The Capital Regime for Small Domestic Deposit Takers: An extra year, but much to do…

Audience: Board members, CEOs, CFOs, CROs, CIOs of SDDT-eligible banks and building societies

At a glance:
 

• The PRA is consulting on the capital elements of the Strong and Simple regime for Small Domestic Deposit Takers (SDDTs).
• SDDT-eligible firms will be able to apply the capital elements from 1 January 2027.
• From 1 January 2026 (the date of UK Basel 3.1 implementation) until 1 January 2027, SDDT firms will be able to apply for an Interim Capital Regime (ICR), essentially the current UK CRR standards.
• The proposal includes some simplifications to the Basel 3.1 Pillar 1 regime, while introducing more substantial changes to the Pillar 2A methodology for credit, credit concentration, and operational risks.
• In addition, the PRA proposes to introduce a new non-cyclical Single Capital Buffer (SCB) for SDDT firms, replacing the existing system of multiple buffers.
• Given the relatively limited simplifications to the Pillar 1 regime, firms looking to adopt the SDDT regime should not underestimate the scale of change required to transition from the current framework. Even with the exemptions, the experience of standardised banks preparing for Basel 3.1 suggests that SDDT firms need to start work well ahead of the 1 January 2027 go-live date.
• Firms near the boundaries of the SDDT regime will need to assess carefully whether the simplifications offered are sufficient, or whether adopting the full Basel 3.1 regime from day one is a better option, avoiding a two-step implementation process.
• We have published a separate perspective of analysing the PRA Basel 3.1 near-final rules part 2.

Introduction
 

The PRA has consulted on the capital elements of the SDDT regime (CP7/24). This follows a Policy Statement (PS15/23) on the scope, liquidity requirements, and disclosures for the regime which have applied since January/July 2024 for any firms that have already opted into the regime (see the timeline below).

The proposal would allow SDDT firms to apply the new capital regime from 1 January 2027. In the year between Basel 3.1 implementation and 1 January 2027, firms entering the simplified capital regime will follow the current CRR standards (ICR), to avoid having to implement and apply the more complex Basel 3.1 standards for only a year.

The PRA expects SDDT-eligible firms to notify and engage with their supervisor regarding their decision to enter the regime. The PRA would then take time to consider practical matters in relation to the SDDT regime’s new P2A requirements and the expectations of the capital the SDDT firm should maintain under the Single Capital Buffer (SCB – see below).

Pillar 1
 

On Pillar 1, in summary, SDDT firms would:

• be required to calculate credit risk RWAs using the Basel 3.1 standardised approach to credit risk (CR SA) and SA credit risk mitigation (CRM) frameworks, with an exemption from the CR SA due diligence requirements;
• be required to apply the Basel 3.1 SA to Operational Risk;
• be required to use the CR SA to calculate market risk capital requirements (effectively treating trading book exposures as banking book exposures). SDDT firms would not be required to calculate market risk capital requirements for business activities subject to foreign exchange and commodity risk; and
• be exempt from calculating capital requirements for Credit Valuation Adjustment (CVA) and counterparty credit risk (CCR) for derivatives in the trading and banking book, with certain exceptions where the SDDT firm is a member of a central counterparty (CCP) or enters into securitisation positions resulting from derivative instruments.

In short, the Pillar 1 framework for SDDT firms will be fairly similar to the framework that will apply to firms subject to Basel 3.1. Exemptions from market risk, CVA and CCR requirements will be welcome, although given the size and complexity limits for the SDDT regime these would only be expected to have related to a comparatively small part of SDDT firms’ activity.

On the one hand, this means that SDDT-eligible firms may face a more significant implementation journey than they had anticipated – even with a ‘stay of execution’ of one year until 2027, those firms will need to apply a credit risk framework that is more granular and risk sensitive than current requirements, and supervisors are likely to expect a high standard of compliance on day 1 given the extra year. On the other hand, for banks close to the SDDT threshold that anticipate a two-stage implementation journey (initially applying the SDDT regime and then eventually the full Basel 3.1 regime) the regulatory barrier to growth will be comparatively smaller given the similarities between the two regimes.

Pillar 2
 

The more substantial simplification of the regime will be delivered through the Pillar 2A and buffer regimes.

Pillar 2A will be simplified for SDDT firms in the following ways:

• removing the use of (and reliance on) IRB benchmarks in the PRA’s existing Pillar 2 policy;
• requiring certain SDDT firms (new and growing firms, firms engaged in unsecured retail lending, and banks engaged in higher-risk lending, which could require increased capital) to provide a detailed assessment in their ICAAP of capital needed in relation to credit risk, using credit scenarios as the core methodology to assess the firm’s exposures to credit risk;
• for Credit Concentration Risk (CCoR), allowing SDDT firms to replace the Herfindahl-Hirschman Index based calculations with a methodology composed of a base add-on for CCoR and variable components for retail and wholesale exposures;
• for operational risk, introducing a bucketing approach, in which SDDT firms are placed in one of three buckets, corresponding to a different level of operational risk; and
• market risk methodologies and expectations would be completely removed.

