, processes, and mechanisms required in the PRA Rulebook Risk Control 2.1 and 2.2 should include systems and procedures for identifying, monitoring and controlling all material maturity mismatch, interest rate, base rate, foreign exchange and similar (eg index-related) risks, and for reporting exposures to senior management and the board of the society on a regular, and timely, basis.

4.114

All societies are expected to have board-approved policy statements, which, among other things, would set out the strategies, policies, processes and systems in place to manage interest rate risk and structural risk.

4.115

The policy statement would be consistent with the society's strategic plan and the related policy statements on funding and liquidity risk management. In the statement, boards would establish the:

1. (a) objectives for interest rate risk management, including risk appetite and controls in place for managing the impact of rate changes on both future earnings and on economic value (and in particular the value of portfolios held at fair value);
2. (b) assumptions to be used in the measurement of interest rate risks, including rate stress scenarios, treatment of reserves and methodologies for determining the duration ascribed to non-maturity deposits;
3. (c) methodologies to be employed in measuring interest rate risks, and the systems to be used for this;
4. (d) governance arrangements for managing and mitigating interest rate risks; and
5. (e) arrangements for allocating capital to interest rate risk positions.

4.116

Interest rate risk policy statements would establish the framework of operating limits within which risks would be maintained, including gap limits, changes in earnings limits, and changes in economic value limits under defined scenarios.

4.117

The policy statement would be a working document, and personnel in the society’s treasury would be expected to be familiar with its contents, as would members of relevant committees (eg the Asset and Liabilities Management Committees (ALCO) and/or the Finance Committee). When aspects of the policy or limits change, the policy document would be expected to be amended as frequently as necessary. The board would be expected to agree all substantive changes.

4.118

Societies are expected to inform their supervisors of all material changes to their policy, and provide a marked-up version of the policy statement on request. Supervisors will review interest rate risk and structural risk policies periodically, as part of their assessment against the guidance in this supervisory statement, and in accordance with the Internal Capital Adequacy Assessment (ICAA) Part of the PRA Rulebook and the PRA Supervisory Statement SS31/15, ‘The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP)’.

4.119

Societies are expected to have interest margin management and other measures in place to estimate the expected impact on profitability of new mortgage and savings products, and to project forward the cumulative effect of new business originations, taking account of any product incentives and loyalty schemes.

4.120

It is particularly important that societies have a clear understanding of their own cost structure, and especially the real cost of funding that will apply over the life of a new lending product. Given their lack of scale and market share, it is essential that smaller societies are able to identify product opportunities that add to earnings, rather than pricing their products only by reference to what else is available in the market. Their funding and administrative cost structures are unlikely to mirror exactly those of the larger market players.

4.121

The PRA does not accept that, because societies’ ability to drive market pricing may be limited, they should relinquish control of those aspects of product strategy that they can influence – including, but not limited to, their ability to price within market spreads, and to control product mix and launch timing.

4.122

Special care needs to be taken to use realistic estimates of funding costs in pricing new lending. If the current blended cost of funds is used to set loan prices, but the society actually then pays a higher rate for new funding taken to finance the new loans, the overall blended cost of funding will gradually increase and the actual longer term margin on new lending will be overstated. Therefore, unless the new lending will be financed entirely from existing funding (eg by reducing the level of treasury assets), it may be more appropriate to use the marginal cost of funding as the basis for loan pricing decisions.

4.123

A glossary setting out more detail on the theoretical methodologies and terminology of pricing model components is included at Appendix 6. However, the extent and sophistication of the actual methodologies and systems that support pricing decisions are expected to be proportionate to a society’s business model, so the ability to calculate and use the various pricing components is expected to vary according to the approach that each society decides to adopt. Nevertheless, for pricing new lending, all societies need, at a minimum, to be able to:

1. (a) estimate the marginal cost of new funding, based on a benchmark rate and its required market spread (ie the components described in (a) and (b) in Appendix 6, paragraph 1);
2. (b) estimate the term liquidity premium that will need to be paid for more stable or cost efficient forms of funding (ie component (e) in Appendix 6, paragraph 1);
3. (c) project forward their future interest rate margin (both planned and under stressed interest rate scenarios); and
4. (d) allocate the estimated operational costs that will be incurred in support of the new lending and associated funding (ie component (e) in Appendix 6, paragraph 4).

