Introducing revisions to the credit risk regulatory requirements
The Basel 3.1 framework represents a comprehensive set of international banking regulations developed by the Basel Committee on Banking Supervision (BCBS) to enhance the resilience of banks and the broader financial system. These reforms aim to address shortcomings revealed during the 2008 financial crisis by refining risk measurement approaches and bolstering capital adequacy standards.
In the UK, these regulations are referred to as Basel 3.1 and address the final elements of the Basel III standards on liquidity and capital that have yet to be implemented in the jurisdiction. The Prudential Regulation Authority (PRA) is responsible for implementing these standards to ensure the stability and competitiveness of the nation's banking sector.
The overarching goal of the reforms is to enhance consistency in risk measurement and capital ratios, particularly among larger lenders that had previously been permitted to develop their own risk models. Revisions to the UK’s Basel 3.1 framework introduce relief for banks, particularly in capital-heavy areas like small and medium-sized clients (SMEs) and infrastructure lending.
On 17 January 2025, the Prudential Regulation Authority (PRA) anannouncing that, in consultation with HM Treasury, it has decided to delay the implementation of Basel 3.1 in the UK by one year until 1 January 2027. As outlined in the BoE’s publication, the delay is to allow more time for greater clarity to emerge about plans for its implementation in the United States.
While this additional time allows firms to better prepare for the new capital requirements and ensures a smoother transition, the overall timeline for full implementation remains unchanged. As with the previous six-month delay outlined in PS9/24, the transitional periods in the rules will be shortened to maintain the final implementation deadline of 1 January 2030. The PRA will continue to monitor international developments and make adjustments if necessary.
Consequently, the UK will implement these standards after the European Union, which introduced them, with certain variations, starting 1 January 2025. While this creates a temporary misalignment, UK regulators have stated that the phased approach will ensure stability and predictability for financial institutions.
In September 2024, the PRA published Policy Statement PS9/24, outlining near-final rules for implementing Basel 3.1 in the UK. This statement focuses on key areas such as credit risk, the output floor, Pillar 2 adjustments, and disclosure requirements under Pillar 3. The PRA's approach aims to align with international standards while tailoring certain aspects to fit the specific characteristics of the UK banking sector.
Key highlights
The PRA's final rules include several changes to the Standardised Approach (SA) for credit risk, which are likely to reduce overall capital requirements for UK CRR firms compared to the initial proposals.
Exposures to Individuals and SMEs:
Exposures to Corporates and Infrastructure Lending:
The PRA maintains its approach to risk weights for unrated corporates: 65% for investment grade and 135% for non-investment grade exposures. The infrastructure supporting factor is removed, but a firm-specific Pillar 2A adjustment for infrastructure lending is introduced. High-quality unrated project finance exposures may qualify for a lower 80% risk weight.
Exposures to Institutions and Covered Bonds:
The PRA retains its Standardised Credit Risk Assessment Approach (SCRA) for unrated institutions, with risk weights for short-term unrated exposures ranging from 20% to 150%. The requirement for real estate collateral in eligible covered bond pools to be revalued at default is removed.
External Credit Ratings and Due Diligence:
Firms must perform due diligence on obligor credit quality and adjust risk weights if due diligence indicates higher risk than the external rating. Multilateral development banks and international organizations with 0% risk weights are exempt from this requirement. External ratings assuming implicit government support cannot be used.
Residential and Commercial Mortgages:
Risk weights for real estate exposures are based on property type, LTV ratio, and dependency on property cash flows. Changes include:
Off-Balance Sheet Exposures:
The PRA has finalized its approach to off-balance sheet exposures, adjusting Credit Conversion Factors (CCFs) to better reflect risk. A 40% CCF applies to ‘other commitments,’ while transaction-related contingent items receive a reduced 20% CCF, down from the initially proposed 50%. The 50% CCF for UK residential mortgage commitments remains unchanged. The PRA has also confirmed its definition of a ‘commitment’ and opted not to adopt the 0% CCF national discretion for unconditionally cancellable commitments related to certain corporate and SME exposures.
Capital Instruments and Defaulted Exposures:
The PRA maintains its proposed risk weight treatment for equity exposures (250% or 400%), with 400% applied to 'higher risk' equity exposures, defined as businesses less than five years old. Subordinated debt (150%) and other capital instruments will be treated as proposed. For defaulted exposures, the PRA clarifies that only defaulted residential real estate exposures not materially dependent on property cash flows can receive a flat 100% risk weight. Other defaulted exposures will have risk weights of 100% or 150%, depending on provisioning level.
The PRA's final rules align broadly with Basel standards but adopt a more conservative approach in some areas, including restricting IRB use for certain exposure classes.
