Introduction

Part

BSOCS Building Societies sourcebook

Chapter

Introduction

Printed on: 16/09/2024

Rulebook at: 06/07/2010

BSOCS 1

Introduction

BSOCS 1.1

Application and overview

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Application

BSOCS 1.1.1

The Building Societies sourcebook (BSOCS) applies to all building societies.

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Purpose

BSOCS 1.1.2

This chapter describes the key financial and lending risks to which societies are exposed and sets out the framework within which the FSA will supervise the treasury activities of societies. It includes details of the five treasury "approach" categories ("Administered", "Matched", "Extended", "Comprehensive" and "Trading") applied, as well as details of the three approaches to lending activities ("Traditional", "Limited" and "Mitigated"). The chapter emphasises the respective responsibilities of boards and management for monitoring and controlling financial risks and lending.

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Other applicable provisions

BSOCS 1.1.3

Societies should note that they must also comply with the applicable prudential rules in GENPRU and BIPRU. Societies should refer to GENPRU and BIPRU for full details of these rules.

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BSOCS 1.1.4

Unless otherwise stated, references in this sourcebook to "society" (except those that relate to BIPRU 12) are to "society" groups, consolidated to include all subsidiary undertakings. For the avoidance of doubt, any undertakings in the society's group that are subject to the requirements of BIPRU 12 must comply with those requirements on a solo basis.

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BSOCS 1.2

Supervisory standards for treasury activities

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Setting risk limits

BSOCS 1.2.1

Under section 5 of the 1986 Act, a society's principal purpose is that of making loans which are secured on residential property and are funded substantially by its members, not undertaking, and trading in, financial risk for profit. Societies should therefore 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 ("boards") should set risk limits which either:

(1) ensure that, as far as possible, exposures to changes in interest rates are minimised; or

(2) where interest rate positions are to be taken, restrict potential reductions in income or economic value, estimated under robust stress testing scenarios, to levels which would not compromise the current or future viability of their societies.

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BSOCS 1.2.2

Societies should aim to eliminate, as far as is practicable, all exposures to risk arising from movements in currency exchange rates.

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BSOCS 1.2.3

(1) As explained in BSOCS 5.2.1 G, a society's system for financial risk management should be adequate. The policy statement envisaged in BSOCS 5.2.4 G should be appropriate for the society's business needs and the complexity of its existing and proposed treasury activities.

(2) The FSA has devised five models for financial risk management and treasury operations, described as supervisory treasury approaches, of increasing sophistication, to assist societies. The approaches are described as "Administered", "Matched", "Extended", "Comprehensive" and "Trading". A society that conducts its treasury activities in accordance with the most suitable (for it) of these five models, can readily demonstrate that it complies with the requirements of SYSC 4.1.1 R, SYSC 7.1.2 R and SYSC 7.1.4 R in the context of financial risk management. But these models are neither mandatory nor exhaustive. Guidance on the characteristics of each approach is set out in BSOCS 1.5.

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BSOCS 1.3

Supervisory standards for managing risks in the lending book

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BSOCS 1.3.1

Under section 6 of the 1986 Act, societies are required to ensure that a minimum of 75% of their commercial assets is fully secured on residential property. Since residential lending will always be such a significant part of a society's business, it is essential that the risks arising from further concentrations within the total lending book are properly managed and mitigated to align with the board's risk appetite.

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BSOCS 1.3.2

Accordingly, societies should adopt formal, board-approved lending policy statements that include limits on the type of lending that will be undertaken (both as a proportion of periodic flows and of stocks), as well as setting out the key underwriting policies and controls. As with financial risk limits, boards should aim to:

(1) ensure that, as far as possible, credit risks arising from lending are aligned with management risk appetite through careful underwriting; and

(2) ensure that any additional risk taken is appropriately priced and managed so that loss levels under stressed conditions would not compromise the current or future viability of their societies.

