UK: Asset Encumbrance: The Elephant In The Room?

Asset encumbrance, also known as earmarking or pledging assets, refers to the existence of bank assets securing liabilities in the event that an institution fails to meet its financial obligations. It originates from transactions that are typically collateralised or asset-backed, such as repurchase agreements, securitisations, covered bonds, or derivatives.

Asset encumbrance not only poses risks to unsecured creditors that are unable to benefit from the liquidation of encumbered assets in case of insolvency, but also has wider stability implications since encumbered assets are generally not available to obtain emergency liquidity in case of an unforeseen stress event.

Since the recession, the level of asset encumbrance has rapidly increased, reflecting more stringent collateralisation requirements, especially on over-the-counter (OTC) derivative markets, and increased reliance on secured funding. From 2007 to 2011, the average asset encumbrance ratio of encumbered assets over total assets increased from 11% to 32%, according to the European Systemic Risk Board ("Recommendation of the European Systemic Risk Board of 20th December 2012 on funding of credit institutions" (ESRB/2012/2), February 2013).

As such, the topic has gained prominence in the regulatory community, with central banks and supervisors increasingly focusing on monitoring encumbrance levels and ensuring that institutions consider asset encumbrance a key component of their risk management and decision making processes.

The European Banking Authority (EBA) has recently published draft Implementing Technical Standards requiring the reporting of a number of regulatory returns on Asset Encumbrance, and public disclosure of Asset Encumbrance information within Pillar 3. The Prudential Regulation Authority (PRA) has also introduced related amendments to its Liquidity Standards as outlined in BIPRU 12.

The changes should help both institutions and regulators alike to understand the level and composition of encumbrance. The priority now for firms is to ensure that their risk management and reporting systems are sufficiently robust and prepared to meet the designated deadlines.

EBA reporting and Pillar 3 disclosures

The current draft EBA Implementing Technical Standards, developed under the remit of the CRD IV package, require firms to submit up to nine reporting templates. The information requested to all firms includes amounts of encumbered and unencumbered assets and collateral by product type, details of the firm's liabilities that generate encumbrance by transaction type, and issuance of covered bonds, among others. More advanced reporting templates covering maturity data or contingent encumbrance need to be reported by firms with total assets exceeding 30bn euro and with an asset encumbrance ratio higher than 15%. All the templates are required to be completed using December 2014 data, with first submission on 11 February 2015.

The EBA standards introduce the concept of 'contingent encumbrance' which refers to the additional assets which a firm may need to pledge when facing adverse developments triggered by an external event over which it has no control (e.g. a downgrade, decrease of the fair value of the encumbered assets, or a general loss of confidence). For the contingent encumbrance return, the EBA has provided two alternative scenarios including a drop in the fair value of encumbered assets and a depreciation of significant currencies, with firms being required to report the amount of additional collateral required in each separately, taking into account existing levels of overcollateralization and contractual requirements including threshold triggers.

Firms will also have to report a range of Asset Encumbrance information following a standard format in their published Pillar 3 disclosures, in addition to current IFRS 7 disclosure requirements, including three disclosures which are condensed versions of the EBA reporting templates, and an additional disclosure covering detailed business narrative.

Changes to UK PRA rules in BIPRU 12

The PRA proposed a number of amendments to BIPRU 12 relating to Asset Encumbrance on its March Occasional CP5/14. The consultation closed in April and the final instrument came into force on 26 May 2014.

Broadly, the following requirements have been introduced:

  • establishment of approach for asset encumbrance by the governing body including regular review and approval
  • risk management, monitoring and active management of the asset encumbrance position
  • provision of information to the governing body and senior management regarding the amount, evolution and types of additional encumbrance resulting from stress scenarios (contingent encumbrance)
  • incorporating asset encumbrance into stress testing scenarios outlined in BIPRU 12.3 and 12.4
  • incorporating strategies to address asset encumbrance into the firm's contingency funding and recovery and resolution plans

Line by line changes to BIPRU 12 can be found in appendix 4 of Policy Statement PS4/14.

How firms can prepare

Firms will need to make sure that any enhancements to their risk management and reporting systems are robust and enable compliance with the new requirements, ensuring that data challenges are addressed early in order to meet the reporting deadlines, and implementing the new PRA requirements.

Close attention should be paid to the wider interactions with other regulatory liquidity requirements, such as contingent encumbrance and liquidity risk stress tests. In this sense, the firm's policies and documentation, including the ILAA, may also need to be updated. Appropriate timescales for any enhancements necessary to comply with rules and guidance need to be discussed and agreed with the firm's supervisors.

Firms should also consider the overlap with wider reporting requirements in FINREP, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) as instances of cross-validation and common approaches to data, reporting and IT implications need to be taken into account.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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