Implementing Basel 3.1: Your guide to manage reforms

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.

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.

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.

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.

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.

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.