Basel 3.1 implementation – getting ahead of the curve

The Basel Framework is based on the Basel Accords, a series of banking regulatory standards issued by the Basel Committee on Banking Supervision (BCBS). The aim of the Framework is to strengthen the soundness and stability of the international banking system. Basel 3.1 is the final set of amendments to Basel 3, which extended the framework in response to the 2007/08 financial crisis. Basel 3 sought to create a more resilient banking system by increasing the quality, consistency and transparency of regulatory capital, and introducing new liquidity requirements (e.g. Liquidity Coverage and Net Stable Funding Ratios) to prevent excessive liquidity risk-taking.

Basel 3.1 aims to enhance the credibility and comparability of the capital framework by reducing excessive variability in risk-weighted assets (RWAs) used to determine minimum capital requirements and buffers. Core measures include:

1. enhancing the robustness and risk sensitivity within the standardised approaches (SA) available for calculating RWAs;
2. constraining the use of internally modelled (IM) approaches used with supervisors’ permission to calculate RWAs; and
3. complementing restrictions on IM approaches by introducing an output floor, based on standardised approach RWAs (aggregated across all risk types).

Basel standards do not apply directly to individual countries – each Basel jurisdiction gives effect to the standards within its domestic rulemaking structures (in the UK this is through PRA rules, although some requirements remain in the UK Capital Requirements Regulation (UK CRR), which was on-shored from EU legislation during Brexit; in the EU it is through the Capital Requirements Directive and Regulation (CRD and CRR) and EBA technical standards). Differences of interpretation and application of the Basel standards inevitably arise, and in some instances, jurisdictions choose to deviate from them to accommodate domestic market specificities.

The PRA’s proposals for the implementation of Basel 3.1 align closely with the BCBS baseline standards, and include removing some legacy EU deviations in the current UK CRR. For some asset classes, the PRA has proposed more extensive modelling restrictions and higher capital requirements than the Basel standards, removing all internal ratings-based credit risk approaches for sovereign exposures). The table in annex 1 lists sets out the key UK-specific measures.

The impact of implementing Basel 3.1 is less likely to be significant where existing PRA rules and supervisory practices effectively front-run or overlap with the proposed changes. Examples include: the PRA’s IRB portfolio risk weight floor for residential mortgages; the PRA’s Pillar 2 methodology for assessing operational risk; the fact that IRB permissions are not typically granted by the PRA for income-producing real estate; and an effective 100% risk weight floor for commercial real estate under the SA for credit risk.

Alongside its proposals for implementing Basel 3.1, the PRA outlined an alternative approach for non-systemic banks and building societies. It proposes that firms meeting the new Simpler-regime criteria on 1 January 2024 would have the choice between being subject to the UK Basel 3.1 requirements or to a new Transitional Capital Regime (TCR). The proposed TCR is based on the existing UK CRR regime and would be in place until the implementation of a permanent risk-based capital regime for Simpler-regime firms. The PRA has already set out threshold criteria for the Simpler regime and is now consulting on liquidity and disclosure requirements. The PRA has said it expects to consult on the capital-related elements of the regime in 2024 and is considering whether the Basel 3.1 approaches for credit risk SA and CRM could be an appropriate starting point.

Challenges around operational readiness

Capturing the full extent of regulatory change

Basel 3.1 is a substantial package of reform: the SA credit risk has been significantly revised and expanded; IRB credit risk has a significant number of amendments; an entirely new framework has been developed for operational risk, and the output floor means that IM banks will need to calculate SA requirements in parallel. The scope of change is far broader than Basel-related elements of the EU’s CRR2 package that the PRA implemented after Brexit.

Individual regulators’ implementation proposals (including those of the PRA) may contain many subtle deviations from both the Basel standards and their existing capital frameworks. Without a line-by-line comparison of the proposals versus the original Basel text and existing capital rules, it may be challenging to identify the complete set of changes, some of which could impact the operation and/or economics of individual business lines. For groups operating in multiple jurisdictions this is an even greater challenge, and comparisons across all relevant proposals is recommended/will be necessary.

Expanding the risk sensitivity of the framework inevitably creates new areas of judgement. The PRA offers clarifications in some areas but has generally avoided prescriptive rules - while this flexibility may be helpful, terms such as ‘material’, ‘significant’, and ‘appropriate’ create new decision points. The consequences of some of these new decisions might only emerge once the rules are fully implemented in practice.

Assessing business impact

Changes in capital requirements under Basel 3.1 have the potential to affect the economic viability of product lines and/or banks’ capacity to provide finance. Changes are also likely to affect internal capital allocation, pricing strategies and performance metrics, which will need to be captured in any holistic assessment of business impact – this could be difficult or impractical to achieve ahead of implementation.

Basel 3.1 introduces a number of operational requirements, including structured due diligence within SA credit risk, and these will likely affect business practices and operational costs. The PRA has indicated that some of the new operational requirements will be supervised proportionately, but resource budgeting for those new requirements might continue to be a challenge beyond day-1 implementation, until supervisory expectations and practices become settled.

Sourcing, validating and processing new data

The revised approaches for calculating RWAs will require new data inputs and structures, updates to calculation engines, and new/revised controls for validating outputs. Banks required to calculate the output floor face additional data challenges (beyond the requirement to run two parallel capital calculations) wherever exposure class definitions, data inputs and risk drivers differ between modelled and standardised approaches.