4.124

In addition to these basic elements of pricing capability, larger and more sophisticated societies with complex product ranges (both lending products and funding products) are expected to be able to:

1. (a) estimate the expected all-in cost of funding at future periods;
2. (b) model the expected customer behaviour for products with in-built optionality (eg early redemption rights for fixed rate loans, withdrawal rights in respect of fixed term deposits such as fixed rate ISAs);
3. (c) define and model pricing treatments for non-maturity deposits, ie deposits that have a behavioural life considerably in excess of their contractual term, and where balances are relatively interest rate insensitive (eg personal current accounts);
4. (d) calculate the capital cost that needs to be recovered via the product margin, to meet expected credit losses; and
5. (e) include in pricing the cost of any currency, interest rate risk and/or basis risk hedging arrangements.

4.125

Larger and more sophisticated societies are also expected to understand and incorporate the concepts of funds transfer pricing (FTP) when pricing core products on either side of the balance sheet. There is a clear relationship between funding costs and asset pricing, and boards / management are expected to be able to track, take advantage of and protect their society from changes in the nature of this relationship over time. As societies adopt increasingly complex approaches, we would expect more features of FTP methodologies to be reflected in their pricing disciplines, but it is not expected that such societies will necessarily implement full internal transfer of revenues and costs between business divisions.

4.126

All societies, regardless of approach, are expected to be able to estimate for new products:

1. (a) their relative contribution to net interest margin arising separately from assets and liabilities;
2. (b) the comparative price/earnings of different prospective products;
3. (c) the future net interest margin arising from proposed new product offerings; and
4. (d) the return on capital implied by the expected margin to be earned, in order to differentiate between the relative attractiveness of different product options.

4.127

Any extension of society activities into more complex forms of funding, liquidity and off balance sheet instruments will dramatically increase the operational risks involved. Societies are expected to ensure that they are fully aware of the specific operational, legal and systems requirements associated with more complex treasury instruments and positions.

4.128

1. (a) controls over standard settlement instructions to ensure that bank details are verified, changes to details need at least dual verification, and that all settlement payments can only be directed to the pre-notified and agreed bank account;
2. (b) payments in settlement of transactions are made securely and with segregation between payment set up and release; and
3. (c) settlement accounts are regularly reconciled, and any unreconciled items are reviewed urgently.

4.129

The documentation, accounting treatment and settlement procedures for such instruments can be highly complex, with significant costs and penalties arising from operational mistakes.

4.130

Societies involved in these areas of activity need rigorous management procedures and control systems to ensure that robust legal documentation is used, that compliance with market practice is achieved, that the accounting treatment is clear, robust and agreed with external auditors and that deal recording and settlement systems are effective (with appropriate contingency arrangements in place).

4.131

Reliance on electronic dealing, custodian, central clearing, treasury management, valuation and risk assessment systems renders societies particularly vulnerable to software or hardware failure. Boards of societies are expected to:

1. (a) ensure that treasury IT systems' access, both physical and logical, is subject to robust security;
2. (b) exercise strong control over the development and modification of treasury IT systems; and
3. (c) involve specialist internal auditors in reviewing the development or modification of treasury IT systems.

4.132

The PRA has devised four models (‘approaches’) of increasing sophistication, to assist societies in assessing their approach to financial risk management and treasury operations. These ‘supervisory treasury approaches’ are ‘administered’, ‘matched’, ‘extended’, and ‘comprehensive’.^[22]

4.133

The PRA expects each society to conduct its treasury activities in accordance with the most suitable approach of these four models, in order to demonstrate that it has complied with the PRA Rulebook General Organisational Requirements 2.1 and Risk Control 2.1 and 2.3 in the context of financial risk management. Where societies have treasury operations in subsidiary undertakings, these are expected to adopt the same approach category as the parent society.

4.134

Appendices 3–5 set out information on supervisory expectations for each of the four approaches and societies can use these to help determine their own chosen approach. The specification of indicative prudential standards and limits for each approach is designed to draw management and supervisory attention to those areas of a society's financial risk management strategy or policy which go (or seek to go) beyond the PRA's general expectation for societies on each respective approach, bearing in mind the level of risk management capability expected by the PRA to be in place for that approach.

