Everything you need to know (for now) about the PRA’s second instalment of Basel 3.1 rules

The Prudential Regulation Authority (PRA) has released the latest version of the ‘near final’ Basel 3.1 rules. Today’s rules focus on Credit Risk and add to Operational Risk and Market Risk updates released in December last year. This is following a similar process of consultation performed by the Federal Reserve Board and the European Banking Authority. 

For those who have tracked nearly 15 years of getting to this point post-financial crisis, you’ll be most interested in what’s changing — and what Basel 3.1 implementation now means to you.

We’ve also published in-depth updates on the implications for Credit Risk, Market Risk and Operational Risk. Be sure to read them for more details.

What is Basel 3.1?

As the UK Treasury puts it, the Basel 3.1 reforms are “the final part of the internationally agreed Basel 3 framework” and “mark the end of the post-2008 crisis capital reforms.”

Introduced by the PRA, the reforms are intended to align with principles established by the Basel Committee on Banking Supervision (BCBS). The main aim of Basel 3.1 is to ensure UK banks can withstand sudden economic downturns or financial shocks.

Basel 3.1 — Summary of what’s changing…

Here are the five main things you need to know today (we’ll update the list as more insights emerge) about the PRA’s second, and last, set of Basel 3.1 rules, and what they might mean for your organisation:

1. Key concerns raised by UK Finance (and other industry bodies) have been addressed. 
2. The total capital impact of the changes is expected to be marginal, but it will vary for each firm.
3. Banks have over a year to implement the new Basel 3.1 rules, needing to be ready by January 2026.
4. There are some material changes to the credit risk requirements for real estate exposures.
5. Substantial rule changes for SME and infrastructure lending will be balanced by pillar 2 adjustments to counter capital increases, but how that works remains to be proposed.

Let’s take a closer look at each of those takeaways below.

#1 ~ Key concerns have been addressed

The updated Policy Statement (PS) released today includes some material changes from the previous Consultation Paper (CP):

• The SME support factor has not been explicitly reintroduced, but the PRA has committed to using Pillar 2a to counteract its withdrawal.
• The output floors have been addressed for consistency, with an adjustment incorporating the impact of capital adjustments.
• Conversion factors have been reduced for some off-balance sheet items.
• For IRB project finance exposures (in Slotting approach), to mitigate the removal of the Infrastructure Support Factor, a lower 50% RW has been introduced for “substantially stronger” exposures.
• Rules allow residential mortgage valuations to be updated.

Note that no further guidance has been provided to clarify the treatment of unrated corporates.

#2 ~ Total capital impact could be be marginal, but will vary

The overall capital impact of Basel 3.1 is expected to be marginal and phased in over four years.

Some lenders using the Standardised Approach will see reductions in Risk Weighted Assets (RWA) if their portfolio has higher concentrations in Residential lending, not materially dependent on cash flows, Buy-to-Let (BTL) lending or low loan to value (LTV) lending. Conversely, lenders who have portfolios focused on Commercial real estate materially dependent on cash flows or high LTV lending are likely to experience higher capital demands.

Due to the new output floors, lenders using one of the IRB approaches will see some of the above effects. But some portfolios, such as residential lending subject to higher input floors, will experience increased capital requirements.

#3 ~ Banks have over a year to implement the new rules

The PRA has pushed back the timeline for Basel 3.1 implementation to January 2026, with four years of transitional arrangements. However, the first year of transitional arrangements is likely to have higher impacts than previous arrangements.

Given the extent of the changes, which will cut across policy, processes and implementation, this remains a challenging timeline for many lenders.

#4 ~ Some material changes to credit risk requirements for real estate exposures

The material changes in today’s PS relating to Real Estate include:

• The use of automated valuation models (AVM). This is now explicitly allowed as a valuation approach.
• The removal of the requirement to use origination valuations except only in certain circumstances. This means property lenders of longer loan terms are no longer disadvantaged by revaluation rules. A backstop has also been introduced to ensure lenders shall revalue properties if five years have passed since the last qualifying valuation.
• The removal of the counter-intuitive floor of 100% for commercial real estate (not materially dependent on cash flows) under the Standardised Approach.

#5 ~ Substantial rule changes for SME and infrastructure lending will be balanced by pillar 2 adjustments

The PRA has offered limited further information on Pillar 2 calculations. SME lenders will see Pillar 2 structural adjustments due to the removal of the SME support factor. This is also the case for infrastructure lending.

However, with CP 9/24 being issued on the 12th of Sept 2024, further clarity is not expected to be forthcoming until mid-2025 at the earliest.

Basel 3.1 — Summary of what it means to you…

The PRA has taken time to listen and consider industry feedback and evidence in support of concerns. The main message is that the capital impact is expected to be limited to 1% across firms, smaller than what was previously proposed. The PRA’s aim is to find a certain balance between its regulatory objective, ensuring safety and soundness against the objective to support growth and competition.

Banks will have until January 2026 to implement the Basel 3.1 changes, and that time is needed as there are substantial amendments throughout. The most notable are the changes to the SME rules, infrastructure lending, conversion factors, mortgage lending and the output floor. Where changes are made, they aim to simplify what was proposed or more accurately reflect the risks — in some cases with lower risk weights, and structural adjustments.

We expect the industry will quickly absorb the rule changes and get key work underway. We see three main areas of focus:

1. Understanding firms’ gaps to the new rules and addressing these to comply.
2. Confirming whatever changes have been made have been done so correctly.
3. A new focus on understanding the business impacts to how key markets and competitive focuses will change (whereby some firms will see much improved circumstances and others will be penalised — shifting pricing, lending plans and portfolio composition).

Alongside the near-final capital rules the PRA has published consultation papers on capital treatment for smaller non-systemic firms, simplifying the capital stack and requirements (the aim being to recognise the burden and cost that is disproportionate to firms that do not pose systemic risks and are yet to reach a certain scale).

What’s next?

For more guidance, you can read our in-depth blogs on what the latest Basel 3.1 update means for…

• Credit Risk
• Market Risk
• Operational Risk

We expect there will remain difficulty for firms to consume, interpret and understand the volume of changes proposed. If you think you need support, complete our short contact form, and we’ll get straight back to you.