Capital framework
More to come
Financial Markets Regulatory Outlook 2023
In focus
- Banks and insurers are facing significant re-design of their respective capital frameworks, the final form of which will come into focus in 2023.
- We expect the EU and UK to finalise their approaches to implementing Basel 3.1. While this will narrow the policy uncertainty banks face, it will also usher in a more fragmented regulatory landscape for cross-border banks.
- The Solvency II reviews in the EU and the UK will continue developing over the course of 2023. These will provide insurers with more clarity on specific reforms and the level of regulatory divergence, and should prompt them to start more detailed implementation planning.
2023 will be the year the frameworks for banking and insurance capital requirements once again come into focus, as policymakers in the UK and EU look to finalise major packages of reform.
Given the macroeconomic context will likely have micro (and macro) prudential implications, particularly in terms of credit losses and diminished business opportunities, the remaining policy negotiations are likely to be buffeted by debates around the impact of revised rules on economic growth. Senior leaders in both sectors will need to invest time to ensure that they understand the strategic implications of changes to the relevant rules.
Banking
Banking regulators around the world will make substantial progress in 2023 towards completing their Basel 3.1 rules. Both the EU and the UK propose to implement Basel 3.1 by 1 January 2025, two years after the original Basel Committee on Banking Supervision (BCBS) target. However, both could still decide to delay further, depending on macroeconomic developments and/or implementation progress made this year by regulators in the US.
As rules are finalised, understanding the relevant areas of regulatory fragmentation will become an imperative for internationally active banks. The publication of final rules will enable banks to finalise their analysis of how strategic positioning, capital consumption and profitability in the markets in which they are active might be affected.
The Prudential Regulation Authority’s (PRA) consultation on implementing Basel 3.1 in the UK, published at the end of November 2022, showed that UK regulators intend to implement capital rules that are much more aligned to the BCBS standards than the approach that is developing in Brussels. Although the PRA's consultation paper mirrored some the EU's proposals, including setting the Internal Loss Multiplier for operational risk capital to 1, the PRA's proposals include a more restrictive treatment for unrated corporates than that set out by the EU and BCBS.
The most significant deviation between the UK and EU frameworks is the PRA’s proposal to permit smaller firms to adopt a Simpler Regime. While consistent with the BCBS expectations that the full Basel framework should only apply mandatorily to globally active banks, this represents a material break with the EU’s approach of applying a single rulebook to all credit institutions.
£4.9 billion
the PRA’s estimate of the operational cost of implementation of Basel 3.1 in the UK1
The PRA also proposed to implement the Output Floor without the majority of the EU’s extended deferrals, and also not to include the preferential approach for unrated specialised lending facilities that exists in the EU framework. Firms with subsidiaries in both the EU and the UK will have to ensure their systems can calculate solo risk weighted assets (RWA) figures for rules in the UK and EU, while calculating Group RWA figures appropriately.
In the EU, the European Council’s general approach to Capital Requirements Directive 6/Capital Requirements Regulation 3, also reached in November 2022, set out a position that eases requirements for third-country branches (compared to those that the European Commission originally proposed), proposes that the Output Floor be applied at all levels of consolidation – albeit with a member state discretion, affirms support for changes to the fit and proper person elements of the package, provides for existing COVID-era public guarantees to be recognised under the new banking package, and supports enhanced environmental, social and governance reporting. Further deviations from the Basel framework remain a possibility as negotiators continue their work to reach agreement in trilogues, expected before end-2023.
The inevitable reality is that Basel 3.1 adoption will mean more divergence in the rulebook for bank capital requirements between the EU and the UK than has existed before. This will place a greater operational burden on cross-border banking groups, but it will also give them an opportunity to assess how a more divergent rulebook might affect their pricing and their optimal product offering in different markets, for example by undertaking UK-based lending that benefits from preferential treatments under EU rules out of EU subsidiaries.
Insurance
The finalisation of the EU and the UK Solvency II frameworks will be particularly important for the life insurance industry, although some of the proposed reforms (including proportionality and reporting) will also be relevant to non-life firms. In the EU, we expect the final outcome of the reforms to look similar to the European Commission's original proposals for amendment. In the UK, the PRA will engage with insurers on the technical details of the Solvency II reforms during 2023 before issuing a formal consultation.
The ongoing EU and UK reviews of their respective Solvency II framework aim to achieve similar objectives - mainly to channel funds into green and sustainable investments. However, the mechanisms applied to achieve this in the two jurisdictions differ quite significantly.
While both the EU and the UK propose changes to the risk margin, UK reforms remain centred around amending the matching adjustment (MA) criteria, although the UK Government is leaving the fundamental spread calibration within the MA untouched as per its recent consultation response. The European Commission, meanwhile, is seeking to adjust the volatility adjustment (VA) and long-term equity (LTE) criteria. While different in substance, these sets of reforms provide both EU and UK insurers with an opportunity to review and adjust their overall investment strategies as well as MA/VA portfolios, in line with the new rules and, importantly, according to their own climate strategy.
Looking ahead, we expect the reforms to prompt insurers to review their product offerings and strategy, especially in light of the current macroeconomic environment. For life insurers, high interest rates coupled with capital reforms could prove to be a catalyst for re-designing existing products or exploring new product features.
Actions for firms
Banks:
- Enhance capabilities that will support Basel 3.1 implementation, focusing on:
- Understanding the strategic and operational challenges and opportunities arising from differences in UK and EU implementations of Basel 3.1.
- The accuracy of RWA calculations (including Standardised RWA calculation for modelled portfolios in internal ratings based banks).
- Developing new data management and reporting capabilities.
- Smaller banks: assess the PRA's proposals and form a view on whether their growth plans mean they should opt into the full Basel 3.1 framework at the same time as other firms on 1 January 2025, or whether they want to opt in to the Simpler Regime. This option must be exercised by 1 January 2024.
Insurers:
- Undertake a planning and prioritisation exercise to prepare for the implementation of specific Solvency II reforms, focusing on areas of reform that are unlikely to change over the coming months. These include changes to MA eligibility criteria in the UK and in the EU, the specific reforms to the VA and the reduction in the risk margin for both EU and UK. For example, insurers should consider their reinsurance programmes if they currently reinsure longevity risk abroad, since a lower risk margin will make these arrangements less commercially attractive.
- Where insurers make use of the MA or VA, they should explore whether the specific reforms warrant any changes to their investment and/or asset and liability management strategies. Where they do not, they should explore whether they could benefit from applying for the VA (in the EU) or the MA (in the UK) under the new rules.
- Review and, where relevant, adjust their overall investment strategies as well as MA/VA portfolios not only in light of the reforms but also in view of their own internal climate and net zero strategies.
Endnote
