The PRA has published its consultation (CP) on the UK implementation of Basel 3.1. As expected, the PRA’s proposed approach adheres closely to the BCBS final framework document, in contrast to the EU proposals. This will result in considerable divergence between the UK and EU rulebooks. Key elements of the PRA’s approach include:
Although there are numerous areas throughout the circa. 1000-page CP where the PRA seeks input before it finalises its approach during 2023, the intended 1 January 2025 implementation date means that firms should use the PRA’s CP as the basis for the design and implementation work their Basel programmes need to complete in order to be ready on time.
On 30 November 2022, the Prudential Regulation Authority (PRA) published CP16/22 setting out its proposed approach to implementing Basel 3.1 in the UK. At the same time, HM Treasury (HMT) published a separate Consultation Paper proposing technical and legislative changes required to support the PRA’s intended implementation approach.
The HMT consultation aims to ease the application of the proposed PRA Basel 3.1 rules through the revocation and amendment in UK law of some parts of the Capital Requirements Regulation (CRR), which activity falls under the competency of the Government rather than the regulator. It highlights the “have regards” obligations on the PRA in the Financial Services Act 2021 and the new responsibilities for the PRA in drafting the new Basel rules. The matters in the consultation will inform the necessary secondary legislation to be laid in Parliament and that will come into effect at the same time as the PRA’s rules on Basel 3.1. HMT has not made all of the changes that the PRA requested, particularly in respect of changes to equivalence provisions in CRR. HMT’s consultation closes on 31 January 2023.
The PRA’s much-anticipated consultation sets out the UK’s proposed approach to adopting the framework initially published by the Basel Committee on Banking Supervision (BCBS) in December 2017. These reforms are referred to by UK regulators as “Basel 3.1”.1
A key question in the lead up to the CP’s publication was to what extent the PRA would diverge from the BCBS standards in its implementation of them. The answer is now clear: the PRA’s proposed rules are strongly aligned with the BCBS and include only limited deviations from it – and some instances of super-equivalence.
The PRA has provided comprehensive assessments of its objectives and the way in which it has met its statutory “have regard” duties throughout the CP. In summary, the PRA feels that adhering closely to the BCBS’ framework document is the best way of meeting its obligation to have regard to relevant international standards and the relative standing of the UK as a place for internationally active firms to operate as well as to continue to provide finance to businesses and consumers in the UK on a sustainable basis in the medium and long term. The PRA notes in the introduction to the CP that it placed significant emphasis on these have regard components in its assessment of how to implement Basel 3.1.
The PRA’s approach contrasts with the EU’s proposed implementation of the same rules through the CRD6/CRR3 Banking Package legislation, which looks set to deviate substantially from the BCBS standards when it is finalised. Although the UK’s approach means that it will align more closely with rules being developed in other BCBS jurisdictions such as Canada, Australia, Singapore and Hong Kong, it now appears inevitable that substantial differences between the UK and EU banking rulebooks will emerge. Banks operating in both the UK and the EU will have to contend with the added complexity: in particular this will require that data and IT systems are flexible enough to cope with multiple calculation options for the same exposure(s).
The challenges that come with implementation complexity manifest in Risk, Finance, technology/infrastructure, and bank-wide governance arrangements: successful implementation, and in particular the realisation of long-term benefits including competitive advantages (including better decision making, faster and lower cost processes) needs a carefully planned and coordinated programme of work. The challenges of dual reporting under UK and EU rulebooks that diverge significantly will make this even more complex. Finding ways of keeping the business users aligned on which regulatory regime they are working to in any given decision that involves a PD, EAD, LGD, RWA or even Pillar 2 capital will be a key challenge for Basel programmes to address.
The PRA makes only limited use of transition periods other than the phase‑in of the Standardised Output Floor (OF), whereas the EU proposals contain several transitional arrangements, including some that extend beyond the 2030 end of the phase‑in for the OF.
One area of alignment is the implementation timing of the package: as previously flagged, the PRA proposes to bring the rules into force by 1 January 2025 and to phase-in the OF over the five years to 1 January 2030. This matches the proposed timing in the EU and also that which regulatory authorities in the US have recently indicated they are likely to adopt. This will give banks a relatively short implementation window between the PRA’s finalisation of its Basel 3.1 rules (likely later next year) and when they come into force. Now more than ever banks must use the CP as a basis to drive their programme design and implementation work.
