The warnings are contained in a speech by Sam Woods, deputy governor for prudential regulation and CEO of the Prudential Regulation Authority (PRA) which was originally scheduled for the Building Society Association (BSA) annual conference in May, but deferred on account of the general election ‘purdah’.

The text of the speech has now been released. In it, Woods acknowledges that ‘financial institutions will always be able to innovate faster than we are able to modify the prudential rulebook’, but cautions that some innovation is ‘pure regulatory arbitrage’ – that is, action taken by firms to reduce specific regulatory requirements without any commensurate reduction in their risk.

In particular, Woods takes aim at off-balance sheet leverage, saying ‘We have noticed that some institutions are now moving on-balance-sheet financing to off-balance-sheet formats using special purpose vehicles, derivatives, agency structures or collateral swaps.

‘Some of these structures might meet the detailed requirements for calculating a specific financial ratio whilst others may have a harmless motivation. But we have noticed that some carry material credit risk which escapes the detailed aspects of the capital framework. When setting up these transactions, firms should be prepared for questions from supervisors about the substance, as well as form, of their proposals.’

Woods also expresses concerns about the treatment of liquid assets. Firms can account for the value in their liquid assets buffer on a ‘hold to maturity’, which he says raises the risk that – especially if gilt yields should rise – market price movements in liquid assets buffers could lead to unrealised losses.

In addition, he flags up examples of banks seeking out funding that matures just beyond the time horizon used to calculate regulatory liquidity requirements.

In each of these areas Woods said the PRA has identified behaviour that ‘might meet the letter of the regulation’, but is ‘designed to circumvent the spirit’, and the regulator will be challenging firms using such approaches. .

In conclusion, Woods stated: ‘Whilst we, as supervisors, may identify issues that warrant further investigation, we will not spot everything. Ultimately, it remains the responsibility of senior managers and boards of directors to identify and mitigate the risk that firms are not complying with the spirit of the regulation.’

Looking both ways, speech by Sam Woods, Deputy Governor, Prudential Regulation and Chief Executive Officer, Prudential Regulation, is here.