UK Basel 3.1: An overview of the proposed changes
On 30 November 2022, the Prudential Regulation Authority (PRA) published a Consultation Paper 16/22 (CP16/22) proposing the implementation of Basel 3.1 standards.
The primary objective of the revisions in the current framework is to improve the reliability of capital ratios, by making standardised approaches more risk-sensitive, addressing limitations of Internal Models (IMs), and restricting the benefits that IMs can provide by introducing an ‘output floor’. This would improve both the measurement of risk and the comparability across firms. The framework was originally proposed to be implemented on January 1, 2025. However, according to the news release dated September 27, 2023, the revised implementation date is July 1, 2025.
1. Coverage:
This article summarises key changes relevant for small- and medium-sized banks with limited or no trading book exposures. Items covered as part of this article include:
Credit Risk: Standardised Approach (SA)
Operational Risk: Standardised Approach
Credit Valuation Adjustment (CVA): Alternative Approach (AA-CVA) and the Basic Approach without hedging effect (‘Reduced’ BA-CVA)
Market Risk: Simplified Standardised Approach (SSA) and the Advanced Standardised Approach (ASA)
Pillar 3 disclosure requirement: For non-listed ‘other institutions’*
Reporting changes: Update to reporting requirements
* Institution which is neither a ‘large institution’ nor a ‘small-and non-complex institution’.
Items not covered as part of this article include:
Credit Risk: IRB approach
Credit Risk Mitigation (CRM): There are no significant changes for firms using SA for credit risk
Credit Valuation Adjustment (CVA): The Basic Approach with hedging effect (‘Full’ BA-CVA) and Standardised Approach (SA-CVA)
Market Risk: Internal Model Approach (IMA)
Pillar 3 disclosure requirement: For ‘large institutions’
Output floor: The objective of the output floor is to provide a backstop that limits the extent to which firms using the IM approaches (IM firms) can lower their Risk Weighted Assets (RWAs) relative to the revised SAs used by SA firms. As per this backstop, RWAs as per IM approaches cannot be lower than 72.5% of their SA RWAs on average across all exposures. The requirement is to be phased in over four and a half years. Provisions relating to the ‘output floor’ are not covered in this article as it is only relevant for firms with IM permissions to calculate the capital requirements.
Pillar 2 framework: No specific Pillar 2 framework related changes are proposed in CP16/22. The PRA intends to review Pillar 2 methodologies by 2024.
2. Key changes:
Key changes are listed below based on the risk category:
2.1. Credit Risk
To make the SA more risk-sensitive, new exposure sub-classes# have been added, and a grading mechanism introduced for unrated corporates and institutions, based on the internal assessment/rating. Additionally, the PRA has also proposed to introduce the due diligence requirements on the use of external credit ratings to ensure that the external ratings prudently reflect the creditworthiness of the counterparties.
Please follow the given links for further details on each exposure class:
Exposures to regional governments and local authorities:
Currently, exposure to regional governments or local authorities shall be treated as exposure to the central government:
in whose jurisdiction they are established
where there is no difference in risk between such exposures because of the specific revenue-raising powers of the former, and
the existence of specific institutional arrangements the effect of which is to reduce their risk of default.
In the proposed rules, the PRA outlines that only UK’s devolved administrations are the only regional governments or local authorities that should be treated as exposures to the UK central government. Therefore, Article 115(2) has been updated to reflect the following list of regional governments that shall be treated as exposure to central governments:
the Scottish Government;
the Welsh Government; and
the Northern Ireland Executive
Exposures to central governments or central banks [no change]
Exposures to public sector entities [no change]
Exposures to international organisations [no change]
Exposures in the form of units or shares in collective investment undertakings (‘CIUs’) [no change]
Other items [no change]
A summary of the existing and proposed risk weights and movements in exposure sub-classes are outlined in Appendix 1 & 2 respectively.