4.135

Societies should expect their supervisors to focus in greater detail on those areas of difference between internal limits and controls and those set out in Appendices 3–5, to identify whether business risks and controls are properly aligned, and, if not, to understand plans to address that misalignment. As such, the limit expectations set out in Appendices 4 and 5 are not intended to be interpreted as hard requirements, but as input into the process of establishing appropriate policies, and as the basis for supervisory dialogue.

4.136

Societies in the administered approach category would have balance sheets where loan assets and funding liabilities are entirely in Sterling, and predominantly (>90%) subject to administered interest rates.

4.137

It is anticipated that the administered approach would suit small, or very small, societies where balance sheet management is typically undertaken by the CEO and CFO (or Finance Manager) in conjunction with the board.

4.138

A society adopting the administered approach to treasury management would hold its liquidity buffer, as required to meet the liquidity coverage ratio in accordance with Article 412(1) of Regulation (EU) No 575/2013 (LCR), in instruments that are within its risk management capabilities. Total liquidity would be sufficient to meet its own OLAR. Both the LCR and OLAR buffers need to be useable in the event of a liquidity stress.

4.139

Societies in this category would not hold any treasury investments (including as part of its liquidity buffer), nor issue any funding instruments, that contain complex structured optionality, whether this optionality relates to interest payable or receivable, instrument term or any other variable. It is expected that liquidity and treasury investments would be focused on short-dated gilts and T-Bills, and short-term deposits with banks and/or other societies (not fixed/floating rate medium term notes, covered bonds or asset-backed securities).

4.140

The PRA would not expect societies on the administered approach to access wholesale funding from financial markets, nor to have external ratings of their debt. Funding from business deposit sources would be limited to a maximum of 10% of funding liabilities. Societies on this approach would not be expected to undertake repo or reverse repo activities, or to encumber their assets, with market counterparties. Administered approach societies are expected to have access to facilities provided by central banks, subject to board-approved internal limits covering both maximum funding and encumbrance levels.

4.141

Administered approach societies would have very limited exposure to fixed interest rate or market floating rate (eg base rate or market rate-linked) assets or liabilities; any retail assets with such characteristics would not represent more than 10% of the balance sheet and would be matched with retail liabilities for the same duration and with the same interest rate characteristics; similarly, retail liabilities with such characteristics would not represent more than 10% of the balance sheet and be broadly matched to similar retail assets. Any fixed rate instruments (eg held for liquidity purposes) or loans would be limited to a maximum repricing tenor of three years.

4.142

Administered approach societies would have pricing systems and procedures sufficient for them to be able to estimate individual product profitability and return on capital based on marginal funding costs, implied liquidity costs and allocated administrative costs. Societies would be able to model the impact on future margins of tranches of new business origination, especially where these involve customer incentives or rates that are not directly in the control of the society itself.

4.143

Societies adopting the matched approach would have balance sheets where assets and liabilities are entirely in sterling, and predominantly (>50% of total assets and >50% of total liabilities) on administered rates. They would be capable of using derivative hedging contracts (or appropriate matching of assets and liabilities with similar interest rate and maturity features) to neutralise, tranche by tranche, product by product, any significant interest rate or basis risk arising from the non-administered rate elements of their balance sheet.

4.144

It is anticipated that this approach would normally suit small to medium sized societies, with limited availability of treasury skills and resources. Typically the CEO of such societies would be supported by a CFO or Finance Manager, and would be primarily responsible for day-to-day risk management through an executive committee or ALCO. The reporting line would be direct to the board, on treasury matters (or through an appropriate board ALCO or Risk Committee), with management information on risk positions provided by an independent source responsible for risk monitoring and aggregation.

4.145

A society adopting the matched approach to treasury management will be expected to maintain its liquidity buffer required to meet the liquidity coverage ratio in accordance with Article 412(1) of Regulation (EU) No 575/2013, in instruments that are within its risk management capabilities. Total liquidity needs to be sufficient to meet its own OLAR.

4.146

Societies in this category would not hold any treasury investments nor issue any funding instruments that contain complex structured optionality, whether this optionality relates to interest payable or receivable, instrument term or any other variable. It is expected that liquidity and treasury investments would be focussed on gilts and T-Bills, and short-term (ie up to twelve months tenor) deposits with banks and/or other building societies (not fixed/floating rate medium term notes, covered bonds or asset-backed securities).

