The Prudential Regulation Authority (PRA) has published its long-awaited implementation plans for Basel 3.1 reforms. Paul Young and Kantilal Pithia explain the key changes and where to start your implementation programme.

The final wave of reforms from the 2008 financial crisis is here. The Basel 3.1 standards look at risk-weighted asset (RWA) calculations to reduce variability and make them easier to compare. They also reduce the gap between internal models and standardised approaches to improve competition.

But with changes to market risk, credit risk and operational risk frameworks, the PRA’s Basel 3.1 implementation will be tricky to navigate. We outline the PRA’s Basel 3.1 plans, the implications, and how you can structure your implementation programme to meet the January 2025 deadline.

Standardised approach to credit risk

There are a number of changes to the standardised approach (SA) under the PRA’s implementation of Basel 3.1. They aim to increase risks sensitivity, reduce reliance on external ratings, and lower variability of risk weights to improve comparability across firms and jurisdictions.

Find out more about these changes:
  • Consistent use of external credit assessment institutions (ECAIs) credit ratings for all exposure types for risk management and risk weighting
  • New due diligence requirements for monitoring counterparties and for externally rated exposures (if due diligence shows a higher credit risk than the external credit rating then firms must increase the risk weight)
  • Clearer differentiation between issued off-balance sheet items and commitments (with further definitions of the latter) – this includes the use of conversion factors (CFs) to calculate commitments, and changes to direct credit substitutions and letters of credit rules for issued off-balance sheet items
  • Changes to risk weightings for rated and unrated institutions with a new standardised credit risk assessment approach (SCRA) for the latter
  • Enhanced risk sensitivity by calculating RWAs for corporate exposures through: use of the ECRA approach for rated corporates; more risk-sensitive methodologies for unrated corporate exposures; and new treatment for specialised lending exposures
  • Replacing the Capital Requirements Regulation (CRR) small and medium enterprise (SME) support factor with a lower CRR risk weight for retail SME exposures and unrated corporate SME exposures
  • A more granular exposure class allocation for real estate, and greater consistency between treatment of residential real estate exposures and commercial real estate exposures (including clearer definitions between the two)
  • New risk weights for equities, with a 400% risk weight for venture capital and others at 250%; clarity over retail exposure classification at default; and retention of 150% weighting for high-risk items

IRB approach to credit risk

The PRA will implement the internal ratings based (IRB) approach to credit risk broadly in line with the Basel 3.1, but with some amendments to reduce complexity and improve comparability across firms.

Read more about these amendments:

Restrictions on using the IRB approach to credit risk

Low default portfolios must use the standardised approach (SA). For exposures to institutions, financial corporates and large corporates, firms must use the foundation IRB (F-IRB) or the SA. Firms can’t use advanced IRB (A-IRB) or F-IRB for the income producing real estate (IPRE) exposure class anymore, and the PRA has proposed a new high volatility commercial real estate (HVCRE) category.

Changes to input floors

Input floors continue to align with Basel 3.1 standards but won't apply the infrastructure or Capital Requirements Regulation (CRR) small and medium enterprise (SME) supporting factors. The probability of default (PD) input floor will be 0.05% except for UK residential mortgage portfolios which have a more conservative PD floor of 0.1%. Loss given default (LGD) floors range from 5% for residential mortgages and between 25-50% for other unsecured and retail exposures. The PRA has also proposed a dual approach to calculate exposure at default (EAD), depending on the firm’s approach to credit conversion factors.

Updated definition of default

The PRA will review its definition of default and update existing guidance in Supervisory Statements and European Banking Authority (EBA) guidelines. It will apply to both SA and IRB firms.

Changes to model governance

Model governance approaches include new requirements for data use and maintenance, revised guidance for IRB governance and validation, including specific requirements for the reports produced by a firm’s credit risk control unit. The PRA will contact firms individually regarding timelines for submissions, and changes aren’t expected until after July 2024.

Greater support for aspiring IRB firms

These firms can use the IRB approach by demonstrating ‘material compliance’ with the UK CRR.

Credit risk mitigation

The PRA broadly aligns to Basel 3.1, with some additional changes to improve consistency and comparability across firms.

For calculating the effects of funded credit protection (FCP), changes include:
  • removing some methods under the standardised approach
  • changing methods under the foundation IRB approach, including LGD values and collateral volatility adjustments
  • a new technique under the advanced IRB approach to address insufficient data.
For calculating the effects of unfunded credit protection (UFCP), changes include:
  • restricting use of current methods in IRB models, which adjust PDs or obligor grades
  • new restrictions on methods for recognising and modelling, which is dependent on the credit risk approach used to manage comparable direct exposures to the protection provider.

Market risk

Basel 3.1 builds on existing methodologies to improve risks sensitivities and the three approaches are:

Simplified standardised approach (SSA)

For firms with small or simple trading activities, this is a recalibrated and simplified version of the existing standardised approach.

Advanced standardised approach (ASA)

More risk sensitive this includes changes to the gross jump-to-default calculation; a broader data range to evaluate risk positions in collective investment undertakings (CIUs); and a framework for future treatment of carbon emissions trading schemes.

Internal model approach (IMA)

This replaces the current framework and integrates the current risks not in value-at-risk (RNIV) framework (see SS13/13). It also offers more comprehensive calculations involving back-testing for non-modellable risk factors (NMRFs); streamlines and tests for appropriateness of modelling approaches for positions in CIUs; and adapts the treatment of non-trading book foreign exchange (FX) and commodity positions.

