Basel 3.1 near-final rules: the fog starts to clear

Audience:

Board Risk Committee members, CEOs, CFOs, CROs, CIOs, Basel programme leads, Basel programme teams

At a glance:

The PRA has published the first part of its near-final rules on Basel 3.1, covering the Fundamental Review of the Trading Book (FRTB), Counterpart Credit Risk (CCR), Credit Valuation Adjustments (CVA) and Operational Risk.

The PRA’s consultation was, by design, much more consistent with the Basel Committee’s framework than the EU’s proposals. This gives rise to considerable divergence from a content-of-rules perspective, much of which is retained in the near-final rules. The PRA’s decision to change the date of its implementation to align with the US proposals (July 2025) rather than the EU date of Jan 2025 means that banks with operations in both, or all three jurisdictions, must deal with timing divergence as well.

Although the PRA has made changes to the sections of the final rules contained in the Policy Statement, many are technical corrections and clarifications and so are not particularly significant. Banks will need to review the documents in detail to determine the specific effects on their portfolios.

EU near-final rules for CRD6 and CRR3 are also in the public domain, allowing UK and EU banks to progress their Basel 3.1 programmes with increasing certainty. However, in the US, industry pushback on the “Basel Endgame” proposals has been very robust, and with elections coming up and a possible change in the political landscape, the US approach remains highly uncertain both in terms of timing and content.

As the PRA has extended the implementation period by six months, it will expect banks to achieve high levels of compliance with the rules. Boards and Executives should:

• Ensure Basel programmes are resourced and funded adequately to complete the work required to implement on time.
• Ensure sufficient calculation capacity is available to deliver a significantly increased number of RWA calculations covering standardised approach for all assets, plus modelled approach where permissions are held, and reflecting both relevant transitional arrangements for the output floor as well as figures for the fully phased-in output floor, as these will likely be requested by supervisors and other stakeholders such as rating agencies;

Basel programmes should take advantage of the clarity provided by the near-final texts to lock in interpretations and progress to implementation and parallel runs. Where strategic decisions are still under discussion, these should be finalised at the earliest opportunity to ensure there is time to implement them.
 

Introduction

The PRA has published PS 17/23, the first part of its near-final rules on Basel 3.1, covering FRTB, CCR, CVA, and Operational Risk. The PS also includes commentary on next steps for Pillar 2 and an interim capital regime for Small Domestic Deposit Takers (SDDTs).

The PRA was at pains to point out through the consultation period that it was open to feedback and willing to listen to industry proposals for changes to the CP on Basel 3.1. The PRA has made some changes from its consultation on the topics covered in this first part of the near-final rules as a result of industry input, a summary of which is set out in Annex 1.

Examples of industry feedback that the PRA has not reflected in the final rules include:

• Request for increased granularity in the financial counterparty bucket (i.e. lower risk weights for some financial firms);
• Request to remove the risk management conditions that must be met before intragroup exposures can be exempted.
• Request to exempt Constant Maturity Swaps from the Residual Risk Add-On
• Request to soften the ‘exact match’ requirements, although the PRA did clarify that ‘exact match’ does allow for multiple trades to be used to achieve the requirement.
• Request to remove the requirement that internal hedges must be exactly matched by trades with external counterparties, and
• Request to remove the requirement to hold additional capital equal to any capital reduction for arm’s-length sales between trading and banking book until the positions mature.

The materiality of the feedback the PRA has not adopted varies. Some, for example the Constant Maturity Swap point, are quite material for some banks; others, such as the request for increased granularity for financial counterparties, are less so.

The EU has also published near-final texts for CRD6 and CRR3 which have passed votes in both Coreper and ECON, giving EU firms a good base against which to progress their implementation.

A summary of key points from the EU texts is set out in Annex 1.

Impact

Both sets of rules are long and complex. Banks will need to review the texts in detail in order to assess the specific impacts of the rules on their portfolios and Basel programmes. While we have noted some key changes this paper is, of necessity, a summary. Nonetheless, the publication of near-final texts in both the UK and the EU provides much anticipated clarity for banks and allows them to progress their programmes with greater clarity on timings and content.

