PRA consultation on final Basel reforms

PRA consultation on implementing final Basel reforms

Completing the UK framework

After a long wait, the Prudential Regulation Authority (PRA) has published consultation paper CP16/22 setting out its proposed rules and expectations for the parts of the Basel 3 standards that remain to be implemented in the UK. These are the final elements of the banking prudential reform package developed by the Basel Committee for Banking Supervision (BCBS) in response to the global financial crisis. Although referred to by the PRA as Basel 3.1, it is commonly known as Basel 4 across the industry.

Key messages

As expected, the PRA proposals have stayed close to the Basel standards with a small number of transitional arrangements and concessions. PRA CEO Sam Woods stressed the importance of alignment with global banking standards and the inclusion of “appropriate but limited adjustments for the UK market”.

The UK has therefore been much stricter than the EU in its interpretation of the Basel standards, and the CP notes explicitly that the deviations proposed by the EU would make it an “international outlier”. This divergence between the UK and the EU will mean that firms operating in both jurisdictions will either need to align to the UK’s stricter regime across all models or run two sets of standards.

There is significant amount of work for firms to do on market risk. In particular they will need to accelerate work on model permissions with the PRA requesting submission of IMA applications by 1 January 2024, a full 12 months prior to the implementation date.

Banks using the Internal Ratings Based (IRB) credit approach will have until 1 July 2024 to submit any model changes required to implement the PRA’s proposals.

Changes to the SME supporting factor and real estate lending were not expected and will be difficult for some challenger banks. There are now also approval mechanisms for elements of the Standardised Approach for credit.

There are positive linkages in the paper to the PRA’s new Strong and Simple regime for non-systemic banks, with an option for banks meeting the eligibility criteria on 1 January 2024 to choose whether they wish to be subject to a new Transitional Capital Regime or the Basel 3.1 rules.

The implementation timeline is also as expected, running from 1 January 2025 with some transitional arrangements (see below). This is in line with the EU and the expected timeline for the US. However, the UK does not support EU transitional regimes for unrated corporates and low-risk mortgages, noting that “uncertain endings create uncertainty for banks”.

The PRA notes that it does not expect the proposals to significantly increase overall capital requirements on average across UK firms, but this remains to be seen.

Quantitative impact study (QIS) data provided by firms indicates that there would be an overall decrease in capital requirements for smaller-sized building societies, while large banks would see a small increase overall.

Importantly, the PRA does not intend to require firms to capitalise for the same risk twice. Where the impact of poorly measured risk weights was previously captured in Pillar 2A requirements or the PRA buffer, those would fall as Pillar 1 increases. This would mean that both capital ratios and minimum Pillar 2 capital requirements would fall.

With the proposed requirements now clearly set out, it is time for banks in the UK to mobilise their implementation programmes if they have not already done so. As previously noted, banks operating across multiple jurisdictions will need to consider carefully how to satisfy distinct sets of requirements — this may be exacerbated further once the US rules are published. A well-defined and structured Basel 4 programme will be essential. For more on effective preparation and project management see our article here.

Scope and applicability

The CP is relevant for all PRA-regulated banks, building societies, investment firms and financial holding companies. The measures proposed would introduce significant changes to the way firms calculate risk-weighted assets (RWAs) for risk-based capital ratios and are intended to reduce excessive variability and make the ratios more consistent and comparable. They are also intended to facilitate effective competition by narrowing the gap between risk weights calculated under internal models, typically used by larger banks, and standardised approaches.

The key proposals in the CP relate to:

A revised standardised approach (SA) and revisions to the internal ratings based (IRB) approach for credit risk
Revisions to the use of credit risk mitigation (CRM) techniques
Removal of the use of internal models for credit valuation adjustment (CVA) risk and introduction of new standardised and basic approaches
A revised approach to market risk
Removal of the use of internal models (IMs) for calculating operational risk capital requirements and the introduction of a new Standardised Approach (SA)
Introduction of an aggregate ‘output floor’ to ensure that total RWAs for firms using Ims and subject to the floor cannot fall below 72.5% of RWAs derived under SAs

Given the significance of the consultation and the complexity of the content, it will run for longer than usual, closing on 31 March 2023.

