Kantilal Pithia takes a look at the headline changes and what firms need to do now.
Contents

Policy statement 17/23 is the first of two papers covering the PRA’s near-final Basel 3.1 implementation. This first policy statement looks at scope and levels of application, market risk, credit valuation adjustment, operational risk, Pillar 2, and currency redenomination. The second paper, due in Q2 2024, will look at credit risk (standardised and internal ratings-based approach), credit risk mitigation, output floor, Pillar 3 disclosures and reporting.  

It’s dubbed as near-final, rather than final, as the PRA is waiting for HM Treasury to legally revoke the Capital Requirements Regulation (CRR) before it can update the relevant sections in the PRA rulebook. In due course, the regulator will publish all final policies, rules, and technical standards in a single policy statement. 

What are the headline changes? 

The PRA has made a number of changes from its previous consultation paper (CP16/22), most notably: 

  • Calculating the default risk for sovereign exposures: Under previous proposals, firms could use the market risk internal model to calculate the default risk for exposure to sovereigns. This aimed to standardise how firms treated these defaults across market and credit risk frameworks. This is no longer permissible. 
  • New transitional arrangements in the credit value adjustment (CVA framework): The PRA previously proposed a transitional period for transactions that are no longer subject to exemptions under Basel 3.1. It's now offering an alternative, to allow firms to immediately include those transactions in the CVA framework, if simpler from an operational standpoint.  

Additional changes are outlined below, but it’s important to note that the amendments listed in the near-final policy paper are non-exhaustive. As such, firms should review the proposed updates to the PRA rulebook PDF [3.42MB] for a more comprehensive understanding of the changes and how they will affect the firms’ unique risk profile.  

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Market risk 

Building on existing methodologies, Basel 3.1 put forward three approaches for calculating market risk; the simplified standardised approach (SSA), the advanced standardised approach (ASA) and the internal models approach (IMA). These approaches aimed to provide more targeted methodologies for estimating market risk, offer greater proportionality, and improve risk sensitivity.  

The PRA also aimed to establish a clearer delineation over the trading and non-trading book (and the associated treatment of internal hedges), to prevent firms from moving risks between frameworks for more preferential treatment. Based on stakeholder feedback, the PRA has clarified that credit-linked notes can count as internal hedges, as long as they meet the credit risk mitigation rules. It has also clarified that firms can treat FX and commodity positions the same across both books for market risk calculations. 

Additional technical clarifications include: 

  • When calculating consolidated capital requirements, firms should treat capital requirements for the interest rate hedging desk and separately to the remaining positions. Treatment of those remaining positions will continue to depend on individual firm permissions for combining positions across multiple entities.  

  • When calculating market risk capital, firms can treat some closed-ended listed collective investment undertakings (CIUs) as stand-alone listed equities. This is to acknowledge that they work in a similar way and carry comparable risks.  

Changes to the ASA 

The PRA previously proposed the external party approach (EPA), as one of four methods for calculating CIU capital requirements. This was a departure from the Basel 3.1 standards, which would allow firms to use risk weights calculated by an eligible third party to improve operations and reduce the need for the fall back approach (FBA). In the near-final rules, the PRA has made some tweaks to: 

  • broaden the range of eligible third-parties as long as their data accuracy has been validated by an external auditor

  • ensure that firms using the EPA get separate risk weights for the sensitivities-based method (SbM), default risk charge (DRC), and residual risk add-on (RRAO) elements of the ASA

In its previous consultation, the PRA proposed an RRAO to capture more complex or exotic risks not covered by the SbM or DRC when calculating capital requirements. This included a non-exhaustive list of what positions may be subject to the RRAO. Following industry feedback, the PRA has clarified that firms can exclude exactly matching back-to-back transactions from the RRAO – but it’s important to note that this doesn’t extend to CMS options as they contain correlation risk, which could potentially be material.  