The PRA published an accompanying aggregated Cost-Benefit Analysis (CBA) assessing its proposed implementation approach. Overall, the PRA sees an aggregate macroeconomic benefit to implementing Basel 3.1 based on reduced risk, improving the competitive landscape for firms, and strengthening international confidence in the UK banking market. The PRA forecasts that the implementation of Basel 3.1 will lead to an increase in CET1 capital requirements for firms of around 3.1% overall (or £14.2 billion). This is a significantly lower figure than the forecast by the European Banking Authority (EBA) for EU banks, but the PRA forecasts differ from the EBA’s as they include assumptions about offsetting factors such as lower Pillar 2 capital requirements and likely actions by banks to reduce RWAs. Of particular note is the PRA’s assessment of the operational costs for industry to implement Basel 3.1, which is approximately £4.8 billion.
The PRA has published a number of questions in the CP, which are helpfully collated in a separate appendix. Many of the questions request firms to provide data to support further or deeper analysis. The consultation is open until 31 March 2023.
The CP is long: across the 13 chapters and 19 appendices it is in the region of 1,000 pages and it covers the full gamut of prudential risks that banks face. We have set out below what we see as the most material points from each of the chapters, noting that - as always - the devil is in the detail and what is most important will vary from firm to firm…
The PRA proposes to allow SA firms to apply for permission to use a risk-sensitive approach for exposures to unrated corporate borrowers. The risk sensitive approach will allow a risk weight of 65% for investment grade obligors, and 135% for non-investment grade obligors. The alternative is a flat 100% for all unrated corporate borrowers.
Firms using the ratings-based approach for rated corporates will be required to undertake their own due diligence of obligors. If firms’ due diligence suggests external ratings are too optimistic, then they must assign a higher risk weight to the exposure.
The PRA proposes to remove the infrastructure support factor.
The PRA proposes to remove the SME supporting factor; it will implement the 85% risk weight for Corporate SME borrowers.
The PRA intends to implement the minimum 10% conversion factor for Unconditionally Cancellable Commitments (UCCs). Unlike the EU, the PRA will not exercise the national discretion to exempt certain arrangements relating to corporate and SME borrowers from the definition of commitments, thereby allowing a 0% risk weight to the commitment.
The CP sets out a number of changes in relation to real estate lending.
Credit Risk – Internal Rating Based (IRB)
In addition to other constraints on the use of internal models, the option to model sovereign exposures under IRB is withdrawn. From a modelling perspective, this is super-equivalent to the BCBS framework, although from a broader prudential perspective it will result in lower RWAs.
The PRA proposes not to apply the infrastructure supporting factor.
The PRA proposes not to apply the CRR SME supporting factor.
The CP proposes a PD floor of 0.1% for UK retail residential mortgages and Qualifying Revolving Retail Exposures (QRRE) that meet the definition of transactors3. This is super-equivalent to the BCBS framework which sets a PD floor of 0.05% for all exposures except Sovereigns.
Under the slotting approach, the PRA will implement the High Volatility Commercial Real Estate (HVCRE) category and the Advanced IRB and Foundation IRB approaches for Income Producing Real Estate (IPRE) are withdrawn; this is super equivalent to the BCBS framework. All firms will be required to use the slotting approach for both IPRE and HVCRE.
The CP sets out that the PRA will move away from its current requirement for full compliance with CRR requirements when assessing IRB models and move to a material compliance approach. Key benefits include an ability for the PRA to ease the path to IRB for new applicants, and allowing the PRA to look at firms’ modelling proposals on the basis of whether they increase aggregate compliance with the rules.
The option to model volatility adjustments under the Financial Collateral Comprehensive Method (FCCM) is withdrawn.
The PRA sets out that if you have a guarantee for an exposure and there is a difference in credit treatments between the obligor and the guarantor – particularly if a direct exposure to the guarantor would be under the SA, the effect of the guarantee must be calculated using the SA. This adds complexity to the CRM process and calculation.
The PRA proposes to adhere closely to the BCBS proposals on amending the LGD framework for FIRB exposures, which will allow FIRB firms to achieve lower LGDs, and so lower risk weights.
The CP, helpfully, provides a number of flowcharts to help readers navigate which collateral approach(es) to apply.
The PRA has been consulting on a framework for Simpler Regime firms since last year.
The CP sets out a revised definition of a Simpler-regime firm following responses to CP5/22:
The purpose of the TCR is to ensure that small firms do not need to apply the Basel 3.1 standards before the future implementation date for a permanent risk-based capital framework for smaller firms.