Credit value adjustment risk framework

The new credit value adjustment (CVA) framework replaces the current own funds requirement calculation methodologies with enhanced eligibility criteria. It aims for continuity with the proposed revisions to the Fundamental Review of the Trading Book (FRTB). And it improves proportionality to allow smaller firms to remain competitive, and larger firms to engage in derivatives while maintaining relatively low CVA costs.

There are three approaches:

Basic approach (BA-CVA)

Contains a reduced version with a simplified methodology for firms that don't hedge CVA risk, with a full version for firms that do.

Fall back alternative approach (AA-CVA)

For firms with non-material residual exposure of cleared over-the-counter (OTC) derivative exposures.

Standardised approach (SA-CVA)

Uses three methodologies to estimate the probability of default (PD) by estimating the movement of CVA risk due to changes in the risk factor value and volatility proxy credit spreads. It includes additional scope items (including transition arrangements to increase coverage of sovereigns, non-financial counterparties and pension funds), and calibration refinements (covering relative risk exposure reduction and calculations of PD and expected loss given default).

Operational risk

The PRA has proposed two key changes to operational risk. The first is implementing a new standardised approach for use by all firms, to calculate Pillar 1 operational risk capital requirements. This is to increase the safety of the financial sector, and for better comparison of risk-weighted assets between firms. Under the standardised approach, operational risk capital will be calculated by multiplying the business indicator component (BIC) by the internal loss multiplier.

The second approach is to exercise national discretion to set the internal loss multiplier to 1.

Output floor

The PRA is implementing the output floor broadly in line with the Basel 3.1 standard, in order to guard against excessive variability and low-modelled risk weights. It applies to the top company of a UK headquartered group, standalone UK firms, and ringfenced banks (either the specific sub-groups or ringfenced entity).

Once the output floor is triggered, all regulatory requirements will be based on the standardised approach risk-weighted asset number. Additionally, all IRB firms must apply the SA in the same way as non-IRB firms.

Reporting templates

The above changes will affect your reporting requirements, and require significant work to make sure the right underlying data is in place. Changes include:

  • credit risk – Pillar 3 disclosures and reporting requirements for both the SA and IRB models
  • market risk – a number of Pillar 3 templates have been replaced, and the C02.00 template has been updated
  • CVA – Pillar 3 reports have been replaced, and the C02.00 has been updated
  • operational risk – new returns and updates to existing Pillar 3 disclosures and wider reporting requirements
  • output floor – new Pillar 3 disclosures and reporting requirements
  • capital summaries – updates to Pillar 3 and wider reporting templates.

PRA P2 framework

The PRA will review it’s Pillar 2A approach to credit risk, reflecting the changes to mitigation, and the SA and IRB models. Specific areas for review include use of IRB benchmarks and interactions with the output floor.

Interaction with the strong and simple regime

The PRA is still finalising the ‘strong and simple’ regime, aiming to reduce the cost and resource pressure of regulatory change on smaller, non-systemically important banks without an international focus. Ultimately, this will result in proportionate regulation that becomes more complex, as the bank grows. This poses problems for smaller banks not knowing where to start with Basel 3.1, or how much of the PRA’s implementation will apply. As such, smaller banks have a choice to stay on the current CRR rules or adopt Basel 3.1.

Phil Evans, Director of Prudential Policy at the Bank of England, highlighted the reasoning behind this move in a recent speech on implementing Basel 3.1 in the UK. He re-iterated that the PRA doesn't expect smaller banks adopt Basel 3.1 related changes twice.

How to get started with Basel 3.1 implementation

The PRA’s consultation puts the final package of banking reforms from the Basel committee in place, and is open for feedback until 31 March 2023. The proposed changes follow the EU’s revised CRR III/CRD VI deadline with a five-year transitional period, from 1 January 2025-2030.

Basel 3.1 implementation will require a significant review of your modelling capabilities and governance processes. This, in turn, relies on accurate, up-to-date data from within your business and across the wider market. Firms may struggle to source the right data, and to successfully apply it using their legacy infrastructure. Changes under Basel 3.1 will also impact reporting processes, so it’s important to consider model outputs and how that data will be used to inform management information, regulatory return and Pillar 2 disclosures.

Implementation will also have a considerable impact on your strategy and there’s a lot to think about. For example, you may need to reconsider your business and portfolio mix, leaning on higher quantities of low RWA to optimise capital. There’s also the impact on your overall capital and internal capital adequacy assessment process (ICAAP) assessments over the next three to five years. In turn this will affect your due diligence, governance and external data requirements. Banks applying return on tangible equity (ROTE) measures also need to consider the implications for deploying capital into targeted business units, and the associated capital transfer pricing processes.

With such a broad scope, successful implementation relies on finding synergies with other regulatory approaches – such as the Fundamental Review of the Trading Book, and the 'strong and simple' regime – to reduce duplication and embed lasting change.

To get started, a scope analysis will help you identify how the rules apply to your firm, based on your regulatory categorisation and scale, and how to implement the changes. From here, you can:

  • assess the impact on governance, people processes and IT systems (among others), with key objectives timelines and deliverables
  • review your current documentation, assumptions and relevant disclosures, returns or reporting requirements
  • design, build and test new processes to support Basel 3.1
  • plan your revised common reporting framework (COREP) requirements and test using dummy data from prior returns.

For more information on Basel 3.1 requirements and implementation support get in touch with Paul Young.

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