What the latest Basel 3.1 update means for credit risk

On 12th September, The Prudential Regulation Authority (PRA) released its much anticipated second set of Basel 3.1 rules, with some material changes in relation to Credit Risk. While the regulator has tried to stay true to its original position, it has also listened to industry feedback and reflected this in the new draft rules. 

A number of Supervisory Statements have also been released, notably SS4/24, providing guidance on the application of the updated IRB requirements at the same time as withdrawing SS11/13. These provide significant clarifications of specific topics, but will also require enhanced reviews and self-assessments to ensure material compliance with the requirements. 

We’ve already written a general summary covering the main changes and implications of the new Basel 3.1 rules, as well as a deep dive on Market Risk and Operational Risk. In this blog, we take a closer look at what it means for those responsible for managing and reporting on credit risk, and what you need to do next.

Why is Basel 3.1 relevant to credit risk?

Credit Risk is generally the most material risk for banks in terms of the capital requirements. From what was issued by the Basel Committee for Bank Supervision (BCBS), through to what the PRA has issued under Basel 3.1, the changes are quite fundamental in the approaches to calculating capital requirements. These rules materially affect both the balance sheets and the profitability of organisations and business units — as well as the way in which lending operates across whole sectors.

The new rules are targeted at reducing unwarranted differences between the Standardised Approach (SA) and the Internal Ratings-Based (IRB) approach. The idea is to ensure there are appropriate capital requirements for entities of different sizes and complexity, that don’t impact unnecessarily on competitiveness in the market.

Regulated entities will all need to adjust core processes related to the credit risk capital requirements, including data capture, model risk (for IRB banks) and the implementation of capital rules and reporting frameworks.

What does the latest Basel 3.1 update mean for credit risk?

The near-final rules have introduced some significant amendments to what was drafted in the early consultation proposals (CP16/22), which proposed a large number of changes from the CRR. The changes in this latest (and near-final) view are particularly in relation to the application of the SA, plus enhancing the requirements for both SME and Infrastructure Project exposures.

Combined with the CP16/22 changes from the current CRR, there is a lot of work to do.

Takeaway #1: SA in the spotlight

The changes in the SA are extensive. One change of particular importance relates to the newly introduced ‘backstop’ that requires a revaluation of real-estate property every 5 years — a material change from the original proposal where only origination valuations were expected, except in certain specified circumstances. 

In general, this will reduce some capital requirements from the original proposal, but it also introduces added steps in maintaining regulatory compliance. That said, the PRA has clarified that robust statistical methods — such as Automated Valuation Models (AVMs) — can be used.

Takeaway #2: Removal of SME and Infrastructure support factors confirmed

The SME and Infrastructure support factors were removed in the original CP16/22, and this remains the position. However, reflecting feedback from industry, the PRA has committed to applying firm-specific Pillar 2A adjustments for each class. This should ensure no increase in the capital requirements for these categories (relative to today’s capital requirements).

The PRA will say how this is to be done at a later point, which extends the range of changes to regulatory requirements and possibly timescales too.

Takeaway #3: Changes to Residential and Commercial Real Estate rules

There has been a significant simplification of the rules required to assess if a real estate exposure is materially dependent on cashflows (MDoC). The previous (and potentially complex) analysis has been replaced by a requirement to assign real estate exposures to MDoC, unless specific criteria are met. Additionally, for Commercial Real Estate, the removal of the 100% floor removes perverse incentives.

