Basel 3.1: PS17/23 and what it means for financial institutions

Decoding PRA’s near-final policy statements on Basel 3.1 implementation 

Embracing a phased approach, the PRA released the first part of the Policy Statement (PS17/23) in mid-December 2023. This initial segment addresses key aspects such as Credit Value Adjustment (CVA), Counterparty Credit Risk (CCR), and Market Risk. The second part of the Policy Statement, slated for release by Q2 2024, will comprehensively cover Credit Risk and the Output Floor, completing the regulatory response to the feedback received during the consultation process.

We capture here a comparison of changes from the PRA consultation paper CP16/22 to the near-final policy statement PS17/23:

Market Risk

CP16/22 proposal: In CP16/22, the PRA proposed the adoption of the Basel 3.1 market risk framework, incorporating three new methodologies: the Simplified Standardized Approach (SSA), Advanced Standardized Approach (ASA), and Internal Modelled Approach (IMA). 

Feedback received: The PRA received eighteen comments, with no significant feedback on the SSA. While some adjustments were made to the draft rules, overall, there were no major changes compared to the initial proposal.

However, feedback primarily focused on specific areas:

• scope of the trading book and treatment of internal hedges
• treatment of exposures to collective investment undertakings (CIUs), carbon emission certificates, and scope of the residual risk add-on in the ASA
• clarifications related to elements of the IMA, including requirements for the expected shortfall model and the floor on the probability of default (PD) in the default risk model.

PRA update: The PRA proposed alignment with the Basel 3.1 standards by introducing new objective requirements for consistent assignment of positions to the trading book or non-trading book. The PRA also decided to expand the range of eligible third parties for the external party approach (EPA), pending validation of data accuracy by an external auditor. The internal hedge policies remained unchanged.

Credit Valuation Adjustment and Counterparty Credit Risk

CP16/22 proposal: In CP16/22, the PRA proposed implementation of the Basel 3.1 CVA risk framework methodologies for calculating capital requirements, comprising three new approaches: the alternative approach (AA-CVA), the basic approach (BA-CVA), and the Standardized approach (SA-CVA).

Feedback received: The PRA received nineteen responses to its proposals concerning  CVA and SA-CCR primarily focused on, 

• impact of the proposed removal of CVA exemptions and related calibration adjustments for SA-CCR 
• proposed transitional approach for trades currently exempt from CVA requirements, and, 
• the calibration of CVA requirements for exposures to financial counterparties.

Except for some draft changes and minor amendments, no significant alterations were made. Several concerns raised by respondents include the potential impact on end-users of derivatives, competitiveness, and capital requirements

It is important to note that any increases or decreases in CVA capital requirements do not automatically translate into corresponding changes in prices for counterparties. The PRA acknowledges, on certain occasions, that there may be an increase in CVA capital requirements. 

PRA update: Given the feedback, and to allow firms sufficient time to adapt, the PRA has suggested a transitional arrangement and considered simplifying its operational aspects. A decision was made to revise the definition to encompass both UK pension scheme arrangements (PSAs) and any third-country funds that would qualify as PSAs if they were located in the UK. 

The PRA has opted to maintain the existing threshold calculation as outlined in the AA-CVA approach. In the case of  BA-CVA, the PRA has amended the near-final rules to explicitly state that the maturity floor does not apply to collateralized transactions, aligning with global standards.

Operational Risk

CP16/22 proposal: In CP16/22, the PRA proposed a new Standardized approach (SA) for Pillar-1 operational risk capital requirements. Additionally, the PRA suggested exercising the national discretion included in Basel 3.1 standards by setting the internal loss multiplier (ILM) equal to 1.

Feedback received: The PRA received twenty-five responses to its operational risk proposals, with a primary focus on the calculation of the standardized approach.

PRA update: In response to feedback, the PRA has made limited adjustments to the draft rules:

• exclusion of divested activities from the calculation of the business indicator (BI) in cases of entity or activity disposals. 
• utilization of business estimates for calculating  BI and its sub-components when audited figures are unavailable.

Impact of Basel Pillar 1 changes on Pillar 2

CP16/23 proposal: There were no specific policy proposals in CP16/22, which instead outlined certain topics the PRA is considering for Pillar 2 as part of the Basel 3.1 standards. 