The PRA language on Trading Book/Banking Book boundary is more prescriptive than the EU or BCBS. Banks may welcome the clarity, although it may be more likely to result in changes from the status quo.
Standardised Approach is very similar to the EU CRR, with the addition of a new bucket for carbon trading (with a risk weight that is the same as for other commodities), an alignment of Jump To Default definition to industry practice and some additional guidance on Residual Risk Add On.
Ability to use Non Modellable Risk Factors in Backtesting will be welcome; there is also a more prescriptive approach than BCBS to capital calculation.
Banks will welcome the fact that the P&L Attribution tests will not apply for the first year after go-live. This shrinks the overall Internal Model Approach ”time to delivery” for many banks.
Replacement of Risks not in VaR with Risks not in model (RNIM) framework, some allowance for materiality criteria and for discounting from PLA. While banks may dispute the need for RNIM, it aligns to EU.
The PRA proposes to disapply the CVA exemptions for Sovereigns, Non-financial Corporates and Pension Fund exposures.
Under the SA-CCR regime, the PRA proposes to reduce the “alpha” factor for exposures to Sovereigns, Non-financial Corporates and Pension Funds to 1, from 1.4.
The Internal Loss Multiplier will be set to 1 for all UK banks, taking loss history out of the Pillar 1 framework, consistent with the EU proposals.
In calculating the Business Indicator Component, newer firms will be allowed to use forecast figures until such time as actual figures are available.
Where the PRA is satisfied that the Pillar 1 charge more adequately captures risks than the current Pillar 2 framework, it will reduce the Pillar 2 charge to reflect this.
The proposed OF would apply to firms in scope of the PRA’s CRR requirements in the following way:
The PRA expects that, if the OF is triggered, all regulatory capital requirements, including buffer amounts, would be based on the SA RWA number.
The CP sets out an expectation that when applying the output floor, IRB firms would apply the SA in the same manner as firms without permission to use internal models.
Unlike the EU, the PRA will not implement the option to cap at 25% the increase in modelled RWAs for OF purposes during the OF phase-in period.
The PRA will review its Pillar 2A methodologies by 2024 – so Pillar 2 requirements and any corresponding reporting requirements will be updated before the Pillar 1 framework set out in the CP comes into force.
The PRA will not double count capital requirements for the same risks in Pillar 1 and Pillar 2A. So, to the extent that the proposals in the CP improve risk-capture in Pillar 1, Pillar 2A capital requirements will be adjusted accordingly. The Pillar 2A framework for operational risk will adjust largely mechanistically, but other areas (such as credit or market risk assessments) will require policy changes.
Pillar 1 proposals are set to come into effect on 1 January 2025. Pillar 2A buffers typically change after each SREP – which happens every one-three years depending on a firm’s SREP cycle. This could mean that some firms’ Pillar 2A add-ons/buffers would not be appropriately calibrated until some time after 1 January 2025. The PRA will consider as part of its Pillar 2 review how to avoid gaps and duplications on Day 1 of implementation.
The PRA proposes to adopt the Basel 3.1 disclosure templates, without material deviations from the content or format.
The CP sets out that reporting frequencies will maintain an element of proportionality, with large, systemically important firms reporting more frequently than smaller firms.
In order to ensure that the regulatory reporting framework is aligned with the changes required to implement Basel 3.1, the CP sets out proposals to delete some existing COREP reports, amend some other reports, and require some new reports.
There are material changes to the Market Risk reporting framework, reflecting the changes in the underlying rule set. Operational Risk and the OF, being wholly new components, also see significant new reporting requirements.
Firms should review the reporting changes in conjunction with the PRA’s recent publications setting out its expectation that regulatory reporting be undertaken to the same standard as financial reporting.
The PRA sets out its approach to re-denominating thresholds that are expressed in EUR or USD in the BCBS framework into GBP for use in its rulebook. In essence, the PRA will undertake an annual process to review thresholds and make adjustments to the threshold amounts if exchange rate movements justify changing them.
There is much to absorb from the PRA’s CP. The headline is that the PRA proposes to stick closely to the BCBS framework. This is not surprising, given the PRA’s previous statements about the importance of adhering to international standards as a means of maintaining confidence in the UK financial system and boosting UK competitiveness. But, as so often happens, simple statements about regulation tend to hide a great deal of nuance. Firms have limited time to complete the design work in their Basel programmes and, given the degree of divergence between the likely UK and EU regimes, for firms operating in both jurisdictions the immediate emphasis should be on understanding those differences and ensuring that their Basel programme is set up to deliver solutions that can cope with both regimes.
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