Many banks still have key strategic decisions to make, such as:

1. How or whether to allocate the effect of the Output Floor to businesses;

• As the Output Floor will be a constraint at the group level, but will affect different portfolios and businesses differently, banks need to assess whether the effect differing businesses have on the overall Output Floor constraint should be allocated to the business in some way (businesses that provide capacity under the floor get a benefit, businesses that use capacity under the floor are charged)

2. Whether and when to de-emphasise or divest certain portfolios;

• Certain portfolios, such as buy-to-let mortgages, will become materially more RWA-intensive than owner-occupied mortgages under Basel 3.1 for both Standardised and IRB banks. Banks that have     significant buy-to-let portfolios and that are capital constrained may need to divest some or all of their exposures. Banks that have not already done so need to perform granular assessments of their  portfolios to ensure they understand how RWAs will change, and for IRB Banks, how portfolios interact with the Output Floor.

3. How to approach jurisdictional differences in regulatory treatments

• Where different jurisdictions have different treatments for similar exposures – for example where the EU allows an SME discount, but the UK does not –  banks need to decide whether to build systems that can manage multiple regulatory approaches to the same exposure to minimise capital requirements or to accept some additional capital cost – but simplify and reduce the cost of systems development– by picking only one treatment for all exposures across all jurisdictions.

4. Understanding the full extent of RWA calculations under Basel 3.1

• Banks that have not yet started their programmes will need to address the increase in calculation capacity required to deliver Basel 3.1. The Standardised approach will require more calculation capacity to reflect increased granularity and risk-sensitivity; banks with model permissions will need to calculate RWAs on both Standardised and modelled bases, and will need to calculate the output floor, likely on both transitional and a fully-phased-in basis to provide full transparency of capital adequacy to both regulators and other stakeholders, such as rating agencies.

The additional clarity afforded by the publication of the near-final texts should allow banks to progress these assessments.

Both UK and EU Banks can now look to finalise their operational risk capital workstreams, as the rules are clear. A key challenge will be ensuring that the sources of the constituent inputs to the Business Indicator calculation are identified, data accuracy is robust, and data points are available in time for calculations to take place and feed into reporting timescales.

UK Banks will need to ensure they are ready to provide data for the PRA’s review of Pillar 2A. While the PRA will not require a revised ICAAP, once the PRA’s timeline becomes clearer, banks may want to consider whether producing a revised ICAAP would be feasible.

Industry provided considerable feedback on the PRA’s consultation, some of which has been reflected in part 1 of the near-final rules. While part 2 will not be published until Q2 2024, there are some areas where the PRA has long-held positions that mean change is unlikely. Conversely, it is likely there will be political interest in some of the areas that will be covered in part 2 of the near-final rules, which may lead to changes being made.

Conclusion

Although the US approach remains unclear, with the publication of the PRA’s first tranche of rules and a near-final public version of the EU’s CRD6 and CRR3 text, the “fog” around the rules banks will have to implement is clearing. Banks should now ensure that their Basel programmes progress rapidly on the basis of the near-final rules where they are clear, and for UK banks, on the basis of the PRA’s CP16/22 for Credit Risk, Credit Risk Mitigation, the Output Floor and Reporting.
 

Annex 1: Summary of the Policy Statement

FRTB

The PRA has made a number of clarifications and changes to the proposals on Market Risk, in particular in relation to the Internal Model Approach (IMA). Overall, the changes are positive for banks, as the PRA has accepted some industry feedback. The amendments provide additional flexibility, consistency and potentially reduce the operational burden for banks in some areas:

