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Finance Conformité28 février, 2023

Implementing Basel 3.1: Your guide to manage reforms

Topic: Basel 3.1

The Prudential Regulation Authority (PRA) released the proposed rules and expectations for Basel 3.1 implementation in the UK. As expected, Consultation Paper (CP) 16/22 includes many European Union (EU)-specific deviations.

This isn’t surprising given the UK’s status as the world’s largest exporter of financial services. The financial sector is global and complex and shifts in regional dynamics have a wider impact. Naturally, that puts the onus on UK regulators to maintain the highest financial standards.

Many jurisdictions—Australia, Canada, Hong Kong, Singapore, and Switzerland—are further along in their implementations and have stayed true to the Basel Committee’s standards, with only minor deviations. Whereas the European Commission’s proposal includes deviations from the Basel III standards that would make the EU an international outlier. But the PRA is striking a balance by fine-tuning the Basel standards for the UK market and UK data without undermining resilience, thus allowing organizations to stay compliant and competitive.

This is a landmark move and PRA’s first major reform post-BREXIT. It also foreshadows the direction of future regulations.

Proposed updates to Basel standards

What’s changing? And why?

The global financial crisis revealed significant shortcomings in how risk-weighted assets (RWAs) and capital ratios are calculated. In response, the Basel Committee on Banking Supervision (BCBS) agreed to a series of reforms to the current standards. These reforms (called Basel III) are intended to enhance banks’ resilience throughout the economic cycle.

In the UK, many of the reforms were addressed through legislation that was built into BREXIT in 2020, and subsequently worked upon by the PRA (e.g., liquidity and leverage ratios). Now, CP16/22 covers parts of Basel III that haven’t been implemented in the UK, with a primary focus on RWA calculations.

Click each of the risk and reporting categories to understand the impact.

  • Credit Risk

    The proposed changes affect three areas under credit risk:

    Revised Standardized Approach (SA) for credit risk

    The PRA proposed several changes to the Capital Requirements Regulation (CRR) requirements and Basel 3.1 standards. In complex situations, it proposes replacing the internal ratings-based (IRB) approach with the standardized approach (SA).

    If the proposal becomes policy, using the SA approach for credit risk will impact:

    • The use of external credit ratings
    • Off-balance sheet exposure values
    • Exposures to central governments and central banks, regional governments and local authorities, public sector entities (PSEs), and multilateral development banks (MDBs)
    • Exposures to “institutions” and “covered bonds”
    • Exposures to “corporate” and “specialized lending”
    • Lending to individuals and small businesses
    • Residential and commercial mortgages
    • Equities, subordinated debt, and other capital instruments, defaulted exposures, and high-risk items

    Timeline: If enacted, the policy would go into effect 01 January 2025.

    Revisions to the internal ratings based (IRB) approach for credit risk

    The internal ratings based (IRB) approach is a key element of the Basel 3.1 package. The PRA proposes an overhaul to the approach, which would have several profound impacts. They include:

    • Creation of new exposure sub-classes for central governments and central banks, and for corporate, institution, retail, and equity exposures
    • Restrictions on IRB modelling for several exposure classes (e.g., central government and central bank, institutions, financial corporates, large corporate, and equity)
    • A new definition of default for SA and IRB
    • Introduction of input floors for loss given default (LGD) and probability of default (PD), in alignment with Basel 3.1 standards
    • Updated general requirements for using the IRB approach

    Timeline: The PRA proposes that firms implement non-modelling related changes and input floors to model parameters by 01 January 2025. Firm-specific timetables for model change applications will follow once the PRA’s “near-final” guidance is published.

    Revisions to the use of credit risk mitigation (CRM) techniques

    The PRA introduced three frameworks for “recognizing” credit risk mitigation (CRM) based on the nature of credit protection and the credit risk approach that was applied to the exposure. The changes impact Funded Credit Protection (FCP) and Unfunded Credit Protection (UFCP) in the following ways:

    Funded Credit Protection (FCP)

    • The financial collateral comprehensive method (FCCM) will change to volatility adjustments
    • Eligible master netting agreements (MNAs) are subject to changes to the FCCM formula for Securities Financing Transactions (SFTs)
    • For firms using the IRB approach, the PRA proposes a number of changes related to SFT value-at-risk (VaR) method permissions
    • The foundation collateral method would become available to firms using the foundation internal ratings-based approach (FIRB) approach
    • Minor changes to eligible forms of collateral, collateral eligibility requirements, and treatment of FCP in RWA calculations

    Unfunded Credit Protection (UFCP)

    • Updated general principles for UFCP recognition, including conditional and unconditional guarantees
    • A revised formula for calculating risk weights for firms using the risk weight substitution method
    • Risk weight substitution of sovereign guarantees

    Timeline: If enacted, the policies would go into effect 01 January 2025.

  • Operational Risk

    Removal of the use of internal models for calculating operational risk capital requirements

    BCBS designed a new operational risk framework. To summarize the impacts:

    • As a rule, all existing operational risk approaches for calculating Pillar 1 operational risk capital (ORC) would be replaced with a standardized approach.
    • PRA would retire the Capital Requirements Regulation (CRR) Pillar 1 operational risk framework and SS14/13 “Operational risk.”
    • The new calculation for Pillar 1 ORC requirements would be:
      ORC = business indicator component * Internal loss multiplier

    Timeline: If enacted, the policy would go into effect 01 January 2025.