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BSOCS 1.3.3

The policy statement envisaged in BSOCS 1.3.2 G should be appropriate for the society's business needs and the complexity of its existing and proposed lending activities. The FSA has devised three models for lending book management, described as supervisory lending approaches, of increasing sophistication, to assist societies. The approaches are described as "Traditional", "Limited" and "Mitigated". A society that conducts its lending activities in accordance with the most suitable (for it) of these three models can readily demonstrate that it complies with the requirements of SYSC 4.1.1 R and SYSC 7.1.2 R, in the context of loan book management. But these models are neither mandatory nor exhaustive. Guidance on the characteristics of each approach is set out in BSOCS 2.

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BSOCS 1.4

Supervisory discussions on change of "approach"

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BSOCS 1.4.1

With regard to any of the five approaches to treasury risk and financial risk management, or the three approaches to managing the lending book, the FSA anticipates that societies will wish to develop further their expertise, and that a change of "approach" may be necessary. In this respect, the "approach" categories should be seen, not as discrete compartments, but rather as stages in the continuous evolution of risk management and systems, with a change of "approach" marking a milestone in that progress. Societies should develop their risk management and systems to the level appropriate to support the scale and nature of their business and the FSA will be encouraging societies to enhance these capabilities where this is considered to be necessary.

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BSOCS 1.4.2

Whilst the "approach" benchmarks are not binding and are guidance only, the process of moving between approaches provides a useful opportunity for the FSA to review a society's progress, and to satisfy itself that policies, limits and systems are appropriate for the activities planned.

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BSOCS 1.4.3

Any society which wishes to move between the five approaches to treasury risk and financial risk management, or the three approaches to managing the lending book, should contact the FSA at an early stage. The FSA will wish to be satisfied that the society has the requisite expertise, management information systems, accounting systems and controls before any significant change in the society's treasury activities or lending policy is implemented.

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BSOCS 1.5

Supervisory approaches to treasury management

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BSOCS 1.5.1

BSOCS 1.5 to 1.10 provide guidance on the five models, or supervisory approaches, to treasury management described in BSOCS 1.2.3 G. Where societies have treasury operations in subsidiary undertakings, these should adopt the same approach category as that of the parent society. An outline description of each approach is set out in BSOCS 1.6 to 1.10, and tables at the end of each of Chapters 3 to 5 summarise the key features.

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BSOCS 1.6

"Administered" approach

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BSOCS 1.6.1

Societies in the "Administered" approach category should have balance sheets where loan assets and funding liabilities are entirely in Sterling and predominantly (>95%) subject to administered rates. In general, it is anticipated that the "Administered" approach will tend to suit small or very small societies where balance sheet management is typically undertaken by the Chief Executive in conjunction with the board.

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BSOCS 1.6.2

Societies in this category should not hold any treasury investments, or issue any funding instruments, which contain complex structured optionality, whether this optionality relates to interest payable or receivable, instrument term or any other variable.

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BSOCS 1.6.3

It is likely to be appropriate for a society that falls into this category to apply for a simplified ILAS waiver.

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BSOCS 1.7

"Matched" approach

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BSOCS 1.7.1

(1) Societies adopting the "Matched" approach should have balance sheets where assets and liabilities are entirely in Sterling and use hedging contracts (or internal matching of assets and liabilities with similar interest rate and maturity features) to neutralise the risk arising from loans or funding other than at administered rates, on a tranche by tranche, product by product basis.

(2) This approach is characteristic of small to medium sized societies, with limited treasury skills or resources. Typically the Chief Executive of such societies will be supported by a Finance Director or Finance Manager, and report direct to the board on treasury matters (or through an appropriate committee).

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BSOCS 1.7.2

The policies of such societies can allow use of standard hedging products for transactions permitted by section 9A of the 1986 Act, for example:

(1) interest rate swaps; and

(2) plain vanilla over the counter ("OTC") options such as swaptions, caps, collars and floors (options purchased only);

for the purpose only of matching individual products and within the exemptions permitted by section 9A. Structural hedging of the whole balance sheet should not be permitted.

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BSOCS 1.7.3

Risk management for such societies should be achieved internally through:

(1) matching reports (detailing individual products and the hedging instruments associated with them); and

(2) gap analysis; for gapping purposes, reserves will need to be treated as having no fixed repricing date, and gap limits should be set at the minimum level required to give flexibility in timing the hedges for individual mortgage and investment products, with some allowance for residual risks (those too small to be economic to hedge) and for holdings of fixed rate liquid assets. Basis risk should be minimised by setting cautious limits for fixed rate, bank base rate and any other market rate assets and liabilities.