4.147

The PRA would not expect societies adopting the matched approach to access significant wholesale funding from financial markets, nor to have external ratings of their debt. Funding from wholesale and business deposit sources would each be limited to a maximum of 15% of funding liabilities. Societies on this approach would not be expected to encumber their assets, except for collateral pledged in support of central bank facilities, derivative contracts and small scale market repo activity in respect of liquid assets. Societies are expected to set board-approved internal overall encumbrance limits to apply in normal market conditions. Firms should set sub-limits by type of exposure as appropriate.

4.148

Matched approach societies would manage the refinancing risk arising from aggregate retail and non-retail liabilities: measurements of refinancing risk (including withdrawal trigger events such as rate expiries or changes) would be aligned with estimated stressed outflow percentages used in determining the LCR and OLAR. Where wholesale funding was taken, wholesale maturities would be limited to a maximum of 5% SDL in any one rolling quarter, and 10% SDL in any one rolling twelve month period.

4.149

Matched approach societies would have exposure to fixed interest rate or market floating rate (eg base rate or market rate-linked) assets or liabilities; and any loan assets or funding liabilities with such characteristics would be matched with liabilities/assets or derivative hedges for the same duration. Contractual balances, where the society currently sets an administered rate (or which will revert to administered rates within twelve months) would typically represent a minimum of 50% of the total loan assets and total funding liabilities of the society. Any fixed rate instruments (eg held for liquidity purposes) or loans would be limited to a maximum repricing tenor of five years.

4.150

In managing the risks of non-administered balances, such societies could use standard hedging products for transactions permitted by section 9A of the 1986 Act, (for example interest rate swaps and plain over the counter (OTC) purchased options such as swaptions, caps, collars and floors) for the purpose only of matching individual products. Structural hedging of the whole balance sheet would not be undertaken if following this approach.

4.151

Interest rate risk management for such societies would be monitored internally through:

1. (a) matching reports (detailing individual products and the hedging instruments associated with them); and
2. (b) gap analysis. For gapping purposes, reserves would be treated as having no fixed repricing date, and gap limits would be set at the minimum level necessary to give flexibility in timing the hedges for individual mortgage and investment products, with some allowance for marginal, residual risks and for holdings of short to medium term fixed-rate liquid assets. Basis and marginal interest rate risk would be minimised by setting cautious limits for mismatches, appropriate to the capabilities and resources of such societies to manage the risks.

4.152

Gap monitoring reports would be updated and considered by the board (or appropriate sub-committee) at least monthly. By implication, societies adopting this approach would not be taking an interest rate view across the balance sheet in determining a hedging strategy.

4.153

Matched approach societies would be able to estimate individual product profitability, including liquidity and administrative costs, and to understand the implications on future margins of tranches of new business origination, especially where these involve customer incentives. They would also be able to evaluate and manage the risks associated with pricing products using interest rate derivatives, and estimate the cost of term funding to match fixed rate product features. The outcome of these methodologies would be used in new product development and pricing decisions.

4.154

The principal difference between the matched and the extended approaches are in the:

1. (a) range of treasury instruments and operations used;
2. (b) availability of independent risk management resource to provide challenge and feedback to the executive directors; and
3. (c) capability to measure and hedge interest rate risk and structural risk across the whole balance sheet, including reserves, rather than just hedging individual transactions.

4.155

Societies adopting the extended approach would be capable of managing more complex balance sheet positions, including higher levels of wholesale funding (some of which might be in Euros or US Dollars), and a mixture of market interest rate positions that would provide more challenges in interest margin management than rates predominantly administered by the society itself.

4.156

Management of treasury and similar financial risks for such societies would typically be controlled by the board acting through an Assets and Liabilities Committee (ALCO) or equivalent sub-committee, which would normally be responsible for agreeing strategy and limits. Reporting to the ALCO, there would typically be a Treasurer running a small treasury department with robust segregation between dealing and settlement activities, monitored and challenged by an independent risk management function reporting to a Head of Risk and/or Chief Risk Officer.

4.157

A society adopting the extended approach to treasury management will be expected to maintain its liquidity buffer required to meet the liquidity coverage ratio in accordance with Article 412(1) of Regulation (EU) No 575/2013, in instruments that are within its risk management capabilities. Total liquidity needs to be sufficient to meet its own OLAR.

