In this instalment of our Series on COVID-19 and RegTech, we are considering the treatment of government guarantees as unfunded credit risk protection. On 27 April 2020, the Prudential Regulation Authority (PRA) issued a policy statement confirming that government guarantees under the Coronavirus Business Interruption Loan Scheme (CBILS) are eligible for treatment as unfunded credit risk protection. What are the implications of this regulatory treatment?
The Capital Requirements Regulation 575/2013 (CRR) requires that lenders hold a sufficient level of capital to protect themselves against risk. For every loan that a lender issues, it has to calculate a risk-weighted asset measure (RWA). The RWA measure determines the riskiness of the loan based on two different approaches: the standardised approach (SA) or the internal ratings-based approach (IRB). The higher the RWA measure, the more capital the lender will have to hold against the loan in question. Lenders can use credit risk mitigation techniques to cover losses, if the borrower is unable to repay the loan. Article 235 CRR calculates the effect of unfunded credit risk protection on risk-weight exposures under SA. The calculation takes into account the risk weight of the exposure to the protection provider. Importantly, Article 114(4) CRR provides that any exposures to the central government of an EU Member State shall be assigned a risk weight of 0%. Since the protection provider is the UK’s BEIS, the reduction in RWA through the government guarantee is significant. Why is this policy step by the PRA so important?
The positive impact on RWA measures is important from an economic policy perspective. The CBILS loan scheme was created to support businesses whose activities have been adversely affected by the coronavirus pandemic. Lending to businesses under financial strain presents a high risk to lenders. Any loans that are not paid back in full constitute a loss to the lender. As a result, the RWA measure associated with these loans is substantially higher than would otherwise be the case. Under Article 122 CRR, risk weights can be as high as 150% for such high-risk loans. Many lenders would likely have to raise significant amounts of capital to match these high-risk loans. This would slow down the process of lending. Given the recent fall in economic activity, governments and central banks around the world have had to find quick ways to pump money into their economies to avoid crippling recessions. To this end, the Bank of England cut its base rate to 0.1% on 19 March 2020 to encourage lending. Treating the CBILS government guarantee as unfunded credit risk protection then guarantees that financial institutions can actually lend. Thanks to the PRA’s announcement, lenders are able to support businesses by lending in their time of need. How can RegTech solutions help?
The regulatory treatment as unfunded credit risk protection is important for regulatory reporting under C07. C07 calculates the credit risk of financial assets including loans. While the PRA’s announcement is important to encourage lending, performing the above calculations effectively is equally important. RegTech solutions like Suade’s offer a fast and accurate means of calculating credit risk on loans. For the PRA’s regulatory announcement, Suade helps its clients adjust the treatment of the loans. The software simply treats the loans as loans with a government guarantee. The necessary functionalities already exist. Suade clients are quickly able to calculate the impact of the CBILS guarantee on their RWAs for CBILS loans. Equipped with the data, Suade clients can evaluate the impact of lending during the COVID-19 crisis on their capital holdings. The Suade RegTech solution makes lending through CBILS possible.
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