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BSOCS 1.7.4

Gap monitoring reports should be updated and considered by the board at least monthly. By implication, societies adopting this approach should not be taking an interest rate view for the purposes of determining a hedging strategy.

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BSOCS 1.7.5

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BSOCS 1.7.6

It is likely to be appropriate for a society that falls into this category to apply for a simplified ILAS waiver.

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BSOCS 1.8

"Extended" approach

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BSOCS 1.8.1

The principal difference between the "Matched" and the "Extended" approaches lies in the capability to measure and hedge structural risk across the whole balance sheet, including reserves, rather than just hedging individual transactions. The approach will thus allow a society to allocate reserves to specific repricing bands representing a considered view of the characteristics of those reserves, and/or the assets deemed to "represent" them, or to manage interest rate gaps as part of a strategy for hedging the endowment effect of interest free reserves against adverse interest rate movements. Risk analysis should also enable it to position its balance sheet to take advantage of a particular interest view.

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BSOCS 1.8.2

The FSA expects that some societies on the extended approach will, subject to being able to satisfy the relevant conditions, elect to apply for a simplified ILAS waiver whilst others may choose to remain as standard ILAS BIPRU firms. For a society that is a standard ILAS BIPRU firm, the FSA will discuss with the society the maximum level of wholesale funding that the society should hold. A society that wishes to operate the simplified ILAS approach will need to satisfy the relevant conditions in BIPRU 12.6, including those relating to the minimum percentage of total liabilities accounted for by retail deposits.

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BSOCS 1.8.3

A society on the extended approach can potentially fund and hold assets denominated in Sterling, Euros or US dollars, whether it is a simplified ILAS BIPRU firm or a standard ILAS BIPRU firm.

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BSOCS 1.8.4

A society adopting the extended approach should:

(1) adopt 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

(2) use the output of that analysis to enable it to position its balance sheet to take advantage of a particular interest view.

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BSOCS 1.8.5

Management of interest risk for such societies will typically be controlled by the board acting through an Assets and Liabilities Committee ("ALCO") or equivalent sub-committee, which will normally be responsible for agreeing any interest rate view. Reporting to the ALCO, there will typically be a Treasurer running a small treasury department with appropriate segregation between dealing and settlement activities.

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BSOCS 1.8.6

Hedging instruments available to be authorised by the board will be the same as for the "Matched" approach, with the addition of (as far as permitted by section 9A):

(1) FRAs/futures; and

(2) foreign exchange swaps/forward contracts/options (purchase only).

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BSOCS 1.8.7

Risk management systems should be based on full balance sheet gap analysis, possibly supplemented by static simulation.

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BSOCS 1.8.8

Gap limits could allow leeway for risk positions, to be controlled by sensitivity limits covering potential changes in both earnings and economic value.

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BSOCS 1.9

"Comprehensive" approach

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BSOCS 1.9.1

The principal differences between the "Extended" and the "Comprehensive" approaches lie in:

(1) the depth and quality of the risk management systems put in place to monitor and control structural risk;

(2) the frequency of analysis undertaken; and

(3) the currencies in which treasury operations would be undertaken.

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BSOCS 1.9.2

Like the extended approach societies, comprehensive approach societies will manage risk using a board/ALCO/Treasurer reporting structure, but the latter will typically subdivide the treasury department further with a separate "middle office" risk management function, segregated from "front office" (dealing) and "back office" (settlement/accounting).

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BSOCS 1.9.3

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

(1) complex interest rate swaps;

(2) complex interest rate caps/collars/floors (purchase only);

(3) House Price Index derivatives; and

(4) credit derivatives.

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BSOCS 1.9.4

Risk analysis should extend beyond static gap/static sensitivity analysis to (for example):

(1) dynamic simulation (such as projecting forward balance sheet elements and simulating the impact of different interest rate scenarios);

(2) duration for individual portfolio elements, or present value of a basis point move calculations, to highlight sensitivity to non-parallel shifts in the yield curve; and

(3) value at risk, using correlation/historic simulation and/or Monte Carlo simulation;

the impact on both earnings and economic value being assessed internally on a very regular basis.

