How the UK proposes to implement Basel 3.1

The Basel 3 Reforms will be live in the UK on 1 January 2025, which is many years later than the original Basel timetable but is consistent with the EU go-live. They will apply to all PRA-regulated firms, although there is an opt out for “simpler regime” firms (banks and building societies smaller than £20b total assets) to remain temporarily on current capital standards, while the PRA determines an appropriate capital regime. By comparison, the scope of Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD)² in the EU includes all banks regardless of size.

Output floor

One of the critical and most controversial features of the Basel 3 Reforms is the introduction of a limit to the benefit of using internal models for capital. This is referred to as the “output floor” and requires that capital can fall to no lower than 72.5% of standardized (i.e., non-modeled) RWAs across all risk types. The Basel Committee proposed introducing the output floor through a five-year transition period after go-live.

For UK-headquartered groups, the proposals call for the application of the output floor to the UK consolidated and Ring-Fenced Body (RFB) consolidated levels. However, for non-UK headquartered groups, the output floor will not apply to any UK entities.

The UK position differs from the EU proposals in two important respects:

1. The EU proposes applying the output floor at the consolidated EU level to all groups, together with a cascade of the impacts to the country level. The details of this are still being finalized. At a minimum, this introduces an asymmetry, since UK groups operating in the EU will be subject to a local (EU level) floor, whereas the reverse will not apply to EU groups operating in the UK.
   
2. In calculating the output floor, the PRA proposes that firms apply the PRA’s proposed implementation of the standardized approach. This contrasts with the EU’s proposed approach, which grants several transitional arrangements to soften the Day 1 impact of the output floor. For example, firms with permission to use the Internal Ratings-Based (IRB) approach are granted preferential treatment for unrated corporates and residential mortgages until 2032. These exposures also benefit from an extended transitional period of eight years. The output floor is one of the main areas cited by the PRA in their assertion of closer UK alignment to the global Basel standards.

This asymmetry is a further element of complexity to navigate and manage. The more favorable EU treatment will also make a difference to the relative competitive position of some firms. And as an example of different applications of the Reforms, it could become a political debating point.

Credit risk

The Basel 3 Reforms propose numerous changes to regulatory capital for credit risk. Many of these are intended to address perceived weaknesses in banks’ internal models and reinforce the quality and consistency of capital measures. The changes include removing internally modeled options from certain exposure types and introducing floors on individual elements of the calculation.

In general, the PRA has followed the Basel standards for the majority of its proposals in the area of credit risk. However, there are a few noteworthy deviations:

• For sovereign exposures, the UK goes further than the Basel standards (and the EU proposals) in planning to remove all IRB options. This will impact many large banks that currently use risk models to determine capital levels in this area.
  
• Equity exposures move to the standardized approach and risk weights increase broadly in line with Basel and the EU proposed approach, although there are subtle differences in the UK definitions of the different exposure classes. The UK, like the EU, is proposing a five-year transitional period.
  
• In the treatment of exposures to unrated corporates, the PRA proposes a more risk-sensitive approach. Exposures that can be assessed as Investment Grade (IG) would be risk-weighted at 65% and non-IG would be risk-weighted at 135%. This compares to the Basel standards (and EU proposals) that require a uniform 100% risk weighting.
  
• There are deviations in the proposed UK treatment of exposures to small- and medium-sized enterprises (SMEs). The PRA proposes to remove the SME support factor, which is being retained by the EU. This will impact retail SMEs most, where the PRA sees the support factor as “doubling up” on preferential treatment. However, to mitigate the impacts on unrated corporate SMEs, the UK will introduce a new lower risk weight of 85% for this class of exposure. There is also a potential oddity in the proposals where exposures to SMEs and unrated corporates that are secured on commercial property seemingly attract a risk weight of at least 100%, which is higher than some unsecured weightings.
  
• As expected, there are a number of changes proposed by the PRA that cover exposures to residential real estate (i.e., mortgage lending). These include clarification of the definition of a professional landlord as one who is borrowing against more than three properties. In terms of the standardized rules, the PRA opts for a “loan-splitting” approach that generates slightly lower risk weights than other options for lending above 50% LTV. This is a moderate concession to smaller lenders, many of whom had estimated considerable capital increases from this aspect of the Basel changes. However, the UK maintains the dependency of loan-to-value (LTV) on the value of the property measured at loan origination, although permitting revaluation on refinancing. This contrasts with the EU proposals, which have moved away from origination value entirely. Regarding the IRB rules, the PRA proposes introducing a minimum level for probabilities of default (PD) of 0.1%, which is higher than the Basel floor of 0.05%. Taken together, these changes are probably intended to improve competitiveness in the mortgage market by eroding the current asymmetries of capital treatment between larger lenders that typically benefit from having IRB models, and smaller ones and new entrants that often do not.
  

