PRA Basel 3.1 Policy Statement - PS 17/23

December 2023

As announced in September 2023, the PRA has published the first package of near-final rules for the UK implementation of Basel 3.1. The first policy statement (PS17/23) covers market risk, credit valuation adjustment risk, counterparty credit risk and operational risk. A second policy statement, on credit risk, the output floor and disclosure requirements, is expected in Q2 2024. 

Alongside PS17/23, the PRA has published:

• A comparison (PDF 3.4 MB) of the proposals put forward in CP16/22 and the near-final rules.
• A statement of policy (SoP) on the Interim Capital Regime (ICR) — relevant for UK banks and building societies that meet the Small Deposit Taker (SDDT) criteria and wish to opt for an alternative to implementing the Basel 3.1 standards until the new `Strong and Simple' regime is fully operational. 

PS17/23 is relevant to all PRA-regulated banks, building societies, investment firms and financial holding companies. The PRA's rules are marked `near-final' due to 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. 

In CP16/22, the PRA stayed very close to the Basel standards, with a small number of transitional arrangements and concessions. At the time, PRA CEO Sam Woods stressed the importance of alignment with global banking standards and the inclusion of `appropriate but limited adjustments for the UK market'. His comments on PS17/23 continue the theme of robust and proportionate regulation for the UK: 

`The rules published today implement the latest Basel standards in the UK and include appropriate adjustments to take on points raised by respondents to our consultation. The focus of these rules is not on the aggregate amount of capital in the system but on making sure that risk is properly captured across a range of firms and activities.'

In response to feedback on CP16/22, the PRA has made some adjustments and corrections to its proposals, the most material of which include:

• The removal of market risk internal modelling for the default risk of exposures to sovereigns, aligning the market risk and credit risk frameworks and addressing capital requirements for some sovereigns; and
• Added flexibility in the credit valuation adjustment (CVA) risk framework through the introduction of an additional, optional, transitional arrangement to reduce the operational burden on firms.

The PRA does not consider that the near-final rules differ significantly from those in CP16/22. It therefore stands by its original cost benefit analysis which estimated that the impact of Basel 3.1 requirements will result in an average increase in Tier 1 capital requirements for UK firms of around 3% once fully phased in (i.e. in 2030). For comparison, this is lower than the EBA's estimate of a 9.9% Tier 1 increase in the EU and the US agencies' estimate of a CET 1 increase of 16% for large holding companies and 9% for depository institutions at the end of their proposed transitional period.

Although there was already work that could be done on a `no-regrets' basis (see our recent article), with publication of these near-final rules banks in the UK now have significantly more certainty over what is required ahead of the 1 July 2025 implementation date. However, there may yet be significant changes when the second policy statement, focusing predominantly on credit risk, lands in Q2 2024. 

Progress has also been made on EU requirements, with a political compromise now reached on CRR3 and the final vote expected in early 2024. In the US, the Federal Reserve Board is yet to publish any concrete follow-up to its July NPR. 

Market risk

CP16/22 proposed three new methodologies under the Basel 3.1 market risk framework, to replace existing calculation methodologies and improve the risk sensitivity of market risk capital requirements:

• The simplified standardised approach (SSA);
• The advanced standardised approach (ASA); and 
• The internal modelled approach (IMA).

It also included improvements to existing approaches:

• Clearer definition of the scope of application of the framework, through stricter delineation between allocation of positions to the trading and non-trading books and specified treatment of internal hedges between them;
• Improved methodologies for estimating market risk, including a more comprehensive standardised approach (SA) and a modelled approach incorporating additional risk factors such as the liquidity of traded positions; and 
• Greater proportionality through retention of a recalibrated version of the existing SA as a simplified alternative for firms with a limited derivatives activity.