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BSOCS 1.9.5

Risk positions could reflect an interest view, subject to sensitivity limits set by the board/ALCO and incorporating basis risk assessment/control. Foreign exchange mismatch (i.e. exchange rate exposure) should be subject to appropriate risk management over foreign exchange movements.

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BSOCS 1.9.6

It is likely to be appropriate for a society on the comprehensive approach to be a standard ILAS BIPRU firm.

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BSOCS 1.10

"Trading" approach

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BSOCS 1.10.1

The "Trading" approach is a category for those societies which wish to take advantage of the ability to trade in securities. Essentially, those societies will adopt the comprehensive approach for the purpose of managing interest risk arising in their banking book, but with additional policies, financial instruments, systems and expertise for managing the market risks inherent in running a separate trading book.

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BSOCS 1.10.2

Such a society should control the additional market risks through a Market Risk Committee of the board and risk management systems should include complex portfolio management, option pricing and value at risk models.

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BSOCS 1.10.3

It is likely to be appropriate for a society on the trading approach to be a standard ILAS BIPRU firm.

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BSOCS 1.11

Supervisory approach to managing the lending book

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BSOCS 1.11.1

BSOCS 1.12 to 1.14 provides guidance on the three models, or supervisory approaches, to managing the lending book described in BSOCS 1.3.3 G. An outline description of each approach is set out at BSOCS 1.12 to 1.14 and the Tables at the end of BSOCS 2 summarise the key features.

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BSOCS 1.12

"Traditional" lending approach

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BSOCS 1.12.1

Societies in the "Traditional" lending approach category should restrict their lending activities mainly to prime quality residential mortgages for owner-occupiers. The traditional approach should suit small or very small societies where lending decisions are fully underwritten on an individual basis, typically by the Chief Executive or a direct report, under clearly delegated mandates.

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BSOCS 1.12.2

Societies adopting this approach should have board-approved lending policies that:

(1) set a minimum limit of at least 85% of loan book for prime owner-occupied mortgages (subject to a mortgage indemnity guarantee or other recognised collateral for loan to values (LTV) in excess of 80%);

(2) limit other types of lending within the maximum 15% balance to prime owner-occupied >80% to <90% LTV without external insurance, prime buy to let, shared ownership, social landlords and secured commercial lending (including fully secured on land) only;

(3) require the use of approved independent valuers (in this context, independent valuer has the same meaning as in BIPRU 3.4.66 R (2));

(4) require stress tests to be undertaken at least annually to identify potential shortfalls in the value of security and allow it to review the appropriateness of its lending limits; and

(5) limit exposure to connected counterparties to <10% capital resources.

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BSOCS 1.13

"Limited" lending approach

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BSOCS 1.13.1

The "Limited" lending approach is suitable for societies that have a slightly higher appetite for credit risk than those on the traditional approach. Societies adopting this approach should control the amount of risk assumed through a comprehensive system of policy limits. These limits will prevent the society from becoming over-exposed to non-traditional lending, and will take account of the differing risks associated with the type of lending and the type of security held. In general it is anticipated that the limited approach will tend to suit medium-sized and larger societies where:

(1) there is operational segregation between underwriting and the review/audit/compliance functions which check compliance with policy and legislation and which review lending/underwriting quality;

(2) there is operational segregation between underwriting and the mortgage sales function;

(3) lending decisions are fully underwritten on an individual or systematically credit-scored basis, under clearly delegated mandates; and

(4) relevant specialist expertise is employed for non-traditional lending, with access to appropriate sources of external and internal information on how risks are developing.

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BSOCS 1.13.2

Societies adopting this approach should have board-approved lending policies that:

(1) set a minimum limit of at least 65% of total loan book for prime owner-occupied mortgages;

(2) set sub-limits, both in terms of total loan book and lending in a twelve-month period, for other types of lending within the maximum 35% balance; and

(3) require stress-testing and scenario analysis of outcomes to be undertaken at least semi-annually.