The PRA proposes transitional allowances / fallback measures where banks may lack some data, for example a proxy for assessing a currency mismatch between a loan and a borrower’s main source of income. But the PRA’s draft rules may result in higher risk weighting in other areas, for example residential real estate exposures without a qualifying valuation could potentially have a risk weighting as high as 150%.

While the PRA proposes to permit IRB banks to implement non-modelling related changes and input floors without applying for new permissions/formal notifications, these updates would need to be in place by 1 January 2025 and subject to appropriate internal controls, challenge and governance.

Transitional and steady state resourcing

Resource management, at all levels, will be an important consideration for Basel 3.1 transition and steady state operations.
For many banks, implementing Basel 3.1 by the PRA’s 1 January 2025 deadline might not be feasible with current “business as usual” levels of resource and within existing business structures. Banks will need to consider additional resourcing requirement to implement the changes, as well as ensuring that relevant teams have the necessary skillset and knowledge to implement and operate the revised framework on an ongoing basis.

It will be equally important for banks to ensure that sufficient time is allocated at executive and committee levels to provide oversight and governance around additional/updated key assumptions and strategic choices – particularly in relation to issues that affect regulatory reporting and public disclosures.

Elevated risks for banks and practitioners during the transition

Operational risks tend to be elevated during and immediately after the implementation of significant regulatory change – there will be a degree of unfamiliarity/uncertainty around operating new requirements, and new risks to manage where interpretations of regulatory standards are necessary.

Spotlight on risks for industry

• Audit and Risk committees might struggle to obtain full assurance around management’s calculations and assertions prior to day-1 implementation, particularly given the scale of simultaneous changes in regulatory rules and business practices.
• A range of possible interpretations is almost inevitable in regulatory reporting and disclosures, but where this is due to underlying issues such as data completeness and accuracy, forbearance from regulators (or the market) should not be assumed.
  Spotlight on risks for practitioners
• The scale and complexity of assurance engagements is likely to increase, and banks’ documentation may continue to evolve after day-1 implementation of the Basel 3.1 regime.
• Practitioners may have to re-evaluate the resource consumption and/or timing for review and assurance engagements. Practitioners will face similar challenges to banks to ensure they are adequately resourced (both in skillset and capacity) to provide assurance and other support.

Regulatory uncertainty & international competition

The interaction between new Pillar 1 requirements and other aspects of the UK prudential framework – particularly Pillar 2 and stress testing – are not fully addressed in the PRA’s consultation. Examples include how house price index shocks in regulatory stress testing scenarios will interact with the ‘value at origination’ requirement for SA mortgage exposures. The PRA has said its Pillar 2 policies will be reviewed and subject to future consultation in this area.

The PRA’s starting point is largely aligned with Basel standards, whereas the EU proposes to deviate (at least temporarily) to account for market specificities, for example a lack of external ratings for EU corporates and the absence of capital markets as an alternative source of finance. However, the PRA has emphasised the openness of its consultation, and given the new accountability measures set out in the 2021 Financial Services Act, there is scope for further adjustments to the proposed rules prior to finalisation.

The lack of clarity on requirements under the PRA’s proposed Simpler prudential regime presents an additional challenge for those banks that are potentially in-scope. The PRA proposes that Simpler-regime banks may choose to operate under a TCR until the new Simpler framework has been fully defined.

This extra time could be helpful for smaller banks that would see increases in capital requirements and operational costs under the PRA’s Basel 3.1 implementation. However, if the PRA ultimately decides to use the Basel 3.1 credit risk SA and CRM standards as a basis for the Simpler regime, these banks may find that in the long run the transitional and operational costs are comparable. If this happens, deferring implementation of Basel 3.1 might not be as advantageous.

Engage in the policymaking process 

The PRA’s Basel 3.1 package will be the most substantial set of rules it has made outside the EU regulatory sphere, and the regulator has emphasised its openness to evidence-based challenge from industry.

While the PRA has proposed a degree of tailoring to the UK market, the Chancellor’s December 2022 letter to the Prudential Regulation Committee (PRC) requires the PRA to consider the relative competitiveness of the UK regime, and the regime’s effect on the real economy. This will become a secondary objective of the PRA following implementation of the Financial Services and Markets Bill, currently going through Parliament, and will require the PRA to factor in a wider set of considerations when designing new rules and expectations.

Industry feedback and alternative proposals are likely to gain more traction if supported with empirical evidence and by directly leveraging the new accountability mechanisms attached to the PRA’s rulemaking powers.

 Establish an implementation programme now

Basel 3.1 implementation is more than a regulatory compliance exercise – it encompasses regulatory policy, data & systems architecture, financial planning and business strategy. Defining a target operating model, programme objectives and measures of success early will help to ensure banks are prepared to deliver all regulatory and business changes in time for implementation in 2025.

Source/upskill resource for transition and end state

The PRA’s Basel 3.1 package is not expected to be finalised until later this year, but it will be important to keep all implementation stakeholders up to date with the latest developments. Sourcing resource for any identified gaps early will help mitigate key person/skill gaps as industry peers commence their own implementation programmes.

Consider scope of “in-flight”/ongoing assurance activity

Banks scoping assurance reviews across the three lines of defence at an early stage of their Basel 3.1 programme could help to identify potential interpretation and operational/reporting issues early, saving time both during transition and post-implementation.

Seeking validation of decision processes, documentation, calculations and controls during testing/parallel run could help to reduce the risk that material errors and deficiencies are identified once the Basel 3.1 requirements are fully operational.