Some other important changes to note from the PRA’s update:

1. 1. Conversion Factors (CF): The CF for other commitments (excluding UK residential mortgages) has been reduced from 50% to 40%. Other transaction-related commitments have been reduced from 50% to 20%. These impact both the SA and Foundation IRB Approach (FIRBA). Supports a reduction in requirements.
   2. Project Finance: In both the SA and IRB Slotting approaches, the rules have been expanded to allow for low risk, high quality projects to receive lower Risk Weights than originally allowed. Additionally, Credit Risk Mitigation (CRM) rules have been updated, meaning eligible collateral can be used to reduce exposure for exposures subject to the Slotting approach (but double counting must be avoided). Supports a reduction in requirements.
   3. Other SME changes: Reflecting the importance of commercial real-estate for non-investment vehicles, risk weights below 100% are allowed. Modifications to the definition of SME have also been made, with the classification now based on the turnover of entities based on the approach to accounting consolidation taken in the obligor’s jurisdiction. The latter is expected to see a larger number of customers falling into the SME class. Supports reduced requirements and complexity.
   4. IRB exposure classes:
      1. Quasi-sovereign is now classed with Sovereigns and Central Banks, so no IRB treatment is allowed for these. Likely minor increase in requirements from the SA approach.
      2. Large Corporates are identified only using annual sales and must be sourced from audited accounts at the highest level of consolidation. Likely neutral impact.
      3. Undrawn exposures are no longer required to be included in assessing the assignment of SMEs to the retail exposure class. Likely reduction in requirements.
   5. Credit Risk Mitigation: There is significant clarification (decision trees) on the appropriate treatments to apply in different circumstances. Also, there is confirmation that Unfunded Credit Protection (UFCP) used to reduce LGDs must have documentary evidence that it can’t be cancelled unconditionally to the detriment of the Bank. However, there is a 2-year transition period to January 2028 to have this fully implemented.
   6. Definition of Default: Finally, in its draft of ‘SS3/24 – Credit risk definition of default’, the PRA has formalised that the ‘months in arrears’ payment allocation scheme is permitted. This is commonly used so no impact on capital requirements is expected.

What does that mean for me?

For anyone responsible for managing and reporting Credit risk, the PRA’s latest update on Basel 3.1 means that, while the implementation date is 01 January 2026, there’s little time to waste. Above, we have provided just a snapshot of the changes from the original CP16/22 — this of course includes many other changes from the live CRR.

As a general rule…

1. A detailed, line-by-line gap analysis should be performed in 2024. Crucially, it should be used to inform remediation plans for 2025 to ensure budgets and resources are then available to become materially compliant by January 2026. We’re currently updating our line-by-line tool at 4most. Get in touch if you need help.
2. The near final rules have wide-ranging changes, and we expect that all banks will need to develop solutions across data, modelling and implementation workstreams, including calculation (Standardised and output floor) requirements, with roll-out plans and permissions that allow compliance in time.
   1. For IRB banks in particular, the introduction of the output floor requirements and aligning to the SA requirements are a significant uplift on current practices.
3. We expect firms will look for independent assurance over the key changes and testing with confirmation of satisfactory results to Risk Committees and Boards ahead of go-live dates.
4. We recommend there is centralised ownership of the overall deliveries as there are many mutual dependencies across these workstreams. We expect firms will need to start reporting to their respective governing bodies in the next month on plans and progress — if this had not already been in place from the initial consultation policy.

Basel 3.1 and credit risk — our thoughts?

While the changes are quite wide-ranging (especially with regards to the SA), they ultimately result in simpler and more intuitive rules. As such, this should reduce some of the overheads (and capital costs) that were expected based on the original CP.

Still, stakeholders shouldn’t be blinded to the extent of the changes that will be driven by the implementation of the new Basel 3.1 rules. The reported low impact of change is an average across the industry. But, having reviewed the rules in detail, there is a lot of change in the core reporting, data and modelling domains.

In our view, this level of activity is not easily completed by resources that are also performing normal BAU work. Banks that leave the assessment of the effort until 2025 run a risk of having to implement short term solutions to ensure compliance in 2026 — with extra costs post-implementation to deliver strategic solutions.

What’s next?

For more guidance, you can read our general summary of the latest Basel 3.1 update, as well as what it means for…

• Market Risk
• Operational Risk

To find out how 4most can help your business respond to the Credit Risk implications of Basel 3.1, complete our short contact form, and we’ll get straight back to you.