Internal model approach 

The PRA has made a number of changes to the internal model approach, with the first relating to calibration of the expected shortfall (ES) model. In the previous Basel 3.1 consultation, the regulator proposed greater flexibility to allow firms to use a subset of risk factors to calculate risk during stressed periods. But these factors must explain 75% of the variation of the fully specified ES model. In the near-final rules, the PRA has amended this so the 75% would only apply at the portfolio level, rather than individual trading desks. Firms failing to meet this requirement would move to the ASA after one month, extended from the originally proposed two weeks.  

The second key change relates to the default risk charge for the treatment of sovereign exposures. Respondents noted inconsistencies in the PRA’s approach, which it has amended in the near-final rules. By prohibiting firms from using the internal ratings based (IRB) approach to model sovereign default risk, the rules would inadvertently give lower capital requirements under the credit risk standardised approach. Similarly, the capital requirements for sovereigns under the default risk requirement (IMA-DRC) would be higher than the AMA.  

As such, the PRA has updated its Basel 3.1 implementation rules so firms cannot model central government or central bank exposures in the IMA-DRC. Firms using the IMA for trading desks that include sovereign exposures that aren’t eligible for the IMA-DRC approach must apply the ASA and other IMA components (eg, non-modellable risk factors, risks not in model and ES).  

Data quality standards 

Risk factors in the ES model must meet specific qualitative and quantitative criteria, based on an appropriate number of verifiable and observable prices. Firms must map these risk factors to the prices they observe, and have a sound methodology to link those prices to the value of the risk factor.  

In the consultation paper, when deriving multiple risk factors from a single observed price, firms couldn't work out the price of one factor by extracting the others. The PRA has updated this rule so firms can now include the value of the other risk factors in their methodology.  

For more complex instruments, firms need to assess a range of dimensions, then split them into buckets to assess the prices in each. In the consultation, firms could use regulatory- or firm-defined buckets, but needed to be consistent in their approach across all dimensions. The PRA has updated this rule so firms can use either approach to assess any dimension, but they can’t use a combination of both for a single dimension.  

RNIM framework 

In its Basel 3.1 consultation paper, the PRA proposed the risks not in model (RNIM) framework to address Pillar 1 capital requirements not in the non-modellable risk factors (NMRF) framework, ES or IMA-DRC models. Keeping this framework in the near-final rules, the regulator has clarified that it will continue to disregard back-testing exceptions, as firms are already holding capital against these risks. The regulator has also clarified that firms can’t use RNIMs in the ES model when back-testing for trading desks. 

IMA permissions and trading desk structure 

Firms applying to use the IMA must follow set requirements on trading desk structures. The PRA has tweaked this rule to allow firms using the IMA to include trading desks that manage IMA-ineligible positions, but those positions would be subject to the ASA.  

CVA 

The credit value adjustment framework replaced the own funds requirement criteria and aimed to improve alignment with the fundamental review of the trading book (FRTB) through one of three approaches.  

Scope changes 

The PRA has made a few changes to the scope of the CVA, transitional changes, and interactions with counterparty credit risk (CCR) calculations.  

Some industry stakeholders were concerned about pension scheme arrangements (PSAs) and the PRA has expanded the definition to include third-country funds that would be a PSA if based in the UK. Similarly, some respondents suggested that intragroup transactions should include entities in non-UK jurisdictions within a consolidated group. The PRA has expanded the definition to include transactions between some international in-group entities. 

The regulator has also added an alternative transitional regime for implementing the CVA, to make it easier for firms to manage the distinction between legacy and non-legacy trades. Firms must select one transitional approach and apply it until 1 January 2030. Both approaches will retain the alpha add-on, but the PRA has clarified that the SA-CCR transitional add-on won’t apply to the leverage ratio framework.  

The PRA has also clarified that the maturity adjustment factor for CCR netting sets that include CVA-exempt trades can’t be set to one. 