PS17/23 provides the following amendments and clarifications to support ease of operations, flexibility around data and modelling requirements, and proportionality, while maintaining the prudent capital requirement standards:

ASA: 

• The scope of eligible third parties has been expanded to ease the operational burden for firms using the external party approach (EPA) for treatment of Collective Investment Undertakings (CIUs). Firms using the EPA should obtain separate risk weights for the Sensitivity Based Method (SBM), Default Risk Charge (DRC) and Residual Risk Add On (RRAO) elements of the ASA from eligible third parties.
• Exact matching of back-to-back transactions can be excluded from the RRAO requirement. 

IMA:

• The 75% minimum coverage requirement for risk factors used to calibrate the model will be applied at the overall portfolio level only, not at trading desk level. The consequences for failing to meet the 75% minimum coverage requirement will only apply after one month, instead of 2 weeks. 
•  IMA-DRC models for central government and central bank exposures will not be permitted. Where firms have permission to use the IMA for trading desks containing sovereign exposures, they will be required to use the ASA for those exposures but will continue to apply the other IMA components (namely Expected Shortfall (ES), Non Modellable Risk Factors (NMRFs) and Risks Not In Models (RNIMs)).
• The PRA has amended the rules and related expectations in SS13/13 (PDF 1 MB) (Market Risk) to provide additional flexibility in two key areas related to data quality standards for NMRFs:
  • Allowing firms to use a single price observation to derive multiple risk factors.
  • Allowing firms to use the regulatory buckets or firm-defined buckets for each dimension of a risk factor for the purpose of the NMRF framework. The amended rules will not permit firms to use a combination of both approaches on a single dimension.
  • Trading desks that manage IMA-ineligible positions may be included in firms' IMA application. However, firms can only use the IMA for IMA-eligible positions and must apply the ASA to any IMA-ineligible positions.  

Scope of application

• Firms are permitted to enter into more than one trade to facilitate `exact matching' of the equity internal hedge. In addition, credit-linked notes can be recognised as internal credit hedges, provided they meet the Credit Risk Mitigation (CRM) requirements.
• Closed-ended listed CIUs should be treated as stand-alone listed equities for the purpose of calculating market risk capital requirements. 

CVA and Counterparty Credit Risk

In CP16/22, the PRA proposed three new approaches for calculating the CVA risk capital requirement — the fall-back alternative approach (AA-CVA) for firms with limited exposure to non-centrally cleared derivatives, the basic approach (BA-CVA) and the standardised approach (SA-CVA). 

In PS17/23:

• The AA-CVA (including its threshold calculations) has been retained, with clarifications made to ensure capital requirements for Securities Financing Transactions (SFTs) are included when the exposure value is calculated using the CRM framework.
• The BA-CVA has been retained as proposed, other than removing collateralised transactions from the applicability of the maturity floor.
• The SA-CVA has been fully retained as proposed. 

The PRA originally proposed removing existing exemptions from CVA capital requirements for transactions with sovereigns, non-financial corporates and pension funds but keeping exemptions for transactions associated with client clearing. This has been retained in PS 17/23, with only a few small definitional tweaks.

CP16/22 included proposals for a transitional arrangement for CVA and SA-CCR capital requirements for `legacy trades'. PS17/23 adds an alternative transitional arrangement.

The PRA originally proposed adjusting the calibration of the existing SA-CCR where it was seen to be overly conservative, i.e. reducing the `alpha factor' from 1.4 to 1 for transactions with pension funds and non-financial counterparties (NFCs). This has been fully retained in the near-final rules. 

Finally, the PS17/23 clarifies that, when interacting with CCR calculations, firms are not permitted to cap the maturity adjustment factor at 1 for CCR netting sets where they include trades that are exempt from CVA capital requirements. 

Operational risk

In CP16/22, the PRA proposed to replace the existing internal modelled and standardised approaches with a new standardised approach (SA) for Pillar 1 operational risk capital requirements and to make use of the national discretion in the international standards to set the internal loss multiplier (ILM) to 1 and remove the mechanical link to historical internal operational risk losses. 

