Basel 3.1 webinar series

The PRA has made substantial changes to its SME proposals. Removal of the SME support factor will still take place. However, the PRA are also introducing a P2A firm-specific adjustment. As a result, any forecast uplift in capital requirements for lending to SMEs is being neutralised. 

A similar approach has been adopted for the treatment of infrastructure lending which also benefits from a support factor under the current regime. The regulator has not provided much clarity about how the firm-specific adjustment will function in practice. Some of the outstanding questions include the fact that by leaving the increase in SME risk weights in Pillar 1 this may have implications for the wider capital stack. For example, it may result in a marginal increase in macroprudential buffers for most firms, given that these calibrated based on Pillar 1 risk weights. It is also unclear how the PRA will ensure that the SME adjustment in Pillar 2A will be variable. Further guidance is required from the regulators on these topics in particular.

The proposals relating to residential mortgage classification represent a compromise from the PRA. 

In a major revision from the original proposals, holiday lets, care homes and student accommodation will not be entirely excluded from the regulatory residential real estate exposure class. However, the litmus test of whether these types of property will receive lower risk weights, is if they can be resold as a standard residential dwelling. Firms will need to develop a clear policy, linked to existing legal definitions, as part of their Basel implementation plans. Significant amendments have also been made to how firms are permitted to carry out valuation of real estate collateral. While the valuation of collateral will still take place at origination, a revaluation backstop has been put in place. This will mean firms will have to acquire an updated valuation every 5 years, with exceptions for larger exposures and in instances when the market is experiencing significant stress. Automated Valuation Models are now explicitly permitted by the PRA in the near-final rules.

The PRA confirmed that the thresholds for IRB models approval has been relaxed. 

The PRA will lower the threshold for approval from ‘full compliance’ to ‘material compliance’. The PRA also clarified that they would seek to adopt a conditional model approval approach, similar to what is already in place in the ECB. This would be in circumstances where approval would reduce the overall level of IRB non-compliance and the firm has a remediation plan in place. The PRA will also allow firms to make and revise model applications under the proposed, near-final, regime before the Basel standards are actually implemented.

There has been little change in Reporting & Disclosures between the consultation stage and the near-final rules. One notable change compared to the current regime is the fact that the PRA have confirmed that they will introduce a specific template for historical Operational Risk losses. This information will feed into policy evaluation for setting the ILM in the future.

We covered how we think that Capital Impact analysis should be approachedby firms, looking at three focus areas in particular;

• Firms need to ensure there is a link in their analysis to business lines. They should not just focus on understanding the overall capital impact of Basel 3.1 on the firm more widely.  
• Firms need to make sure that they took into account any adjustments that may occur in P2A over the next 12 months. This includes considering the potential impact of PRA adjustments for SME Lending and Infrastructure Finance exposures. This work should include understanding the potential impact rebasing of Pillar 2A Operational, Credit and Market Risk requirements. We believe that it would be prudent for firms to build in additional capital headroom to account for these changes given the outcomes are still uncertain.
• Ensure that any impact analysis considers the wider effect of Pillar 1 adjustments across the entire capital stack, including the P2B buffers. 

There was a discussion on the Impact of the Output Floor on capital and financial resource management. For large banks subject to the output floor, there is going to be an increased impetus to gear capital around this, as the binding constraint under the new regime. Under the new regime, there will also be less incentive for firms to ‘collect’ as many IRB models as possible in the expectation that this will significantly reduce their overall capital requirement. Instead, firms will need to consider what the optimal interaction is between their portfolio, risk weighted assets and active IRB model approvals. As part of this, IRB firms may also need to consider, especially from a resourcing perspective, if they should shrink their pool of active IRB model approvals. This could bring with it cost benefits.

Basel 3.1 will overlap with a lot of other existing PRA and FCA regulation. We are currently in an environment where a significant amount of regulatory change is taking place. As a result, we expect that this task will be a major challenge for most firms. Some of the most notable examples of regulatory change discussed include:

• The Bank of England Data Review.
• The upcoming Securitisation Framework consultation.
• Third Party Risk Management which is a significant focus area for both the PRA and FCA.
• The recently released guidance on Model Risk Management.

Any team or individuals tasked with implementing Basel 3.1 will need to ensure that they have oversight of ongoing regulatory change and understand how it may impact Basel 3.1 implementation.

Finally, we provided an overview of what firms would need to consider from a Data perspective. This included a focus on the importance of data lineage. We believe that firms should first identify the main areas – such as credit risk, operational risk, market risk. Firms should then identify the key data fields that contributes to deliverables that matter. This will include regulatory reporting, models, and key MI. For this prioritised pool of data, firms should then start tracking their data provenance. Once the different data flows have been understood, firms should begin to think about what parts of those data flows that should be kept the same, and more importantly, those that would need to be amended to align with the Basel 3.1 changes. We also highlighted the fact that firms would need to ensure they have a complete, accurate, up-to-date sets of data for decision making. While some of this data may already be available, firms will need to refine this so it contributes to decision-making processes. In our opinion, only after this is achieved can data quality controls be designed and implemented.

In the near-final rules the PRA confirmed that firms can utilise valuation models such as AVMs. They also confirmed that firms could utilise indices for valuations. So the answer to this question is yes. However, firms using indices would need to ensure that this approach is sufficiently prudent – i.e. that the firm can justify why using indices does not cause misalignment with other valuation approaches. 

The PRA did not provide any explicit detail on this in PS9/24. However, in our experience this approach is allowed under the current framework. Therefore we expect it to be applicable under the new Basel 3.1 standards. 

Basel 3.1 is focused on changing the calculation of Credit Risk, Market Risk and Operational Risk Pillar 1 capital. However, the capital stack should be viewed holistically. Any change to the Pillar 1 capital requirement will have a direct impact on how a firm calculates and holds capital in P2A (idiosyncratic risks) and P2B (stress testing). The PRA has stated its intention to sequence its Pillar 2 review work. It will first focus on the direct impacts of Basel 3.1  as part of off-cycle review of Pillar 2A (this will include items like the SME Lending Adjustment). We expect this to take place next year. It will then review all firms overarching Pillar 2A methodologies after implementation. We assume this will take place whenever your first SREP assessment occurs post 1 January 2026. 

Yes, CP 16/22 included proposals to amend existing, introduce new and delete redundant reports, to align the regulatory reporting and disclosure requirements with wider changes in Basel 3.1 proposals. PS9/24 follows the same approach. Furthermore, instructions and reporting templates have been amended to remedy some errors reported by firms in their feedback to the consultation paper and provide further clarifications in the instructions. See PS 9/24 Appendix 12 (Disclosures), and 13 and 14 (Regulatory Reporting) for more details on the changes in instruction and reporting templates.