Timeline

The majority of the proposals would apply from 1 January 2025. The PRA also sets out a number of transitional arrangements:

Output floor — phasing in over five years from 1 January 2025 to 1 January 2030
Credit risk SA — a five-year transitional period starting from 1 January 2025 for SA and IRB firms for the implementation of the revised treatment of equity exposures
CVA framework — a five-year transitional treatment under which only legacy trades that would be exempt from CVA RWAs prior to the application of the new CVA requirements remain exempt. Firms would have the option to irreversibly apply the new CVA requirements to these trades instead
SA-CCR framework — firms would be allowed to apply the reduced alpha multiplier to trades with certain counterparties, including legacy trades with such counterparties, from the proposed implementation date of 1 January 2025, but would be required to maintain additional Pillar 1 capital equal to the reduction in capital requirements on the proposed implementation date for the legacy trades. The additional capital requirement for the legacy trades would reduce linearly over five years

Interaction with other frameworks and initiatives

Strong and simple: the PRA has begun work on a “strong and simple” prudential framework for non-systemic banks and building societies. It proposes that firms meeting the Simpler-regime criteria (including the size threshold which has increased from £15bn to £20bn) on 1 January 2024 would have the choice between being subject to the Basel 3.1 standards or to the new Transitional Capital Regime that would be in place until the implementation of a permanent risk-based capital regime for Simpler-regime firms. However, as the new regime is yet to be specified in full, this may not be a straightforward decision. Firms that are part of a group based outside of the UK — whether a subsidiary of a foreign headquartered banking group or a firm with a foreign holding company — cannot meet the Simpler—regime criteria but could apply for a modification of the criteria that would enable them to be subject to the Transitional Capital Regime.

Leverage ratio: most of the changes to calculating the leverage exposure measure were implemented in January 2022. Changes relating to the credit risk SA, including proposed changes to the treatment of off-balance sheet items and the proposed amendment to the SA-CCR, would flow through to the leverage framework. However, no new policy is required for the leverage ratio specifically.

Large exposures: no further changes are proposed to the large exposure requirements which have already been transferred from the CRR to PRA rules and amended to implement the Basel 3 standards. However, changes to prudential standards in the CP would have a consequential impact on the large exposure requirements.

Liquidity risk: proposed changes to prudential standards in the CP would automatically flow through to the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) although Basel 3.1 standards did not make amendments to either standard directly.

Consideration of climate risk: the PRA notes that the Basel 3.1 standards were not designed to include specific climate risk-related measures and that the proposals are therefore broadly neutral in terms of the UK net-zero target. However, consideration has been given to the net-zero target in developing certain proposals for credit risk SA and IRB and market risk.

The Basel Framework sets out two approaches for calculating risk-weighted assets (RWAs) for credit risk – the standardised approach (SA) and the internal ratings based approach (IRB).

Basel 3.1 introduces amendments to the SA to reduce reliance on external ratings, increase risk-sensitivity and promote comparability between firms. In particular, it proposes:

More granular method for unrated exposures to banks and companies, and for exposures in jurisdictions that allow the use of credit ratings
Recalibration of risk weights for exposures to rated banks
More granular value table for exposures to companies
More granular treatment for retail exposures
Increased risk sensitivity for exposures secured on residential real estate, by setting weightings based on LTV
More risk-sensitive methods for exposures secured on commercial real estate
More granular risk weights for exposures to subordinated debt and shares
Off-balance sheet items become more sensitive to risk, by modifying credit conversion factors (CFs)

The PRA proposals align to the Basel CR-SA framework, with the following exceptions:

Enhanced risk-sensitivity, including lower risk weights for low-risk mortgage lending and the introduction of specific treatments for ‘specialised lending’
A more risk-sensitive treatment for exposures to unrated corporates, including unrated funds
Revisions to the risk weights for corporate exposures including to SMEs
A more risk-sensitive approach to risk-weighting equity exposures, including a prudent treatment for higher risk ‘speculative unlisted equity’
Removal of implicit assumptions of sovereign support for exposures to banks
Off-balance sheet CFs aligned to local UK market conditions
A proportionate approach to SA operational requirements, including for the new due diligence requirements for the use of external credit ratings

The PRA proposes to remove the SME support factor under both SA and IRB approaches, maintain the lower CRR risk weight for retail SME exposures and introduce a new lower risk weight for unrated corporate SMEs.

In relation to climate risk, for specialised lending under the credit risk SA, the PRA considers that the proposed removal of the infrastructure support factor would be offset by its proposal for project finance exposures (which explicitly covers environmental infrastructure projects) where ‘high quality’ exposures would receive lower risk weights.

