Understanding Basel 3.1

Basel 3.1 seeks to make two considerable adjustments to the regulatory landscape. The first will materially alter the composition of capital requirements by making major underlying changes in the calculation of Pillar 1 capital. In particular, this relates to credit, market and operational risk. While the second will make the capital regime more risk sensitive.

The aim of the regulations is to reduce the likelihood of future banking crises by encouraging transparency and more standardised practices, ensuring that banks have a more accurate and comparable assessment of their risk exposure.

Basel 3.1 is likely to have a significant impact on a large number of regulated banks and building societies in the UK. The scale of the changes being proposed, and their materiality, means this will be one of the most significant regulatory challenges facing firms in the medium term.

The PRA will replicate the scope of application currently in place under the CRR, with a few significant exceptions. The current framework applies to:

• PRA-authorised banks and building societies.
  PRA-approved or PRA-designated holding companies and building societies.
• Small domestic deposit takers (SDDTs) will be able to join the Strong and Simple Framework, a more proportionate prudential regime for less systemically important banks and building societies.

The current state of Basel 3.1 implementation in the UK is progressing steadily. The Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) have been working closely with banks to ensure a smooth transition and adherence to the new regulations.

Basel 3.1 has several impacts on the UK banking sector. One of the key objectives of the framework is to enhance the risk management practices of banks, particularly in relation to capital adequacy. Banks must therefore assess regulatory capital requirements more accurately, to absorb potential losses, reducing the risk of financial instability.

Basel 3.1 introduces stricter rules for measuring and managing risks, including credit, market, and operational risks. This encourages banks to adopt more robust risk management frameworks and processes to improve the sector’s overall resilience.

The implementation of Basel 3.1 also aims to promote transparency and accountability in the banking industry. Banks are required to enhance their reporting and disclosure practices, providing stakeholders with more comprehensive and timely information about their risk profiles and financial positions.

The Basel Framework can be traced back to four key instances. These are:

• The Basel Committee on Banking Supervision: The committee, comprising banking supervisors from various countries, responsible for developing and maintaining the Basel Framework.
• Basel I: The first iteration of the Basel Framework introduced in 1988 focused on credit risk and established minimum capital requirements for banks based on their risk-weighted assets.
• Basel II: Introduced in 2004, Basel II expanded on Basel I to introduce additional risk categories, including operational risk and market risk, providing more detailed guidance on how banks should assess and manage these risks.
• Basel III: Basel III, introduced in response to the 2008 financial crisis, further strengthened the regulatory framework by increasing the quality and quantity of regulatory capital banks are required to hold. It also introduced measures to address liquidity risk and leverage ratios.

The aim of credit risk proposals is to enhance risk sensitivity and robustness in the standardised approach (SA) and reduce excessive complexity and lack of comparability in firms’ calculations of RWAs through the Internal Ratings Based (IRB) approach.

Proposed changes in the credit risk SA include introduction of new exposure classes and reduction of firms’ reliance on external credit ratings.

Under the IRB approach, the PRA have proposed removing the option to use IRB for certain exposure classes, and restricting the type of internal modelling that can be used for others.

However, there does appear to be a positive for IRB firms, particularly those on the cusp of receiving approval for IRB models. The threshold for approving IRB model applications under the current proposals will change from ‘full compliance’ to ‘material compliance’. This may foreshadow a relaxation in the requirements associated with IRB model approval.

The output floor will perform as a backstop against excessively low risk weights and excessive variability among firms with internal modelling (IM) permissions.

Under the PRA’s revised Output Floor proposals, IM firms, will be required to calculate Risk Weighted Assets as the higher of;

• Total RWAs using all approaches they have the supervisory approval to use, including IM approaches, and
• 72.5% of RWAs calculated using only standardised approaches.

As per PS17/23, the PRA will implement a new operational risk framework, for Pillar 1 operational risk capital requirements and exercise the national discretion included in the Basel 3.1 standards to set the internal loss multiplier (ILM) equal to 1. The new SA will replace all existing approaches for Pillar 1 operational risk requirements.

Operational Risk has been a major weak point of the Basel 3 reforms with the Advance Approach being largely discredited by the latter half of the last decade. As a result, both the Advanced Approach and Basic Indicator Approach will disappear in Basel 3.1.

The ILM is meant to provide a risk sensitivity element to the calculation of Pillar 1 Operational Risk. However, in the UK, the PRA has decided to set the ILM to one. By setting the ILM to 1 the PRA is essentially trying to smooth the capital impact of the new requirements. This decision has the effect of neutering a key element of the new standardised approach to operational risk.

The PRA has planned a review of the Pillar 2 framework for later in the year, and some of the idiosyncratic operational risk that is not captured through the ‘removal’ of the ILM, will be recalibrated through Pillar 2 operational risk capital requirements.

As per PS17/23, the PRA will implement the Basel 3.1 market risk framework, replacing the existing calculation methodologies and improve risk sensitivity.  Three new methodologies form the framework, and they are:

• Simplified standardised Approach (SSA)
• Advanced standardised Approach (ASA)
• Internal modelled approach (IMA)

In alignment with Basel, the PRA has implemented more restrictive guidance on what instruments must be assigned to the trading book, and therefore subject to the market risk framework. There are industry concerns that the proposals are too conservative and restrictive, but the PRA did not make material changes between Consultation and Policy. This may be partially because their proposals largely align with international peers which they can use as political cover.

Overall, the PRA intends to improve the coherence of the market risk framework, promote consistency across firms, and more comprehensively address the market risks posed by firms’ exposures.

As per PS17/23, the PRA will amend the scope and calibration of CVA risk and standardised approach to counterparty credit risk.

The new CVA risk framework methodologies for calculating capital requirements will comprise of the Alternative Approach, the Basic Approach, and the Standardised Approach.

The main aims of the PRA’s proposals are to improve the risk-sensitivity and comparability of CVA capital requirements. It attempts to achieve the following:

• More comprehensive treatment of CVA risks and better recognition of CVA hedges.
• Closer alignment with industry CVA practices for accounting purposes.
• New methodologies, which have less reliance on modelling.