ICR firms will not be subject to the Basel 3.1 P2A off-cycle review mentioned in the Pillar 2 section of the PRA’s near-final policy statement on Basel 3.1. However, the PRA states that it intends to carry out an ad-hoc P2A off-cycle review for ICR firms; data will be collected (and results delivered to individual firms) before the 1 January 2027 implementation date.

Consistent with the operational simplifications in P2A, the PRA is also proposing to reduce the frequency of ICAAP and ILAAP submissions to a minimum of every two years, with the exception of P2A and P2B elements of the ICAAP, which will have to be updated annually. SDDT firms should identify overlaps between their ILAAP and ICAAP documentation, in order to cut down on duplicative information provided in both the ICAAP and ILAAP.

Capital buffers
 

Another significant area of operational simplification is the proposed SCB, which would replace the current Capital Conservation, Countercyclical and PRA Buffers with a single buffer (see diagram below).

The SCB would not be a minimum requirement but rather a supervisory expectation, much like the existing PRA buffer. Its value would be a minimum of 3.5% of an SDDT firm’s RWAs, to be met with CET1 capital, and will be assessed taking into consideration three components:

1. impact of stress tests on SDDT firm’s capital resources;
2.  the firm’s risk management and governance; and
3. supervisory judgement. To improve the usability of buffers for SDDT firms under stressed circumstances, the PRA is also proposing to remove automatic capital conservation measures for the SCB (i.e., the Maximum Distributable Amount threshold).

The new P2A and P2B framework is likely to introduce increased predictability for SDDT firms, and exemption from the comparatively volatile CCyB will be a relief for those SDDT firms which find it more difficult to raise capital. While the PRA does not expect the P2 framework one-off costs to outweigh the benefit brought by the streamlining of the supervisory process, SDDT-eligible firms have considerable work ahead to implement the changes to the new supervisory regime. As the implications of the off-cycle review will guide the new supervisory mechanics, the PRA will not likely fully define the SDDT supervisory process within the next year. To get up to speed as soon as feasible, firms should engage with supervisors early (including before, during, and after the P2A off-cycle review) to understand the upcoming requirements better, in particular in relation to the use of new non-cyclical scenarios for credit risk P2A and the stress testing of capital resources as part of the SCB process.

While the new regime is a simplification compared to the Basel 3.1 standards, SDDT-eligible firms should consider some actions to ensure preparedness ahead of the go-live date:

• The SDDT regime is available through a “Modification by Consent” and so firms meeting the criteria do not need to seek permission from the PRA to move into the SDDT regime. However, given the range of issues that firms need to discuss with their supervisors, firms would be prudent to notify the PRA of their intent to adopt the regime as early as possible.
• While the PRA recognises that an SDDT firm can leave the regime voluntarily, as well as growing beyond the scope thresholds, firms should consider that the process to leave the SDDT regime may be subject to constraints. SDDT firms will need to present exit plans to their supervisor demonstrating their capacity to comply with the full Basel 3.1 regime upon exit.
• SDDT firms should not underestimate the scale of the change required to implement the Pillar 1 regime – even with the simplifications, the data, systems, policy and process upgrades required to implement the more risk-sensitive SA to credit risk in Basel 3.1, and the operational risk regime, are material. For example:
  • some of the data required for Basel 3.1 risk weight attribution may not be retained in systems (valuation at origination);
  • systems will need to be able to categorise exposures in ways that systems may not already support (investment grade vs non-investment grade);
  • capital calculation processes and systems will need to support more granular calculations and new exposure classifications (real estate asset class);
  • policies and processes around property valuation will need to be revised to recognise new expectations for revaluations; and
  • firms will need to be able to collect and categorise the data for the operational risk regime.
• The increased risk-sensitivity of the Basel 3.1 CR SA, while allowing for greater competition with IRB banks, comes at the cost of increased capital volatility (as compared to the current CFR SA), and so requires a greater need for scenario-based capital planning.
• Early investment in stress testing and scenario building capabilities will be beneficial for banks from an early stage given their importance in the Pillar 2A and SCB frameworks.

Conclusion
 

The PRA expects the capital impact of the new regime to be relatively small: capital ratios (as a percentage of RWAs) would be a few basis points lower than those of firms under the full Basel 3.1 framework (15% vs 15.4%). Other simplifications are estimated to bring net benefits in aggregate (between £101m and £226m), but the PRA recognises that its estimations depend on the type and number of SDDT-eligible firms that consent to the regime.

SDDT firms will welcome the simplification of the P2A and buffer requirements, and, more generally, the introduction of a capital regime that is better tailored to their size and complexity without creating a significant regulatory barrier to growth.

Larger firms that qualify as SDDT firms – particularly those with expectations for growth – will have to decide if the simplifications in the SDDT regime are sufficient to warrant adopting the regime, or if moving straight to the full Basel 3.1 regime and avoiding a two-stage implementation journey, with the attendant costs, is preferable.

Nonetheless, firms adopting the SDDT regime will need to ensure they progress rapidly to implement the data, systems, policy and process work required to comply with the new approach.