What it means
Prudential regulation concerns the financial strength of firms. Instead of checking how a firm treats customers, it asks whether the firm has enough capital and cash to absorb losses and keep operating in a downturn.
The PRA does this for the firms it covers, while another body, the Financial Conduct Authority, focuses on conduct and consumer protection. The PRA was created when UK financial regulation was reorganised after the 2008 financial crisis.
The aim was to give the central bank a clear role in watching the stability of individual firms as well as the system as a whole. Because it sits within the Bank of England, it can draw on the central bank's economic expertise.
It sets and enforces rules on how much capital firms must hold, how much liquid cash they need and how they manage risks. It also reviews firms' internal models, tests their ability to withstand stress scenarios and approves senior managers.
Firms that fall short can be told to raise capital, change their plans or limit activities. For businesses outside finance, the PRA matters in three ways.
It affects how much banks charge for loans, because capital rules influence lending costs, and it affects the safety of deposits and insurance policies. It also shapes the reporting a finance team may need to provide when borrowing from regulated lenders.
The same three letters can mean other things in other contexts, such as a pre-retirement account or a patient safety review in hospitals. In finance, particularly in the UK, PRA almost always refers to the regulator.
When reading a report, check the context to be sure. The regulator also plays a part in handling failures.
If a bank or insurer gets into serious trouble, the PRA works with the Bank of England's resolution team and other authorities to keep critical services running. The goal is to avoid taxpayer bailouts by making firms plan for their own orderly wind-down.
In practice
Real-world examples.
Example
A mid-sized UK bank plans to pay a large dividend. The PRA reviews its capital position and asks it to reduce the dividend so that it keeps a stronger buffer against loan losses. The bank agrees, and shareholders are told the reason in the next announcement.
Example
An insurance company wants to launch a new line of business. It must show the PRA that it holds enough capital to cover the risk and that its senior managers are fit and proper.
Example
A foreign bank opens a branch in London. It needs authorisation from the regulator, and the PRA examines its financial strength and its plans for managing risk before the branch can take deposits. The process can take many months, so the bank starts preparing early.
Case study
Seen in the real world.
Fenwick Mutual is a fictional building society that wanted to grow its mortgage lending quickly. Its management believed it had enough capital, but the regulator asked for a stress test that assumed house prices falling sharply and unemployment rising.
The test showed that capital would dip below the required level in the worst scenario. In this illustrative case, the society paused its fastest growth, raised funds by issuing capital instruments and agreed a plan with the regulator, and the board noted that the exercise made the society stronger and its members safer. Its credit rating was unchanged, and depositors saw no change in service.
The chief executive later told staff that the regulator's questions were useful because they exposed risks the society had been underestimating. Management made the stress test a yearly routine instead of a one-off response to a request. The board also asked for the capital forecast to be updated each quarter. Members were told in the annual report what had changed and why.
Watch out
Common mistakes.
- Confusing the PRA with the Financial Conduct Authority, when one focuses on safety and soundness and the other on conduct and consumer protection.
- Assuming the PRA regulates every financial firm, when many, such as most investment advisers and consumer credit firms, are supervised only by the conduct regulator.
- Thinking the PRA guarantees deposits, when deposit protection comes from a separate compensation scheme.
Questions
People also ask.
Is the PRA part of the Bank of England?
Yes, it is a part of the central bank, although it has its own board and rulebook.
Which firms does the PRA supervise?
Banks, building societies, credit unions, insurers and certain large investment firms. Smaller firms outside these groups usually deal with the conduct regulator alone.
What does prudential mean?
It means concerned with safety and financial strength, such as holding enough capital and liquidity to survive losses. The word comes from prudence, the habit of planning carefully for bad times.
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