Consistent with the Basel 3.1 standards, the PRA proposes to:

Remove the option to use the IRB approach for certain categories of exposures and restrict modelling within the IRB approach for certain other categories of exposures where it is judged that the model parameters cannot be estimated reliably for regulatory capital purposes. Firms using the IRB approach would no longer be required to model all material exposure classes.
Adopt exposure-level, model parameter floors (‘input floors’) to help ensure a minimum level of conservatism for portfolios where the IRB approaches remain available.
Provide greater specification of parameter estimation practices to reduce variability in RWAs for portfolios where the IRB approaches remain available.

The PRA proposals deviate from Basel 3.1 in the following ways:

It allows firms to apply for permission to permanently apply the SA to subsets of exposures within a roll-out class.
It does not implement a specific ‘extraordinary circumstances’ condition thereby retaining the existing reversion conditions.
It extends the scope of the application of the 1.25 asset value co-efficient of correlation multiplier to all large financial sector entities (FSEs), amending the CRR FSE definition to explicitly include the total assets of the entire group and amending the definition of an unregulated FSE to include all FSEs that are not prudentially regulated as either a credit institution, investment firm, or an insurer.
It introduces a new formula to compare P and EL amounts in PRA rules to help ensure that specific provisions for defaulted exposures cannot be used to cover expected loss (EL) amounts on other exposures.
For revolving exposures that are at or over limit, firms would be required to model exposure at default (EAD) directly – the PRA does not consider CFs a meaningful concept for on-balance sheet exposures.
It prohibits modelling of exposure at default for exposures subject to the slotting approach as it considers that this would reduce unnecessary complexity in the regulatory framework
Firms are currently required to recognised post-default additional drawings for non-retail exposures. This is aligned with the Basel 3.1 standards, however in recognition that some jurisdictions may require post-default drawings to be reflected in loss given default (LGD), the PRA proposes that firms be permitted to use either approach for non-retail exposures as well as for retail exposures.

The PRA also proposes:

Changes to improve the operation of the elements of the IRB framework that do not derive from the Basel standards. This includes changing the threshold for approving IRB model applications and IRB model changes from ‘full compliance’ with the IRB requirements to ‘material compliance’.
Changes to existing expectations / general requirements for use of the IRB approach to improve the overall consistency and coherence of the PRA’s IRB framework.

The PRA notes that, for specialised lending under the IRB approach, were it to require the ‘slotting’ approach for object and project finance exposures, there could be an increase in risk weights resulting in firms being deterred from investing in green finance projects. The PRA therefore proposes to continue to allow the use of the Foundation IRB (FIRB) and Advanced IRB (AIRB) approaches, or slotting for object and project finance exposures, to avoid any potential negative impact on the net-zero target.

CRM techniques are used by firms to reduce the credit risk associated with an exposure or exposures that they hold. The CRR allows firms to reflect two forms of eligible CRM in their RWAs – funded credit protection (FCP) and unfunded credit protection (UFCP).

Key proposals for funded credit protection (FCP) that are consistent with Basel 3.1 include:

Under the SA, removal of certain methods for calculating the effects of FCP and amendments to the methods that remain available
Under the FIRB approach, amendments to existing methods for calculating the effects of FCP, including new supervisory LGD values and collateral volatility adjustments
Under the AIRB approach, a new technique for calculating the effects of FCP where firms lack sufficient data

Key proposals for unfunded credit protection (UFCP) that are consistent with Basel 3.1 include:

Restrictions on existing methods where firms adjust PDs and/or obligor grades in IRB models
New restrictions on recognising and modelling UFCP which would depend on the credit risk approach applicable to comparable direct exposures to the protection provider

Also aligned to the Basel standards are a number of material changes to the CRM framework in order to reduce excessive variability of RWAs, including:

Withdrawal of the option to use own-estimate volatility adjustments in the Financial Collateral Comprehensive Method (FCCM) for firms using all credit risk approaches - FCCM with use of supervisory volatility adjustments would remain available
Restricting the use of the internal models approach for master netting agreements to firms using the FIRB and AIRB approaches and extending this approach to cover single transactions, in addition to the existing scope of transactions subject to master netting agreements (MNAs) - renamed as the ‘SFT VaR method’)
Introduction of a new integrated approach to collateral recognition for firms using the FIRB approach, which would incorporate and update existing methods for recognising financial and non-financial collateral - the foundation collateral method
Introduction of new restrictions on the availability of methods for recognising the effect of UFCP, based on the credit risk approach that would be applied to comparable exposures to the protection provider, as well as the credit risk approach that applies to the exposure itself
Withdrawal of the ‘double default’ approach for recognising the effect of UFCP in the IRB approach
The PRA proposes to clarify that firms may choose to disregard CRM across all credit risk approaches and CRM methods