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The alternative, basic and standardised approaches 

In its near final rules, the PRA has made some clarifications to the alternative and basic approaches: 

  • Under the alternative approach, the PRA’s clarified that if firms are using the credit risk mitigation (CRM) framework to calculate exposures, then AA-CVA calculations must also include SFT capital requirements

  • Under the basic approach, the PRA’s clarified that the maturity floor doesn’t apply to collateralised transactions, for better alignment to international standards  

  • Under the standardised approach, the PRA’s confirmed that firms can split legal netting sets into ‘synthetic netting sets’ if they don’t have SA-CVA permissions for all positions within it. It has also provided further details in the draft supervisory statement to cover the queries to the standardised approach

Operational risk 

The standardised approach to operational risk in its Basel 3.1 implementation received a lot of feedback, which has resulted in a couple of changes to the business indicator (BI) calculation. Some respondents felt that if they included divested activities to calculate the BI, using the proposed three-year average, it would generate a biased operational risk capital requirement. Firms can now request approval to exclude divested activities from the BI, if they can effectively demonstrate that bias. Additionally, if firms don’t have audited figures to feed into the BI calculation or associated sub-components, firms can use business estimates instead.  

Pillar 2 

The PRAs Basel 3.1 consultation didn’t include any specific policy proposals for Pillar 2, but outlined its key considerations and goals. This included the need to avoid double counting between Pillar 1 and 2A for the same risks, however this remains a key concern for the sector. As such, the regulator received a significant amount of feedback, and has announced two reviews to clarify its position: 

  • A review of Pillar 2 capital requirements before the final Basel 3.1 implementation date (1 July 2025)

  • A review of Pillar 2 methodologies once the PRA has published its final rules

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Interim capital regime 

For a more proportionate prudential approach, the PRA is simultaneously implementing the Small Domestic Deposit Taker (SDDT) regime. As the timelines don’t align between the two frameworks, SDDTs can either adopt Basel 3.1 in the short-term, or stay on the current Capital Requirements Regulation (CRR) via the Transitional Capital Regime (TCR). For greater clarity, the PRA has renamed the TCR the Interim Capital Regime (ICR) and made some other amendments: 

  • The PRA has re-iterated that the ICR is only applicable to SDDTs or SDDT consolidation entities that opt into the SDDT Regime. Firms that don't apply for the modification would be subject to Basel 3.1 by default 

  • In its consultation, the PRA stated that firms would be eligible for the ICR if they met SDDT criteria on 1 January 2024 – this reference date no longer applies

  • The PRA has clarified that firms that no longer meet the SDDT regime criteria will stop being eligible for the ICR, and eligible firms can leave the ICR on request

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Next steps

While PS17/23 gives further clarity on the PRA’s Basel 3.1 implementation, it's still only partial, with the remainder due in 2024. There’s also ongoing uncertainty over Pillar 2 methodologies and capital requirements, which could be a stumbling block for implementation programmes. Overall, the PRA expects tier 1 capital requirements for major UK firms to increase by 3.2% by the end of the transitional period in 2030, which is in sharp contrast to the EU’s implementation (which estimates a 9.9% increase), or the US implementation (which estimates a rise of 16% for CET1 capital for large holding institutions). While this is most likely due to variations in how the standards are applied, and how they interact with local regulatory frameworks, the difference in the PRA’s current projections and potential final rules could be concerning for long-term strategic and capital planning (including the impact on the ICAAP). 

But to meet the updated deadline of 1 July 2025, firms will need to keep moving forward and consider how to factor these changes into the firm’s business goals and long-term outlook. These elements will affect the firm’s risk appetite and associated triggers, and it’s important to consider these elements when implementing the PRA’s Basel 3.1 framework. Firms also need to think about good use of data, data completeness, and modelling to support accurate management information, regulatory reports, Pillar 2 impact and Pillar 3 disclosures.

For more insight and guidance on Basel 3.1, contact Kantilal Pithia.

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