Scope of IRB Permissions:
The PRA has clarified the IRB Permission process, ensuring revised permissions align with implementation. Firms should liaise with supervisory teams for approvals, considering 'material compliance' under the final rules. Non-compliant IRB model change applications may be approved if they reduce overall non-compliance and have a credible remediation plan.
Roll-Out and Permanent Partial Use:
The PRA revised the materiality assessment to a cumulative threshold across all roll-out classes, minimizing cherry-picking. Specialized lending and qualifying revolving retail exposures remain under IRB, with context-specific changes to the materiality assessment.
Restrictions on Using the IRB Approach:
IRB use is restricted for central governments, central banks, and quasi-sovereigns. For institutions, financial corporates, and large corporates, firms must use Foundation IRB (F-IRB) or SA. The slotting approach is required for Income Producing Real Estate (IPRE) and High Volatility Commercial Real Estate (HVCRE).
Exposure Classification:
The PRA reversed its proposal to include undrawn commitments in SME assessments, aligning with current practices. The definition of HVCRE has been updated to exclude residential developments, aligning with BCBS standards.
Input Floors:
The PRA maintains input floors generally aligned with BCBS standards, with a 0.1% PD floor for UK residential mortgages and 0.05% for other exposures. LGD floors range from 5% for residential mortgages to 25-50% for other unsecured and retail exposures. A dual approach is used for EAD input floors.
Parameter Estimation and Supervisory Factors:
The PRA finalizes changes to model parameter estimation to reduce RWA variability. Continuous scales in PD models are prohibited, with a ‘point-in-time plus buffer’ approach for non-mortgage retail models. Firms must consider 'seasoning' effects as a PD risk driver, potentially through a margin of conservatism. The PRA allows obligor grade adjustments for undocumented support, subject to risk management requirements.
The PRA's final rules largely align with Basel standards, including changes to Funded Credit Protection (FCP) and introducing new methods for firms lacking data. For Unfunded Credit Protection (UFCP), restrictions are placed on recognizing and modeling CRM, and limits on PD adjustments are introduced.
CRM Approaches and Methods:
The PRA revised rules for recognizing CRM on guarantees and other unfunded credit protection secured with financial collateral. A decision tree clarifies the treatment of ineligible protection providers and cases where both financial collateral and guarantees can be recognized.
Securities Financing Transactions (SFTs):
Firms may recognize a wider range of collateral for repurchase transactions and securities lending in the trading book, provided additional criteria are met. Only margin lending transactions with legal transfer of title are eligible for wider recognition.
Collateral Eligibility:
Financial collateral with a material positive correlation to the lender's assets is not eligible. Equities or convertible bonds listed on a recognized exchange are eligible under FCCM. Changes improve CIU collateral recognition.
Unfunded Credit Protection (UFCP):
UFCP includes guarantees, credit insurance, and credit derivatives. The PRA maintains that risk weights of exposures should match those of protection providers under SA.
The PRA has finalised the rules to implement the Output Floor (OF) broadly in line with the proposals, with technical fixes for accounting provisions and a shorter phase-in period to recognise the delay to implementation. In-scope firms are required to calculate Risk-Weighted Assets (RWAs) as the higher of:
The key change from the proposals is to amend the approach to accounting provisions to reflect feedback from firms, allowing firms to make certain adjustments to Common Equity Tier 1 (CET1) capital and Tier 1 capital, particularly in cases where expected loss (EL) amounts diverge from accounting provisions. The PRA has maintained that the OF applies at the UK consolidation group level and on an individual basis where applicable, with certain provisions for subsidiaries of overseas groups and Ring-Fenced Bodies (RFBs).
TThe PRA has launched an off-cycle review of firm-specific Pillar 2 requirements to address the consequential impacts of Basel 3.1 Pillar 1 changes. This review ensures that the removal of SME and infrastructure lending support factors is offset through structural adjustments in Pillar 2A. The PRA will adjust firms’ Day 1 Pillar 2 requirements (both variable parts of Pillar 2A and the PRA buffer) and rebase firms’ variable Pillar 2A requirements throughout the output floor transitional period to prevent disproportionate impacts on capital requirements.
Additionally, firm-specific structural adjustments will be applied to account for the removal of SME and infrastructure lending support factors. Future consultations will further refine Pillar 2 methodologies, particularly concerning sovereign exposures, credit concentration risk, IRB benchmarks, interest rate risk in the banking book (IRRBB), and pension risk.
The PRA has published final disclosure requirements covering credit risk, market risk, credit valuation adjustment (CVA) risk, counterparty credit risk (CCR), operational risk, and the output floor. While the majority of disclosure templates remain unchanged from initial proposals, modifications have been made to credit risk and operational risk disclosures to reflect updates in final rules. These measures aim to enhance transparency and comparability across the financial sector.
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