Consistent with Basel standards, the PRA:

Assigns positions to the trading book vs the non-trading book to determine whether they are to be treated under the market risk or credit risk framework
Proposes constraints on the recognition of internal hedges between risks across the two books
Proposes to supplement existing requirements for structural foreign exchange risk
Proposes the use of three new market risk approaches to replace the current methodologies – the Simplified Standardised Approach (SSA), the Advanced Standardised Approach (ASA) and the Internal Model Approach (IMA)
Proposes to retain the existing derogation for small trading book business – which permits firms with very limited trading activity (i.e., the size of on-and off-balance sheet trading book business is less than 5% of total assets, and less than £44 million) to use the credit risk approach to measure market risk

Firms would be allowed to use a combination of IMA and ASA to calculate market risk capital requirements. However, a firm using the SSA would need to do so for all market risk positions, and a firm using the small trading book derogation would need to do so for its entire trading book.

The PRA also proposes to specify a unique risk weight for carbon emissions certificates, which could be adjusted if the PRA sees future evidence that the calibration of the Basel 3.1 standards is excessively conservative.

Simplified Standardised Approach (SSA)

Aligned to Basel, the PRA proposes to retain the existing standardised approach – recalibrated to reflect market conditions and events.

The PRA introduces eligibility criteria that firms would need to meet to continue using this ‘limited market risk’ approach – i.e. either:

Aggregate market risk assets and liabilities are less than £440 million and less than 10% of total assets, or
There is eligibility to use the derogation for small trading book business

Also consistent with Basel, the PRA stipulates that firms with correlation trading portfolios (CTP securitisations) be prohibited from using the SSA due to the complexity of correlation trading.

Advanced Standardised Approach (ASA)

Basel 3.1 introduces a new ‘risk sensitive’ standardised approach available to all firms – i.e., those that do not have permission to use an internal model approach. Under this approach, capital requirements are the sum of:
A sensitivities-based method (SbM) capital requirement;
A residual risk add-on (RAO); and
A default risk charge (DRC).

The PRA maintains alignment with this approach, but proposes:

A minor adjustment to the ‘gross jump-to-default’ calculation under DRC
A separate framework for the treatment of carbon emissions certificates
Amendments to the capital requirements for collective investment undertakings (CIUs): the Basel approach sets out three methods for calculating CIU capital requirements – the Look-Through Approach (LTA), the Mandate-Based Approach (MBA) and the Fall-Back Approach (FBA). Unlike Basel, the PRA proposes that firms would require specific permission to use the MBA approach. Moreover, the PRA also proposes to implement a fourth method – an External Party Approach (EPA) where a firm has access to a risk weight for the CIU that is calculated by an external third party.
Additional prescription around how non-trading book FX and commodity positions should be reflected.

Internal Model Approach (IMA)

Basel introduces a new IMA approach to replace the existing framework – with permission required at trading desk level. Under this approach, capital requirements are the sum of:

An expected shortfall (ES) calculation – which incorporates the risk of losses in a firm’s trading positions due to movements in market variables;
A default risk charge (DRC) – which measures the jump-to-default risk of credit and equity positions in a firm’s trading book, and;
A separate capital requirement for non-modellable risk factors (NMRFs).

The PRA aligns with this approach but:

Is more prescriptive around NMRFs by requiring firms to develop and document capital requirement methodologies for individual NMRFs. The PRA also proposes requirements for recognition of NMRFs in back-testing.
Proposes simplification of the modelling approaches for positions in CIUs, subject to tests to ensure they are appropriately conservative
Proposes additional prescription around how non-trading book FX and commodity positions are reflected.

Beyond the proposed implementation of IMA, the PRA also proposes the introduction of a rule requiring firms to hold additional capital requirements for material deficiencies in risk capture in their internal models.

