Basel 3.1 – PRA PS 9/24

September 2024

The PRA has published the second part (PS9/24) of its package of ‘near-final’ rules for the UK implementation of Basel 3.1 covering credit risk, the output floor and disclosure requirements. Part 1 (PS17/23) was issued in December 2023, covering market risk, credit valuation adjustment risk, counterparty credit risk and operational risk. Both policy statements address the proposals put forward in CP16/22 in November 2022.

Only minor changes were made in PS17/23. However, in PS9/24, having received the greatest volume of feedback on the proposals for credit risk and the output floor, the PRA makes more significant amendments. In doing so, it has sought to balance the feedback from industry with its aim of close alignment with the Basel standards, its views on the bottom-up risks and its secondary objective of competitiveness. Phil Evans, PRA Director of Prudential Policy, notes in his accompanying speech that the goal is for banks to hold “an appropriate amount of capital” – enough to be resilient but not so much that it stifles growth.

Overview

The key amendments in PS9/24 relate to SME and infrastructure lending, conversion factors (CFs), residential mortgages and the output floor. PS9/24 also links to the Strong and Simple regime for Small Domestic Deposit Takers (SDDTs). The PRA has published a separate consultation (CP7/24) on the capital elements of this regime. 

Critically, PS9/24 also confirms that the UK implementation timeline will now run from 1 January 2026, with a transitional period to 1 January 2030. This will allow firms more time to apply the requirements and finalise model permission applications but is a slight compression of the transition period which was previously four and a half years. UK implementation will now lag the main EU implementation by a full year – there is a specific carve-out for the EU market risk implementation to start on 1 January 2026.

The US position is less clear. The US Basel 3 Endgame is expected to be re-proposed and to feature broad and material changes, which will undoubtedly have implications for the timeline. Banks operating across the three jurisdictions will have to continue to manage these conflicting schedules.

Overall, the UK Basel 3.1 package remains highly aligned with the Basel standards. Whilst this second PS clearly includes measures to support UK competitiveness, in the main these are introduced as additions rather than modifications to the standards.

In the case of CFs, the PRA has specifically targeted international competitiveness. The reduction in CF for transaction-related contingent items brings the UK in line with the EU. The reduction in CF for “other commitments” brings it in line with the Basel text, where previously the UK was super-equivalent.

The PRA considers that the original aggregated cost-benefit analysis in CP16/22 remains “appropriate” and that the adjustments will not significantly increase costs for firms. It estimates that the impact of the changes will be less than 1% in aggregate on capital requirements phased in over the four years, i.e., lower than the impact of the proposals in CP16/22 and in other jurisdictions due, in part, to some of the risks that will now be addressed in Pillar 1 capital requirements previously being captured elsewhere in the UK’s Pillar 2 framework. 

'Near-final' rules

As with the first package, the PRA’s rules are marked ‘near-final’ because of the requirement for some retained EU rules to be revoked before they can be fully implemented. Banks should not anticipate any significant modifications going forward. The PRA intends to set out all the final policy materials, rules and technical standards covered by PS9/24 and in PS17/23 in a single, final PS in due course.

In more detail

The most significant announcements relate to:

1. SME lending 

Noting the importance of SME lending for growth, the PRA has made amendments to reduce the operational burden for firms and lower capital requirements.

Although the PRA has not gone quite as far as some might have liked, with the near-final rules still removing the favourable “supporting factor” inherited from the EU, there are additional changes to limit the impact, including:

• A new firm-specific structural adjustment to Pillar 2A (the ‘SME lending adjustment’), to ensure that the removal of the SME supporting factor under Pillar 1 does not result in an increase in overall capital requirements for these exposures. More details on the implementation of this will be available “in due course”.
• A new, simplified definition of SME to reduce the operational burden for firms applying the definition and broaden the scope of exposures which qualify for preferential treatment as an SME.
• Removal of the requirement that SA risk weights for commercial real estate (CRE) exposures should be no lower than 100% for exposures where repayment is not materially dependent on cashflows from the property, resulting in lower risk weights.

• Infrastructure lending

The near-final rules remove another inherited EU “supporting factor”, relating to infrastructure lending. Potential capital increases will be mitigated through:

• A new lower risk weight of 50% (70% in CP16/22) for “substantially stronger” project finance exposures under the IRB slotting approach. For higher quality lending, the new risk weight represents a reduction that is greater than the original supporting factor being removed.
• Another firm-specific structural adjustment to Pillar 2A (the ‘infrastructure lending adjustment’) to ensure that the removal of the infrastructure support factor under Pillar 1 does not result in an increase in overall capital requirements for infrastructure exposures.
• Lower, more risk-sensitive CFs for off-balance sheet items

The near-final rules adjust CFs as follows to “benefit international competitiveness”:

• Lowering the CF for ”transaction-related contingent items” from 50% in CP16/22 to 20% , bringing the UK in line with the EU
• Lowering the CF for “other commitments” (except for UK residential mortgage commitments) from 50% to 40%.  This brings the PRA rules in line with the Basel text, whereas previously they were super-equivalent.

2. Residential mortgages

The near-final rules introduce a more risk-sensitive and operationally simpler approach to the valuation of residential real estate under the credit risk standardised approach (SA), including:

• Addition of a ‘backstop’ revaluation event requiring firms to obtain a new valuation once every three or five years (depending on the property), to prevent products without natural refinancing events, such as lifetime mortgages, from being unjustifiably disadvantaged.
• Removal of the requirement for firms to adjust a valuation to reflect the value of the property that would be sustainable over the life of the loan.
• Clarification regarding downward revaluation requirements, making them more mechanistic, and therefore simpler, by requiring firms to revalue properties if they estimate through their regular monitoring that the market value of the property has decreased by more than 10% relative to the value recorded at the last valuation event.

3. Calculating the output floor

The proposals in CP16/22 prioritised simplicity, requiring no additional work from IRB firms to adjust their capital resources to reflect differences in the treatment of provisions in the standardised and IRB approaches. However, feedback noted that in some cases the floor would be a less accurate measure of required capital. The near-final rules now introduce an adjustment to risk weighted assets to reflect the different treatment of accounting provisions under the SA and the IRB approaches.

4. Clarification on use of Automatic Valuation Models (AVMs)

The near-final rules also clarify that the use of AVMs for the desk-based generation of house valuations is permitted. With the industry relying significantly on automated valuation methodologies to support operational efficiency in the real estate lending business, banks will welcome the PRA clarification that they can be used.