• The PRA has improved consistency across the overall regime by only allowing banks to use the advanced standardised approach (ASA) for sovereign exposures instead of IMA, consistent with the approach used in the credit risk framework. This change was requested by the industry and is positive for banks as use of ASA for sovereign exposures leads to lower capital impact.
• The PRA has expanded the expected shortfall (ES) minimum coverage requirement of 75% to the overall portfolio level instead of the individual trading desk level, which is a less burdensome approach for banks. The period for rectifying the coverage when it falls below 75% has also been extended from two weeks to one month before any consequences kick in.
• The flexibility in how banks may use a single price observation to derive multiple risk factors will increase. The banks will also be able to choose whether to use the regulatory defined or bank-defined bucket for each dimension of a risk factor (rather than for risk factor overall) which will provide more granularity and help to improve models’ accuracy.
• In setting stress scenario risk measures of a NMRF, firms now have more flexibility when ensuring that for the NMRF there are no subsets with material correlation within idiosyncratic credit spread risk factors, as final rules now allow for a negligible margin.
• In ASA, the PRA expanded the range of eligible third parties that could be used for the calculation of capital requirements for collective investment undertakings (CIU) using external party approach (EPA), subject to validation of the accuracy of their data by an external auditor. This amendment should ease the operational burden for firms using the EPA.
   

CVA and CCR

• The PRA changes for CVA have also been largely positive. Most notably, the PRA has amended the definition of pension scheme arrangements (PSAs) and the scope of group entities potentially eligible for the intragroup exemption. PSA definition will include both UK and third-country funds that would be PSAs if they were located in the UK. The intragroup transactions will include transactions between certain overseas group entities.
• The PRA has also introduced an alternative optional transitional approach for legacy trades under which banks could include legacy trades in the CVA calculation but apply a discount factor to scale down the resulting capital requirements. This should help firms to avoid significant operational burden associated with the segregation of new and legacy transactions. Banks will be required to select one transitional approach only and apply it consistently over the transitional period to 1 January 2030.
• The PRA has also made changes to align to Basel 3.1 standards in some areas. For example, the PRA has clarified that the maturity floor does not apply for collateralised transactions. The PRA has also given more flexibility to firms in treatment of wrong-way risk which previously should have been taken into account in the exposure scenarios, but now can be accounted for in at least one of i) exposure scenarios; ii) probability of default; or iii) loss given default. The additional flexibility gives banks more options for how to reflect wrong-way risk although in offering the options the indication is that the PRA will focus on this issue, so banks should ensure they are ready for scrutiny.
• The PRA has deleted the proposed specific provision on eligible collateral for counterparty risk of securities financing transactions in the trading book. Banks that used this derogation to recognise sub-investment grade debt and eligible credit risk mitigations will welcome the change as it gives clarity on financial instruments that are eligible to be included in the trading book (and not only those already in the trading book as the proposed provision specified).

Operational Risk

The PRA has not made any material changes to the proposals for Operational Risk set out in the CP. In summary:

• Thresholds for the Business Indicator (BI) buckets remain as previously consulted upon.
• The Internal Loss Multiplier (ILM) remains set to 1 for all banks.
• The PRA has made two clarifications based on feedback from banks:
• to allow banks to request supervisory approval to exclude divested activities from the calculation of the BI when it would lead to a biased estimation of the operational risk capital requirements; and
• to allow banks to calculate the BI and sub-components with business estimates when audited figures are not available.
   

Pillar 2

Although the CP did not contain any policy proposals for Pillar 2, the PRA nonetheless received forty-seven responses related to Pillar 2, with many respondents expressing concern over the interaction between Pillar 1 and Pillar 2 under Basel 3.1.

As a result, the PRA plans to conduct an off-cycle review of bank-specific Pillar 2 capital requirements ahead of the implementation of Basel 3.1, to address potential double counting of capital.

The off-cycle review will primarily:

1. adjust banks’ Pillar 2 capital requirements to address identified double counts; and/or
2. rebase banks’ Pillar 2 requirements so that changes in Pillar 1 RWAs don’t result in banks holding higher (or lower) capital than underlying risks warrant.
    

While the PRA will not expect banks to undertake a revised ICAAP for the purposes of the review, it will undertake a data collection exercise, details of which will follow.