4.158

In addition to bank deposits and government securities, it is anticipated that societies on this approach might wish to hold limited positions in market-quoted debt securities, including senior debt, covered bonds and senior notes issued under securitisation transactions, subject to internal policy limits. Exposure to longer-dated fixed rate instruments would particularly be subject to internal limits.

4.159

The PRA would expect societies adopting the extended approach to have the systems and capabilities to transact repo business, and to have in place a number of repo lines consistent with their planned activity.

4.160

Societies on the Extended approach would be expected to limit their wholesale funding from financial markets (including from securitisation) to a maximum of 25% of funding liabilities, with sub-limits covering instrument types and the maximum amount to be obtained from a single source. Such funding might require the society to obtain and maintain an external debt rating. Societies will in any case need to meet any future EU or PRA guidance or rules on the Net Stable Funding Ratio (NSFR)^[23] when implemented in the United Kingdom.

4.161

As for matched, extended approach societies would plan and set limits and early warning indicators on future aggregate retail and non-retail refinancing requirements (see ‘Aggregate Refinancing risks’ paragraphs 4.78 –4.82 ). Any methodology would reflect the expected future cash outflow characteristics of a society’s liabilities.

4.162

Measurements of refinancing risk (including withdrawal trigger events such as retail rate expiries or rate changes) would be generally aligned with estimated stressed outflow percentages set out in the ILAAP and used to determine the LCR and OLAR. Where wholesale funding is not material, the board may decide that there is no need for a separate ladder of wholesale maturity limits. Wholesale maturities (excluding pass-through structures) would be limited to a maximum of 5% SDL in any one rolling quarter, and 10% SDL in any one rolling twelve month period, to ensure that the risk of higher levels of wholesale funding reliance would be mitigated by a longer average tenor, and to avoid bunching of refinance requirements.

4.163

Under the extended approach, societies would set internal limits on the level of encumbrance (including to central banks) that they are prepared to accept in normal market conditions. Normally, extended approach societies would not be expected to encumber more than 20% of balance sheet assets with market counterparties (that is, excluding assets encumbered under facilities provided by the central bank). But it is for each society to determine its own individual approach, based on its specific risk appetite, corporate plan and risk management capabilities, as set out in the ‘extensions’ process in Chapter 5 of this SS. Firms should set sub-limits by type of exposure as appropriate.

4.164

A society on the extended approach could potentially fund and hold assets denominated in Sterling, Euros or US dollars. However, the proportion of the balance sheet held would be appropriate to the nature of its business as a building society and its capability to manage such additional risks, including any additional reporting requirements arising.

4.165

Extended approach societies would have strong internal controls on their exposure to fixed interest rate or market floating rate (eg base rate or market rate-linked) assets or liabilities. Contractual balances, where the society currently sets an administered rate (or which will revert to administered rates within twelve months) would typically represent a minimum of 40% of the total loan assets and total funding liabilities of the society. Fixed rate instruments (eg held for liquidity purposes) with a repricing tenor beyond five years would be limited to a maximum of 5% of funding liabilities. Societies would set internal limits on the level of basis mismatch in aggregate (max per base) and by major mismatch pairs (eg bank rate/SONIA, bank rate/administered, SONIA/administered, SONIA/term rate, administered/administered).

4.166

In managing its interest rate risk and structural risk, a society adopting the Extended approach would implement policies and systems to enable it to undertake the hedging of individual transactions within the context of an overall strategy for structural hedging, based on detailed analysis of its balance sheet and the expected behaviour of individual products and instruments under an interest rate stress.

4.167

Societies on this approach would agree a risk appetite for balancing earnings risks and economic value risks arising from the investment of free reserves, but would not model and manage earnings risks arising from quasi-fixed rate non-maturity deposits (‘NMDs’). Some boards might choose to prioritise stabilising their society’s net interest income against the impact of adverse interest rate movements by allocating reserves across specific repricing bands representing a considered view of their characteristics, and then originating fixed rate receivables or transacting derivatives to match that profile. Other boards might prefer to prioritise the stability of economic value, by allocating reserves to the overnight repricing band, thereby accepting the earnings volatility that would emerge from the impact of changes in rates on returns from the assets financed by reserves in that repricing band.