PS17/23 makes limited amendments to the calculation of the Business Indicator (BI):

• Divested activities are excluded from the calculation of the BI where entities or activities have been disposed of and using a three-year average to calculate the BI would lead to a biased estimation of the operational risk capital requirements. This is subject to supervisory approval and is in line with the intention of CP16/22.
• Firms may calculate the BI and sub-components using business estimates when audited figures are not available.

The PRA has not made any changes to other areas of the original proposals, including setting the ILM to 1. 

Pillar 2 framework 

The PRA did not propose any policy changes to the Pillar 2 framework in CP16/22 but provided a high-level description of the Pillar 2 implications of the changes proposed to the Pillar 1 framework. It intends to conduct an off-cycle review of firm-specific Pillar 2 requirements ahead of Day 1 implementation of the Basel 3.1 requirements and review the Pillar 2A methodologies once the rules are finalised. 

For the off-cycle review of capital requirements, the PRA will not expect firms to conduct a full ICAAP, nor does it plan to reset firms' Pillar 2 capital requirements through a full Capital Supervisory Review and Evaluation Process (C-SREP). Instead, it intends to:

• Adjust firms' Pillar 2 capital requirements to address identified double counting; and
• Rebase firms' variable Pillar 2A requirements and PRA buffer so that the changes to Pillar 1 RWAs do not result in unwarranted higher or lower Pillar 2 capital requirements where the relevant risk level has not changed.

Further details on the off-cycle review will be announced in the second near-final policy statement in Q1 2024. For now, the PRA notes that:

• For firms with a more significant trading book, it will adjust the market risk add-ons for areas previously captured under Pillar 2A that will now be either partially or fully covered in Pillar 1 (e.g. illiquid and concentrated positions). Similarly, it will consider how add-ons related to CVA risk would need to be adjusted to address improved capture in Pillar 1 (e.g. removal of some counterparty exemptions). 
•  It will rebase credit concentration risk and IRRBB requirements so that changes to Pillar 1 RWAs do not result in unwarranted higher or lower Pillar 2A requirements where the risk level has not changed.
• For most firms the total operational risk capital requirements would remain unchanged. 
• It intends to rebase firms' PRA buffer by taking their existing nominal buffer and rescaling it as a fixed percentage of projected Basel 3.1 RWAs. 

The Interim Capital Regime

In CP16/22, the PRA proposed to introduce a Transitional Capital Regime for non-systemic banks and building societies eligible for the Simpler Regime to remain subject to existing CRR, rather than Basel 3.1, requirements, until implementation of the final Simpler Regime capital rules.  

In PS15/23, the PRA redefined Simpler Regime firms as Small Domestic Deposit Takers (SDDT). In PS17/23, the TCR is renamed the Interim Capital Regime (ICR). Other than the name changes, the near-final rules remain broadly unchanged. 

With the first set of near-final rules now published, banks have significant work to do to ensure timely compliance with the PRA's Basel 3.1 requirements. This includes, but is not limited to:

• Reviewing and updating existing policy interpretations.
• Performing gap analysis assessments against the near-final rules.
• Re-visiting impacts with front office and educating board and executive management.
• Standing up and executing a strategic implementation programme.
• Identifying and making necessary changes to operating models.
• Building and implementing RWA calculators for the new standardised approaches for market and operational risk.
• Submitting IMA model applications or reapplications at least 12 months before the start of the implementation period.

In anticipation of the second PS in Q1 2024, they should also continue work to: 

• Source data for new attributes required for real estate, unrated corporates and institutions.
• Build and implement RWA calculators for the new standardised approach for credit risk.
• Build the standardised floor calculation for IRB.
• Submit IRB model applications or re-applications at least six months before the start of the implementation period.

For more detailed analysis of the PRA's policy statement and to discuss how KPMG in the UK can support your Basel 3.1 implementation, contact our regulatory and implementation experts.