Separately, and after Basel 3.1 rules have been finalised, the PRA will conduct a broader review of Pillar 2A methodologies.
 

Currency Redenomination

The PRA did not make any changes to the proposals for currency redenomination (converting EUR values in the Basel framework into GBP) so the GBP values for thresholds between treatments remain per the consultation. The PRA decided not to permit banks flexibility to use the EUR thresholds, as it feels that all UK banks should use the same thresholds for safety, soundness, and competition reasons. This will mean banks with operations in both the UK and EU will have differing thresholds they have to manage, for example for the SME threshold.
 

Interim Capital Regime

• Those smaller banks that meet the Small Domestic Deposit Taker (SDDT) criteria can become an ICR bank, or ICR consolidation entity (where appropriate owing to legal entity structure) and access the ICR. This will enable them to access a transitional regime based on existing, less costly CRR provisions between Basel 3.1s implementation and a future permanent risk-based capital regime for smaller firms (SDDT regime).
• While previously banks these firms would have had to meet the criteria by a proposed 1 January 2024 “reference date”, banks can now meet the SDDT criteria simply from the date it becomes an ICR bank (with consent) – enabling more flexibility around when firms can reach the requirements to enter the regime.
• While the SDDT criteria will be the primary gauge used to decide admittance – the PRA has stated it reserves the right to remove a bank from the ICR where it advances their statutory objectives. Similarly, the PRA can still admit those banks that do not meet all ICR requirements. Banks should engage with their supervisor if they feel they merit inclusion (even if individual requirements may not all be fully met).
• Once admitted ICR banks must not drift away from the agreed criteria. If ICR banks know they will cease to meet the SDDT criteria, they should plan ahead as they will be required to comply with the full PRA Basel 3.1 prudential requirements upon exit.
   

Next Steps

• The PRA intends to publish a second near-final PS, covering the remaining chapters of CP16/22 not addressed above, in Q2 2024
• The PRA intends to consult on a simplified capital framework for SDDTs in Q2 2024 (Phase 2 of the SDDT regime). As part of that CP, the PRA intends to propose how the ICR will end when the SDDT capital regime is implemented.
• The final PS is intended to take effect from 1 July 2025, which will be aligned with the date of HMT’s revocation of the relevant parts of the CRR.
• Full implementation, including the phasing in of the Output Floor, is expected to occur by 1 January 2030.
   

EU rules

As well as the PRA’s near-final rules, the EU has published near-final texts for CRD6 and CRR3. In contrast with the PRA, the EU has maintained the 1 January 2025 deadline for implementation, with longer transition periods stretching until end-2032 and some reporting elements entering into force on 30 June 2024.

In terms of content, the EU rules differ from the PRA near-final rules in several areas, including:

• On market risk, the EU near-final text introduces a new transitional arrangement allowing banks to use the A-IMA approach for trading desks that still do not meet Profit & Loss (P&L) attribution requirements until end-2026. Given that UK banks will be able to waive the P&L attribution test until 30 June 2026 this sets up a six-month divergence period for banks operating in both jurisdictions, which is a further aspect of complexity that implementation teams will have to manage.
• On the use of multiple market risk approaches, the EU rules appear more restrictive, as they allow the use of multiple approaches only if own funds requirements calculated with A-IMA are at least 10% of total market risk requirements.
• For the Operational Risk Business Indicator, the EU rules will, until end-2027, allow EU parent companies to request permission from the consolidating supervisor to calculate separate interest, leases, and dividend components for specific subsidiaries. This will allow banks to manage the complexity and  
• The EU rules apply to all supervised banks regardless of size, although there is recognition of proportionality in the texts. In the EU, the EBA will assess the Basel 3.1 prudential framework for smaller and non-complex banks by end-2027. The introduction of the SDDT regime in the UK will ensure a significant degree of proportionality in the regulatory regime for smaller UK banks, reducing operational complexity and costs. The ICR will allow SDDT banks to avoid having to comply with Basel 3.1 before adopting the final SDDT regime.