In addition to the proposed changes to the capital rules, the PRA is signaling greater freedom of choice between IRB and standardized approaches for credit risk, albeit with limitations to prevent “cherry picking”. And by indicating that they are prepared to approve models that are “substantially compliant” rather than fully compliant, they are potentially accelerating the onerous and time-consuming process of model development, submission, and regulatory approval.

Credit valuation adjustment (CVA)

The PRA’s implementation of the CVA risk charge is broadly aligned with Basel’s proposals, with some areas of divergence. This includes the granularity of risk weights, and the specific treatment of domestic and cross-border intragroup transactions. In line with Basel, the PRA proposes no exemptions for exposures related to sovereigns, non-financial counterparties, and pension funds from the CVA charge. This is to some extent offset by a reduction of the alpha factor under the SA-CCR approach from 1.4 to 1 for non-financial counterparties and pension funds, which is a divergence from both Basel and the CRR.

Operational risk

Basel simplifies the framework for operational risk by replacing the four current approaches with a single standardized measure. This non-modeled approach is based on a basic indicator component, which is a measure of a firm’s size and economic activity, and which the PRA proposals adopt. However, the UK does not further consider historical operational losses and, in line with the EU, sets the operational risk Internal Loss Multiplier (ILM) at 1.

The PRA’s proposed implementation of the Fundamental Review of the Trading Book (FRTB) capital rules is broadly aligned with Basel’s proposals, with some exceptions. For the Standardized Approach (SA) these relate to the definition of gross Jump to Default, a requirement to use a "sticky strike” approach for the calculation of Vega, and the introduction of a new “Carbon Trading” risk bucket. A new approach is also proposed for the treatment of Collective Investment Undertakings (CIUs) enabling the use of third-party risk weights under certain conditions.

For the Internal Models Approach, the PRA’s consultation includes divergences to Basel and the EU in several areas. These include the ability of banks to include the impact of Non-Modellable Risk Factors (NMRFs) when performing desk level backtesting, a detailed specification on NMRF stress period selection, and a new capital charge for non-data-related risk modelling deficiencies under the existing Risks Not in Model (RNIVM) framework.

For many UK banks, the release of the proposed UK capital rules clarifies what needs to be done over the next 24 months until go-live.

The initial response will likely be to assess the impact of the proposals on the organization as a whole and its component businesses and risks. This assessment will particularly focus on where the UK proposals diverge from either the Basel standard or the EU proposals. It will require detailed analysis of regulatory capital impacts and change drivers. There will also be interaction and dialogue as part of the PRA’s consultations, and indeed industry and individual firm lobbying to iron out kinks in the proposals or argue for more favorable changes.

For many banks, the preparations to operate successfully in post-Basel 3 Reform world are already well advanced. This is not just about embedding the changes operationally, although that itself is complex. It is also about understanding how the bank will operate and succeed with the new capital levels, complexities, and constraints that the Reforms bring.

Overall, the UK proposals add another important piece to the global Basel 3 Reforms jigsaw. The PRA has taken the opportunity to craft UK-specific rules while not significantly deviating from the Basel standards. The US is now the last significant market yet to show its hand.
 

This article is co-authored by Dr. Sonja Körner, EY Global Financial Services Risk Banking Capital Markets Leader, Shane O'Neill, Partner, Financial Services Risk Management, Ernst & Young LLP, Fred Speight, Senior Manager, Regulatory Insights, Ernst & Young LLP and Shaun Abueita, UK Traded Risk Business Consulting Leader, Ernst & Young LLP.

Summary

The UK’s proposed implementation of the Basel 3 Reforms represents a significant shift in the way that firms will need to measure the risks they face across their businesses. Although aligned to the global Basel standard in many areas, there are important UK-specific departures across the various components of the Reforms. The proposals introduce many complexities that require tackling in order to go live by 1 January 2025.