The UK Prudential Regulation Authority (PRA) has published a consultation paper on operational continuity for larger retail and investment banks. It follows on from a 2014 discussion paper on the topic and sets out proposals that may affect a bank's financial and operational resilience procedures and governance and outsourcing arrangements. The rules will be applicable from 1 January 2019.
Introduction
On 15 October 2015 the PRA published a consultation paper on operational continuity (CP 38/15). It sets out proposals that are intended to ensure that critical shared services are arranged in a way that facilitates continuity in the event of a bank failing, with rules applicable from 1 January 2019. The consultation paper does not fundamentally alter the PRA’s position on operational continuity, as set out earlier this year in discussion paper (DP 1/14); rather it develops the principles set out in DP 1/14 and proposes draft rules and a supervisory statement. An addendum defining the scope of application is due to be published at a later date.
These more granular requirements will need to be considered by PRA-regulated firms which have critical economic functions. Below we provide some high-level observations on the draft supervisory statement, focusing on the development of the principles established in DP 1/14.
Draft Supervisory Statement
Scope
The rules will apply to firms which provide critical functions (as defined in the Banking Recovery and Resolution Directive) in relation to critical shared services they receive – defined as services performed for one or more units of the firm, or for multiple entities within a group, whose failure would lead to the collapse of or present a serious impediment to the performance of the firm’s critical functions. In practice this will limit application of the requirements to larger retail and investment banks.
Critical shared services, as was the case in DP 1/14, may be provided from either an operational subsidiary, a division within the PRA-regulated firm or by a third party.
Facilitating recovery and resolution
Such firms will be obliged to demonstrate that the operational arrangements associated with critical shared services they receive facilitate recovery and resolution, and provide for continuity of service through resolution. The PRA makes it clear that they expect firms to make changes to achieve this. The introduction to the draft supervisory statement explicitly states that the PRA may use its statutory powers to require a firm to meet its operational continuity expectations. Where a firm has identified the disposal of business units or legal entities as part of its recovery strategy, the PRA expects it to be able to demonstrate how its operational arrangements improve the execution of recovery options by shortening the disposal timeline. This places a significant burden of proof on the firm.
Financial resilience
The capital and liquidity requirements applicable to a critical shared services provider remain broadly the same as set out in DP 1/14, based on three and six months’ working capital. CP 38/15 provides further detail on the stress scenarios the financial resources of a servicing entity must be able to withstand and provides details of items that may be excluded from the calculation of fixed overheads by the servicing entity.
CP 38/15 also requires the segregation of the liquidity resources of an intra-group service provider from other group assets. The resources must be available to the service provider regardless of the failure or resolution of other group entities. This may involve holding liquid assets outside the group or making deposits with third parties.
Operational resilience
Firms are required to ensure that the services will remain operational despite the failure of any group entities. The PRA provide examples of how this can be achieved such as ensuring that the operating division of a firm or group provider has change capabilities and operational contingency arrangements.
Contractual service provision
Consistent with the position in DP 1/14, contracts should prevent service providers terminating or changing the provision of services as a result of a firm or a member of the group entering into a period of stress or resolution.
objective service level agreements
CP 38/15 introduces a requirement that service level agreements from group providers are objective and on third party terms. The PRA sets out further detail on the minimum considerations relevant to documenting the service level from servicing entities.
access to operational assets
Firms must be able to articulate clearly how access to operational assets supporting critical shared services will be guaranteed at the point of stress or resolution of a firm, another group entity or the critical shared service provider itself. This places a higher burden of proof on firms that was anticipated in DP 1/14.
charging structure
CP 38/15 retains the requirement that there be an arm’s length charging basis for services from the critical shared service provider.
prevention of preferential treatment
The requirement that there is no preferential treatment for certain group entities over others is retained from DP 1/14.
governance arrangements
CP 38/15 develops the governance requirements, including emphasising that the critical shared services can be provided without relying on senior staff that may be dismissed or that may no longer form part of the same group after resolution. Further guidance is given on reporting lines, requiring that where there are multiple reporting lines, the PRA expects firms to ensure that there is clarity on reporting lines in the event of resolution, prioritising operational continuity for critical shared services.
outsourcing
The PRA expects firms to refer to the rules in the Outsourcing Part of the PRA Rulebook when considering their operational arrangements supporting critical shared services. A consequence of the outsourcing rules will be that a firm that outsources critical shared services will continue to remain responsible for functions that require senior management judgement or decision-making that could affect the prudential soundness or risk appetite of the regulated firm. For this reason, the PRA expects these functions to be retained within the regulated firm.
Implications for Firms
Firms which provide critical functions will need to consider how they meet their obligations under the paper carefully. There is ongoing debate around how to ensure the continuity of service through resolution, with no clear view as to the right answer at this stage. Further work is underway by the Financial Stability Board (FSB) which is also likely to affect the PRA’s policy approach in due course.
The central question around the issue is whether firms should work to isolate their operational infrastructure supporting critical shared services in separate operational subsidiaries. Whilst the paper is at pains not to suggest that this will be required, in practice it will be difficult for a firm operating such infrastructure on a divisionalised basis to demonstrate operational continuity on resolution of the firm (although there will be a good case to be made where the firm is subject to a single point of entry resolution strategy at the level of its ultimate parent). By sitting on the fence on the issue, the PRA is – pending the outcome of the FSB deliberations – permitting the status quo for now: but those firms which retain the divisionalised model can expect an uphill battle on submission of their next Recovery and Resolution Plan submissions.
The paper also represents something of a lost opportunity to address level playing field concerns in the context of operational subsidiarisation. The use of an operational subsidiary structure imposes additional capital and liquidity costs on firms (in addition to the very high costs associated with implementing such structures). Whilst it is helpful that the PRA seeks segregation of the liquidity buffer required by firms operating on the divisionalised basis, it would have been helpful to address explicitly the impact of each structure on capital and liquidity holistically.