Feedback received: The PRA received forty-seven responses related to Pillar 2, encompassing queries on the timing and details of the planned review of Pillar 2A methodologies. Key concerns included uncertainties around how and when firms' Pillar 2 capital requirements would be adjusted to address potential double-counting issues and changes in RWA, arising from the implementation of Basel 3.1 standards. 

PRA update: The PRA recognized potential timing challenges, noting the need for firms to prepare for changes in both Pillar 2A methodologies and rule modifications, the PRA deemed it pragmatic to separate the review of firm-specific Pillar 2 capital requirements from the review of Pillar 2A methodology. This approach is considered to be the least burdensome to align the Pillar 2 framework with the Basel 3.1 standards.

• In response to the considerations mentioned, the PRA plans to conduct an off-cycle review of firm-specific Pillar 2 capital requirements ahead of day 1 of the Basel 3.1 standards implementation.  Notably, Interim Capital Regime (ICR) firms and ICR consolidation entities are exempt from this off-cycle review. 
• The PRA intends to mechanically adjust firms’ Pillar 2A operational risk requirements in line with changes in Pillar 1 RWAs. This approach aims to maintain the total nominal operational risk requirements for most firms unchanged under the Basel 3.1 standards.
• Adjustments to market risk add-ons are planned for areas transitioning from Pillar 2A to Pillar 1 coverage, such as liquidity and concentrated positions. Additionally,  the PRA will reassess add-ons related to the CVA risk to address improved capture in Pillar 1 including the removal of certain counterparty exemptions. Rebasing market risk and CVA risk-related add-ons for all firms is also part of the proposed adjustments.
• The PRA aims to publish its proposals on capital-related measures in Q2 2024, specifically addressing simplifications to Pillar 2 for ICR firms.

Currency redenomination

CP16/23 proposal: In CP16/22, the PRA proposed to redenominate thresholds and monetary values from EUR and USD into GBP, utilizing the average daily spot exchange rate for the 12-month period before July 10, 2020, rounded to two significant figures.

Feedback received: The PRA received five responses regarding its currency redenomination proposals. Respondents advocated for increased flexibility to employ thresholds denominated in EUR rather than GBP.

PRA update: After thorough consideration of the feedback received, the PRA has decided not to make any modifications to its currency redenomination proposals as outlined in CP16/22.

Interim Capital Regime (ICR)

CP16/23 proposal: The CP16/22 suggested that firms satisfying the criteria for Small Domestic Deposit Taker (SDDT) be exempt from adhering to the Basel 3.1 standards outlined in the consultation paper. In response to this, the PRA put forward the idea of implementing a  Transitional Capital Regime (TCR). The TCR would enable SDDTs to continue being governed by the existing Capital Requirements Regulation (CRR) until the permanent risk-based capital framework for SDDTs (SDDT capital rules) comes into effect.

Feedback received: The PRA received fourteen TCR-related comments:  

• regarding the process by which firms would opt into the regime 
• raised concerns regarding the adequacy of  the TCR in  preparing firms for compliance with the SDDT capital rules
• the risk of TCR persisting over an extended period

PRA update: Following the feedback received during the consultation process, the PRA has opted to keep the draft rules concerning the TCR largely intact, incorporating only minor amendments.

Significantly, the PRA will henceforth refer to the TCR as the ‘Interim Capital Regime’ (ICR) in the near-final instrument and statement of policy. This nomenclature will persist throughout the policy statement and in all forthcoming PRA publications.

Next steps for UK banks

In the policy statement PS17/23, PRA did not change anything fundamentally to those proposed in the original consultation paper CP16/22. The core comments from the respondents were heard and corresponding required changes were made to the near-final policy. We expect the same for the second part of the near-final policy statement to be published in Q2 2024.

The implementation date for Basel 3.1 standards is set for July 1, 2025, and is not expected to change. Banks and financial institutions should therefore seize the opportunity to prepare themselves adequately – learn from past experiences, establish a comprehensive plan, and work with regulatory experts who have the experience to navigate the complex Basel regulations.