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BSOCS 1.14

"Mitigated" lending approach

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BSOCS 1.14.1

The "Mitigated" lending approach is suitable for societies that undertake a diverse range of lending. Societies adopting this approach should mitigate their risk through sophisticated credit risk management systems that control the amount of risk assumed, both through a comprehensive system of policy limits and through the operation of stochastic risk models. In general it is anticipated that the mitigated approach will tend to suit only the largest societies where:

(1) there is a segregated and independent risk function reporting directly to the board (or a board-level committee);

(2) there is full segregation between credit underwriting and the review/audit/compliance functions which check compliance with policy and legislation, and which review lending/underwriting quality;

(3) underwriting is independent of mortgage sales function;

(4) lending decisions are underwritten on an individual or systematically credit-scored basis (but subject to manual override), under clearly delegated mandates; and

(5) relevant specialist expert teams are employed for non-traditional lending, with access to appropriate sources of external and internal information on how risks are developing.

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BSOCS 1.14.2

Societies adopting this approach:

(1) should have board-approved lending policies that set appropriate limits, both in terms of total loan book and lending in a twelve-month period, for each type of lending; and

(2) should undertake full econometric risk analysis, stress-testing and scenario analysis of outcomes at least quarterly.

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BSOCS 1.15

Review of financial risk management approach and assessment of lending approach

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BSOCS 1.15.1

Societies should perform an initial review of their current financial risk management approach in the light of the guidance in BSOCS and undertake a self-assessment of controls over their lending book in the light of the BSOCS lending criteria. Having done so, the society should inform its supervisor at the FSA in writing of the approaches that it considers are the ones most suited to its systems and controls for managing financial and lending risks, provide details of any features of its systems, controls or activities that fall outside the parameters of those approaches, and discuss with its supervisor what, if any, actions are needed on the part of the society to address these. This should be completed by 1 October 2010.

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BSOCS 1.15.2

The FSA recognises that, where the need to make changes to funding profile, treasury investments or lending profile to achieve compliance with SYSC is identified, it is likely that the move to achieve this will be gradual. The FSA will discuss with each society an appropriate period of time over which any realignment should be undertaken.

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BSOCS 1.15.3

Subsequent to this initial review, societies should continue to review the suitability of their allocated approaches as appropriate and speak to their supervisor at the earliest opportunity if they anticipate that their systems, controls or activities will fall outside the parameters of those approaches.

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BSOCS 1.16

Interpretation

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BSOCS 1.16.1

In this sourcebook "administered rate" is defined as a rate of interest (which may be applied to lending or funding) which is, to the extent compatible with regulatory requirements and the general law, set from time to time at the discretion of the society and is not geared automatically to changes in an external reference rate, subject to the following:

(1) a society operating under the administered or matched approaches to financial risk management that chooses to set a contractual floor or cap should set nothing other than a floor (minimum rate receivable) on a rate charged on mortgages and/or a cap (maximum rate payable) on a rate payable to retail savers; these are the only limitations that may be applied to administered rate products allocated against the minimum policy limit; and

(2) a society not operating on either of the approaches in (1) may choose to include any guarantee in combination with an administered rate; it would however be expected to set appropriate sub-limits to control the level of basis and re-pricing risk taken, and to be able to evidence that it has assessed the cumulative impact of all such guarantees on its ability to vary rates generally as part of its regular stress and scenario testing programme.

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BSOCS 1.16.2

In this sourcebook "total loan book" is defined as total outstanding lending whether secured on property or unsecured.

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BSOCS 1.16.3

For the purposes of BSOCS 2.6.3 G, loans to companies or partnerships secured on buy-to-let property should always be considered commercial.

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BSOCS 1.16.4

In this sourcebook reference to the term of any funding or treasury investment (including those held to comply with BIPRU 12) should in all cases be taken to mean the residual date to maturity.

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BSOCS 1.16.5

The status of the provisions in BSOCS is indicated by icons containing the letters R or G. Please refer to chapter six of the Reader's Guide for further explanation about the significance of these icons. The Reader's Guide can be found at
http://fsahandbook.info/FSA/pdf/rguide.pdf

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