The three new approaches introduced by the PRA for calculating CVA risk requirements are consistent with Basel:

Fall-back Alternative Approach (AA-CVA) – for firms with limited non-centrally cleared OTC derivatives. Firms using this approach would set their CVA capital requirements equal to 100% of their counterparty credit risk capital requirements
Basic Approach (BA-CVA) – either reduced or full, which is available to all firms (with no approval or notification needed). The PRA aligns fully to Basel on BA-CVA, except where it proposes a recalibration of reduced risk weights for transactions with pension fund counterparties by introducing a new risk weight category
Standardised Approach (SA-CVA) – for use by firms that have supervisory approval. Calculation relies on firm-computed CVA sensitivities to counterparty credit spread and market risk factors. The PRA is aligned to Basel but with a recalibration of risk weights for pension fund transactions (to introduce counterparty credit spread delta risk calculations). To improve consistency of CVA capital requirement calculations across firms, the PRA proposes that the SA-CVA capital requirements would need to be calculated from a regulatory CVA measure instead of each firm’s accounting CVA measure

Also consistent with Basel:

Firms may use a combination of BA-CVA and SA-CVA but would need to justify their approach to the PRA when applying to use SA-CVA
CVA capital requirements will need to be calculated by all firms undertaking covered transactions in both the non-trading book and trading book

The PRA proposes the following additional changes beyond the Basel specifications:

An increase in the scope of application of the CVA risk framework to include exposures to sovereigns, non-financial corporates and pension funds, considered to have material CVA risk
Retention of the existing CRR exemption from CVA capital requirements for client clearing transactions
Retention of the existing CRR exemption from CVA capital requirements for specific intragroup transactions that meet the EMIR requirements
The introduction of an additional approach where, following notification to the PRA, both domestic and cross-border intragroup transactions can be exempted from CVA capital requirements
A transitional arrangement to CVA capital requirements for legacy trades with previously exempt counterparties
A reduction in the SA-CCR alpha factor from 1.4 to 1 for transactions with pension funds and non-financial counterparties.

Consistent with Basel 3.1 standards the PRA proposes to:

Replace all existing operational risk capital requirements with a single standardised approach (SA)
Introduce a new calculation for Pillar 1 operational risk capital requirements based on the Business Indicator Component (BIC) multiplied by the Internal Loss Multiplier (ILM)
Exercise national discretion to set the ILM equal to 1

The PRA also proposes to:

Continue to apply supervisory judgement regarding the relevance of past losses to future operational risk by using its more sophisticated approach under the Pillar 2 framework
Maintain the requirements for firms to evaluate and manage their exposure to operational risk as set out in the policies and processes in the CRR.

Consistent with the Basel standards, the PRA proposes to apply an output floor of 72.5% to RWAs to set a lower limit (floor) for the capital requirements produced by internal models (IM). RWAs will be calculated as the higher of: the total RWAs calculated using all approaches that they have supervisory approval to use (including IM approaches) or 72.5% of RWAs calculated using only standardised approaches. The PRA proposes that this floor applies to in-scope firms as follows:

On a consolidation basis only, at the UK consolidation level of UK-headquartered groups
On an individual basis to UK stand-alone firms
On a sub-consolidated basis for RFB (ring-fenced bank) sub-groups, or individual basis where the RFB is not part of a ring-fenced sub-group.

The output floor requirement will not apply to UK-based subsidiaries of banking groups headquartered overseas that are subject to group consolidation outside the UK, although the PRA may consider extending the requirement if it considers there to be a prudential case to do so

The PRA proposes to engage with firms originating significant risk transfer (SRT) securitisations, including during the output floor transition period, to understand the impact of the proposed use of standardised methodologies for securitisations.

In line with Basel 3.1 the output floor will be phased in from 50% to 72.5% over five years.

No new Pillar 2 policies are announced in relation to this CP. The PRA plans to review P2A methodologies more fully in 2024. However, it is currently considering:

How Pillar 2A operational risk, market risk and credit risk methodologies interact at a high level with the proposed changes to Pillar 1 risk-weighted asset (RWA) approaches set out in this CP
At a high level, the consequential impacts to capital buffers including the PRA buffer
The timing and setting of firm-specific capital requirements.

In order to reflect the proposals set out in the CP, the PRA proposes to adopt the Basel 3.1 disclosure templates, without material deviations to the content or format.

To maintain proportionality, the PRA proposes that large and listed firms disclose at the minimum frequency prescribed in the Basel 3.1 standards. All other firms would disclose the proposed templates at a frequency no greater than the existing minimum frequency of their Pillar 3 report.