  • Market Risk

    A revised approach to market risk

    Based on revised eligibility criteria, firms may need to adapt their calculation methods for market risk capital requirements. The proposals in CP16/22 make existing internal model (IM) permissions for market risk redundant. Current internal model approach (IMA) firms would automatically move to the advanced standardized approach (ASA) unless granted a new IMA permission.

    • The Simplified Standardized Approach (SSA) is for firms with limited derivates business. They will retain a recalibrated version of the existing standardized approach.
    • The Advanced Standardized Approach (ASA) is a new, more comprehensive standardized approach for firms that do not meet the criteria to use the SSA but have not been granted supervisory permission to use the new IMA.
    • The Internal Model Approach (IMA) is a new model for firms that have been granted supervisory permission. It would replace the existing modelled approach.

    Timeline: If enacted, the frameworks would go into effect 01 January 2025.

  • Counterparty Credit Risk

    Removal of the use of internal models for credit valuation adjustment (CVA) risk

    The PRA proposes removing the use of internal models for credit valuation adjustment (CVA) capital requirement calculations. PRA also proposes the following new rules for CVA risk frameworks:

    • The alternative approach (AA-CVA) is suggested for firms with limited, non-centrally cleared derivatives. These firms would set their CVA capital requirements to 100% of their CCR capital requirements.
    • A new basic approach (BA-CVA) can be used by all firms. There will be two versions:
      1. The “reduced” BA-CVA version is simplified for firms that do not hedge CVA risk.
      2. The “full” BA-CVA version is intended for firms that hedge the counterparty credit spread component of CVA risk.
    • The standardized approach (SA-CVA) can be used by firms that have been granted supervisory approval, and should improve the consistency of CVA capital requirement calculations across firms. The PRA proposes that SA-CVA capital requirements be calculated from a regulatory CVA measure, instead of each firm’s accounting CVA measure.

    Timeline: CVA changes should be implemented by 01 January 2025, except transitional provisions.

    Transitional provisions are included in a five-year transition plan, in which only legacy trades are exempt from CVA RWAs before the application of the new CVA requirements established in CP16/22.

  • Output Floor

    The output floor is a central new element in the Basel 3.1 standards. It ensures that RWAs for firms with IM permissions do not fall below a defined percentage.

    The PRA proposes applying an output floor to all UK-headquartered groups, within the scope of the PRA’s CRR requirements. The proposed minimum floor is 72.5% of RWAs, calculated using only SAs.

    Timeline: If enacted, five-year transitional agreements for the output floor would apply, beginning 1 January 2025.

  • Reporting Impact

    Number of affected reports

    CP16/22 established the following reporting proposals related to Basel 3.1 implementation:

    • Credit risk: Two COREP templates were deleted, and 13 templates are updated
    • Market risk: Two COREP templates were deleted, one template was updated, and 14 templates were added
    • CVA: One COREP template was deleted, one template was updated, and three templates were added
    • Operational risk: Three COREP templates were deleted, one template was updated, and one template was added
    • Output floor: Two COREP templates were updated, and one template was added
    • Capital: Four COREP templates were updated
    • Pillar-3: Nine templates were deleted, 19 templates were updated, and 16 templates were added

    Timeline: If enacted, the report changes go into effect 1 January 2025, except where transitional arrangements are in place.

A strong and simple regime

The PRA is trying to mitigate complexity without introducing undue risk. It’s “strong and simple” initiative attempts to streamline the framework for domestic banks and building societies, while protecting their resilience.

CP16/22 also provides clues about how the prudential regime could evolve in the future. It suggests that a majority of firms may prefer a “streamlined approach” over a focused or calibrated method, wherein smaller firms can use the existing framework as a starting point and modify elements that are overly complex – rather than adopting a narrower and more conservatively calibrated set of requirements.  

Simpler-regime firms can choose to enter a transitional regime based on current CRR provisions (the Transitional Capital Regime) during an interim period. The interim period falls between the proposed Basel 3.1 standards implementation date and the future implementation date for permanent risk-based capital regimes.

Alternatively, high-growth firms can opt for Basel 3.1 and its more risk-sensitive standardized approach. As such, Basel 3.1 is a good overall package and a reference point for developing the Pillar 1 part of a simpler regime.

Basel 3.1 Commentary Figure 1

How to start your Basel journey now

Consultation on Basel 3.1 closes in March 2023 with the actual implementation of the reports beginning 01 January 2025, i.e., keeping the implementation date in line with the rest of Europe, with some exceptions for transitional provisions such as output floor.

Help with Basel implementation is available

Firms that are impacted by the proposals in CP16/22 have significant changes to review before they can prepare for the new methodologies and submissions. They need a comprehensive, end-to-end understanding of Basel 3.1 changes and the impacts for their firms. From there, they can map the changes to their regulatory processes.

Regulatory changes are complex and resource intensive. They also create an opening to review your risk controls, regulatory processes, and technology. As global leaders in risk management and regulatory reporting, Wolters Kluwer can support your Basel implementation. Our experts have advised and guided banks across Europe, Canada, Asia and Australia. What questions do you have?

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Yogesh Patil
Lead Technical Product Manager, Regulatory Reporting, Wolters Kluwer FRR
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