Basel 3.1 – all you need to know

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What is Basel 3.1?

It is the last set of amendments to the capital regime for banks after the Global Financial Crisis.

Basel 3.1 seeks to make two major changes to the regulatory landscape.

First, it will materially alter the composition of capital requirements by making major underlying changes in the calculation of Pillar 1 capital.

Second, the reforms aim to make the capital regime more risk sensitive.

This is going to be one of the most significant challenges facing firms over the next few years, so follow us for more updates on everything you need to know, and everything you will need to do.

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At present there is a great deal of divergence between the Standardised Approach and the Internal ratings-based Approach to credit risk.

How will Basel 3.1 change things?

Under Basel 3.1 proposals, there will be far more granularity in the risk weights that will apply to the Standardised Approach. As a result firms can expect these risks weights to generally go down.

The opposite is true for IRB where proposals, such as the introduction of conservative input floors will increase the risk rates that will be applicable to IRB.

What about the Output Floor?

The Basel 3.1 Output Floor can be seen as a minimum capital requirement that is applicable to IRB firms. This means that such firms will need to hold at least 72.5% of the capital required under the Standardised Approach, even if the IRB method suggest holding a lower amount of capital.

Disclosure Requirements are also changing with Firms that used the Standardised Approach needing to disclose their financial data in far more granularity than they have been so far. The same is true for IRB firms who will now be required to disclose far more granular assessments of the standardised method of computation of RWAs.

Taking into account the impact of the more conservative model parameters, the impact of the Output Floor and indeed the far more enhanced disclosure requirements, IRB will be less beneficial going forward than it has been.

What is the main outcome here?

Firms will need to undertake a thorough cost benefit analysis to determine if the IRB approach is still right for them.

This must include the impact of the Output Floor on their risk weight assessment.

There are also a number of operational requirements that apply to IRB firms. For instance, the PRA proposes to ban the use of IRB method for certain low risk exposures. In addition, model risk principles that have recently been published will also be applicable to IRB firms. Firms should also account for these operational considerations in their analysis.

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As part of the Basel 3.1 reform the PRA are proposing some big changes to mortgage risk weights.

This could have a material impact on risk weights across the sector.

What are the new proposals?

Under the new proposals, the regulatory real estate exposure risk weights will continue to be determined based on the type of property and the loan-to-value ratio. There is no change there.

But what is new is that they will also be determined by whether repayments are materially dependent on the cash flows generated by the property.

Furthermore, the definition of residential mortgages is changing such that property like care homes, purpose-built student accommodation and holiday lets, will all be treated as commercial exposures.

These changes will result in material upwards revisions to the underlying risk weights.

What do firms need to consider?

There are three main things that firms will need to consider:

1. Firms will need to perform a gap analysis between the old and new capital regimes. This will help to understand how the changes will impact the underlying risk weight calculations.

2. Firms will have to assess their data capabilities and understand what additional data may need to be collected or analysed.

3. Firms will need to consider key areas of judgement when allocating their risk weights. When determining whether repayments are ‘materially dependent on the cash flows generated by the property’, Judgements should generally align with underwriters’ assessments.

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One of the most discussed changes brought about by the PRA’s proposed implementation of Basel 3.1 is the removal of the SME Support Factor.

What is the SME support Factor?

It allows lenders to apply a reduced risk weight to qualifying exposures of corporate and retail SME. Small and medium size enterprises (SMEs) are defined by the PRA as firms that have an annual turnover of less than £44 million. The quantum of the discount is dependent on the size of the firm’s lending exposure but can be up to 24% for certain corporate SMEs.

As you can see from the graphic on the screen, the PRA’s proposal reduces the unrated corporate SME risk weight to 85%, and the risk weights for retail SMEs can vary based the type of exposure.

This means that, in the worst-case scenario, unrated corporate SME risk weights will have a maximum uplift of 9%. While retail risk weights may increase significantly.

What are the positives?

The risk weights for some corporate SME exposures will remain unchanged.

For retail transactor exposures, risk weights will generally be lower than the current regime. The best-case scenario is a decrease in risk weights of 19%.

How should banks respond?

The impact of these changes is dependent on banks’ lending exposures. Firms should perform an assessment of their portfolio to understand the impact to their capital requirements.

This may be a time for banks to revisit their strategies and reconsider their SME portfolio mix to ensure that it is capital efficient. This could lower average risk weights and reduce capital requirements.