4.168

The PRA would expect that any allocation profile of reserves to repricing bands would be agreed by both ALCO and the board. The profile would be used to define an interest rate risk ‘balanced’ position under which the society would operate for the duration of the plan. This ‘balanced’ position would need to reconcile the board’s tolerance of earnings instability with its tolerance for economic value instability: that is, the allocated duration of free reserves would be set strategically by the board with the intention of producing a more stable earnings or economic value profile (the longer the tenor of the profile chosen for earnings stabilisation purposes, the greater the potential change in economic value that could arise on a change in interest rates). The chosen earnings and economic value stabilisation objectives would, under normal circumstances, be reviewed only as part of the corporate planning process. Therefore, any profile allocated to reserves would not be altered repeatedly to adjust tactically for changes in the society’s own expectations for both short-term changes in interest rates and longer term yield curve shifts.

4.169

As a minimum, risk management would be based on full balance sheet gap analysis, supplemented by static simulation of both earnings and economic value under an interest rate stress. Gap limits might allow some leeway for positions caused by imperfect hedging (eg of pipeline and prepayment risk), to be controlled by board-approved sensitivity limits covering potential changes in both future NII earnings and economic value.

4.170

Hedging instruments available to be authorised by the board would be the same as for the matched approach, with the addition of: forward rate agreements/futures; and foreign exchange swaps/forward contracts/options (purchase only).

4.171

Extended approach societies would understand and apply the key principles and components of pricing methodologies to enable them to calculate and report individual product profitability, taking account of liquidity and administrative costs, and the funding structure of their balance sheets (both term and source) – but they would not be expected to implement a full FTP system. They would be able to model future margins on tranches of existing and new business, taking account of expected customer behaviour in respect of product incentives and embedded optionality that could affect prepayment or deposit withdrawal rates relative to the prevailing term structure of interest rates. Extended approach societies would have specific controls to ensure that future NII is protected from the impact of fixed margins on earnings flexibility in the event of stress. Such societies would also be capable of allocating, by product, a charge for capital that is aligned to their ICAAP and business plan. An FTP-informed methodology would be a key input to the new product approval process.

4.172

The principal differences between the extended and the comprehensive approaches are the:

1. (a) depth and quality of the risk management systems and controls;
2. (b) frequency and complexity of position and risk analysis undertaken; and
3. (c) range of instruments and currencies in which treasury operations are carried out.

4.173

As with extended approach societies, it is expected that comprehensive approach societies would manage risk using a Board/ALCO/Treasurer reporting structure. The structure of a comprehensive approach society’s treasury and treasury risk management activities would exhibit many of the following features:

1. (a) First line, reporting to a Group Treasurer or Treasury Executive who is a direct report of the CFO, comprising the:
   1. o Front office Deal/ Execution function; and
   2. o Middle Office – Asset and Liability Management (‘ALM’) function.

1. (b) First line, reporting to the Chief Financial Officer (‘CFO’) or Group Financial Controller (‘GFC’) who is a direct report of the CFO, comprising:
   1. o Back Office – Administration & Settlement; and
   2. o Financial Control – Payments & Bank Reconciliation function.
   3. This structure segregates the first line Treasury functions. (Note: some societies may choose to place Middle Office under the control of the CFO or GFC).

1. (c) Second Line, reporting to a Chief Risk Officer operating at (or just below) board level, possibly through a Head of Financial Risk, overseeing the:
   1. o Balance Sheet Risk Management (‘BSRM’) function;
   2. o Liquidity Risk Management function;
   3. o Treasury Credit Risk Management function; and
   4. o Treasury Policy Compliance function.

1. (d) Third Line Internal Audit Function, reporting through the Head of Internal Audit to the Chair of the Board Audit Committee, covering third line reviews of:
   1. o treasury management and deal execution risks;
   2. o treasury administration, settlement and payments risks;
   3. o treasury operational risk;
   4. o balance sheet risk management (including liquidity / market / interest rate risks);
   5. o treasury credit risk; and
   6. o treasury governance and policy reviews (including ILAAP & ICAAP).

4.174

Other specialist functions such as debt capital markets, structured financing, collateral management, investor reporting and debt ratings management may be undertaken by comprehensive approach treasuries and may either sit within the above outline structure or as separate discrete teams reporting to the appropriate line manager / executive.