Proposed changes relating to the following exposure classes are not covered in this article:
Exposures in the form of covered bonds
Items representing securitisation positions
# E.g. Retail exposures are bifurcated into regulatory retail’ (transactor and non-transactor) and ‘other retail’ categories. Real estate exposures are categorised into ‘acquisition, construction, development’ (ADC), ‘regulatory real estate’ and ‘other real estate’ categories.
2.2. Operational Risk
All the existing operational risk approaches [Basic Indicator Approach (BIA), Standardised Approach (SA), and Advanced Measurement Approach (AMA)] are proposed to be replaced by the new Standardised Approach (SA). A more detailed overview of the proposed changes is provided in the Operational Risk article.
2.3. Credit Valuation Adjustment (CVA) and Counterparty Credit (CCR) Risk
Three new methodologies have been introduced to replace the current framework:
Alternative Approach (AA-CVA): Available to firms with limited non-centrally cleared derivatives
Basic Approach (BA-CVA): Available to all firms
Standardised Approach (SA-CVA): Available to firms with prior permission from the PRA. In addition, an annual attestation is required confirming that the firm continues to meet the requirements to use this approach.
The detailed calculations and a comparison between AA-CVA and BA-CVA are provided in the Credit valuation adjustment and counterparty credit risk article.
2.4. Market Risk
Key changes to the Market Risk framework include:
The existing Standardised Approach has been recalibrated and renamed as the Simplified Standardised Approach (SSA)
Introduced a new more comprehensive standardised approach - the Advanced Standardised Approach (ASA)
A clear distinction is provided between the trading and non-trading book. Prescribed a list of positions with an initial classification as trading and non-trading book.
Detailed calculations and a comparison between SSA and ASA are provided in the Market Risk article
2.5. Pillar 3 Disclosures
An overview of the current Pillar 3 disclosure requirements is provided in the UK Pillar 3 disclosure requirements article.
There are no changes proposed to the disclosure requirements for ‘small-and non-complex institutions’, however, as part of this CP, there are additional disclosure requirements for ‘large institutions’ and ‘other institutions.’
Additional disclosure requirements for non-listed ‘other institutions’ are outlined below:
** ‘Template’ is for quantitative information and ‘Table’ is for qualitative information.
2.6. Reporting changes
For each of the risk areas (e.g., credit, market, operational) listed above there are a number of reporting requirement changes proposed. These are outlined in the Reporting changes article.
Appendix 1: Existing and proposed risk weights across exposure classes under the standardised approach
1. Exposures to Institutions, MDBs and Corporates:
* A risk weight of 30% may be assigned if the Common Equity Tier 1 Ratio >= 14%, and the Leverage Ratio >= 5%.
# Specialised lending exposure means a corporate exposure that is not a real estate exposure and has any of the following characteristics:
exposure was created specifically to finance and/or operate physical assets
the borrower has little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed
the terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates
Following are the sub-categories of specialised lending exposures:
‘Project finance’ means funding for which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure.
‘Commodities finance’ means short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (including crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure.
‘Object finance’ means the funding of the acquisition of physical assets (including ships, aircraft, satellites, railcars, or fleets) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed by and pledged or assigned to the lender.
** ‘High-quality’ include whether the exposure is to an entity that can meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions; and that conditions covering the entity’s revenue and creditor protection are satisfied.
2. Retail exposures:
Existing and proposed risk weights for retail exposures are outlined below:
3. Exposures in default:
Existing and proposed risk weights for defaulted exposures are outlined below:
4. Real estate exposures:
Existing and proposed risk weights for real estate exposures are outlined below:
5. Subordinated debt, equity and other own funds instruments
Existing and proposed risk weights for subordinated debt and equity exposures are outlined below:
# Venture capital means an equity exposure that is:
(a) not listed on a recognised exchange; and
(b) held to provide funding to a newly established enterprise, including for:
(i) the development of a new product or related research to bring the product to the market;
(ii) the build-up of the production capacity of the enterprise; or
(iii) for the expansion of the business of the enterprise.
Appendix 2: Credit risk – standardised approach: Key changes to exposure class/sub-class