4.175

Societies adopting the comprehensive approach would be capable of managing complex balance sheet positions, including high levels of wholesale funding in a mixture of currencies, and a range of market interest rate positions that require sophisticated risk measurement and mitigation, using a range of OTC and exchange traded instruments and derivatives. Positions would be measured and managed through a set of internally agreed and monitored limits, calibrated to control for concentration risks (both in assets and liabilities) and to ensure that the society has sufficient capacity to manage risks to its liquidity, funding interest margin and economic value risks over its corporate plan horizon.

4.176

A society adopting the comprehensive approach to treasury management is expected to maintain its liquidity buffer required to meet the liquidity coverage ratio in accordance with Article 412(1) of Regulation (EU) No 575/2013, having regard to its risk management capabilities and internal risk appetite. Total liquidity needs to be sufficient to meet its own OLAR.

4.177

Societies on the Comprehensive approach would normally be expected to carry an external debt rating, and to set limits on their wholesale funding from financial markets within the statutory maximum of 50% of funding liabilities, with sub-limits covering the composition (by source, funding instrument type and currency) and maturity structure of such funding (to avoid bunching of wholesale refinancing maturities and over reliance on short-term debt). Societies will in any case need to meet any future European Union or PRA policy on the Net Stable Funding Ratio (NSFR)^[24] once implemented in the United Kingdom.

4.178

Comprehensive approach societies would set internal limits on the level of encumbrance that they may be subject to, including sub-limits by type of exposure (repo, covered bond, securitisation, derivative margin, etc.).

4.179

A society on the comprehensive approach could fund and hold assets in a range of currencies. However, the proportion of the balance sheet held would be appropriate to the nature of its business as a building society and its capability to manage such additional risks, including any additional reporting requirements arising.

4.180

Comprehensive approach societies would have strong internal controls on their exposure to interest rate risk: the impact of rate changes on both earnings and economic value would be assessed by appropriate stress testing internally on a regular basis. Societies would set internal limits on the level of basis mismatch that may be carried, both in aggregate, and against different sub-types of interest rate index or base.

4.181

In managing its interest rate risk and structural risk, a comprehensive approach society would adopt policies and systems to enable it to model the expected behaviour of individual products and instruments under an interest rate stress and to implement policies that would require appropriate hedging strategies to be implemented in respect of revealed risks.

4.182

Societies on this approach may employ structural hedging techniques to stabilise earnings on free reserves and non-maturity deposits (NMDs) against the impact of adverse interest rate movements, setting portfolio allocations that represent the board’s considered long term view of the duration characteristics of those exposures and its risk appetite for balancing future NII earnings risks against economic value risks. Any such allocations would be regarded as interest rate change neutral ie not taking an interest rate view. The profile of the allocations would not be altered repeatedly or without board approval to adjust tactically for changes in the society’s own expectations for short-term changes in interest rates.

4.183

More generally, if the society had developed an interest rate view and wished to position its balance sheet to take advantage of that view, it would do so only within the board risk appetite represented by EVE, NII and any Value-at-Risk (VaR) sensitivity limits and triggers, and having incorporated an assessment of basis risk impacts.

4.184

Risk analysis would be based on full balance sheet analysis of both earnings and economic value under a variety of interest rate stresses, and would extend beyond static gap/static sensitivity analysis to include:

1. (a) dynamic simulation (projecting forward balance sheet elements and simulating the impact of different interest rate scenarios);
2. (b) duration for individual portfolio elements, present value of a basis point move calculations, VaR or other means to highlight sensitivities to parallel and non-parallel shifts in the yield curve; and
3. (c) foreign exchange mismatch (ie exchange rate exposure), which would be subject to appropriate risk management over foreign exchange movements.

4.185

Hedging instruments available for use under agreed board policy could include those for the extended approach plus (as far as permitted by section 9A of the 1986 Act) potentially:

1. (a) complex interest rate swaps;
2. (b) complex interest rate caps, collars or floors (purchase only);
3. (c) index-linked derivatives; and
4. (d) credit derivatives.

4.186

Comprehensive approach societies would be expected to operate a fully-fledged pricing model tailored to its own business model but taking into account the theoretical elements set out in Appendix 6. The model would incorporate all relevant costs including structural costs, liquidity costs, administrative costs, expected credit losses, hedging costs and an appropriate charge for capital. The methodology would be used proactively to influence balance sheet structure as well as volume and pricing of new business flows. Such societies may possibly wish to implement an enterprise-wide FTP solution which delivers business unit profitability and transfers all risks to a specific central unit or hub to increase visibility and enhance risk management.