Basel 3.1: PRA clarifies a standardised approach to credit risk

SME and infrastructure lending support factor is confirmed as having been removed from Pillar 1, but the introduction of a structural adjustment in Pillar 2A will mitigate some of the impact. The practical elements of the application and where the capacity exits in Pillar 2A to provide this offset remain unclear – however, in a nutshell, the control over this offset is given to the PRA and the onus is on firms to provide data for their Pillar 1 capital increase.

The 100% risk weight floor commercial real estate not materially dependent on cash-flows from the property has now been removed.

There are several helpful clarifications to mortgage lending valuations. Notably, the PRA has maintained the use of loan-to-value (LTV) at origination but they have introduced a backstop to update the value every five years. However, use of Automated Valuation Models (AVMs) will still be permitted.

Regular revaluations

Properties that account for 3% or more of a firm’s exposure or RWA must undergo regular revaluations. This ensures that the valuations remain current and reflective of the market conditions.

Trigger events

There’s a new requirement for firms to revalue properties if the property market falls by 10% or more. This is part of a broader effort to ensure a more risk-sensitive approach to valuing residential real estate. The rules mandate that firms obtain a new valuation at least once every five years to ensure that products without natural revaluation events aren’t disadvantaged.

Documentation and transparency

Firms must maintain detailed documentation of the valuation process and the assumptions used. This includes the methodologies and data source, ensuring transparency and consistency in the valuation process.

Credit conversion factors (CCFs) for off-balance sheet exposures amended with:

1. Preferential 20% CCF for transaction-related contingent items (eg, trade finance exposures)
2. 50% CCF for UK Residential mortgage pipeline
3. Lower 40% CCF for ‘other commitments’

Simplified capital regime for Small Domestic Deposit Takers (SDDTs) will use Basel 3.1 rules as the basis for the SDDT capital regime.

The standardised approach to credit risk has kept the more risk sensitive approach for unrated corporates and funds, which will be welcomed by large UK banks although a divergence from BCBS and EU.

The output floor is broadly in line with the proposals, but with a technical fix for accounting provisions and a shorter transitional period ending 2030.

Exposure class allocation

The PRA has introduced a more granular 16-level hierarchy for reporting and allocation of exposures to appropriate classes. This improves clarity and consistency in exposure classification, promoting more accurate risk assessment.

Impact

Enhanced granularity and consistency in exposure classification enables firms to better assess and manage their credit risk, potentially leading to more efficient capital allocation.

However, firms may need to update their systems and processes to accommodate the new hierarchy.

External credit ratings and due diligence

The near-final rules enhance requirements for the nomination of External Credit Assessment Institutions (ECAIs) and the use of credit ratings. The PRA also introduces new due diligence requirements to reduce mechanistic reliance on external ratings.

Impact

This encourages firms to develop more robust internal risk assessment capabilities, reducing overreliance on external ratings. This may lead to more accurate risk pricing and improved risk management practices.

However, the increased due diligence requirements may also result in additional operational costs for firms.

Exposure values for off-balance sheet items

The credit conversion factor (CCF) for unconditionally cancellable commitments (UCCs) has increased from 0% to 10%. The rules set CCF for other commitments at 40%, excluding UK residential mortgage commitments, which remain at 50%.

Impact

The higher risk-weighted assets for off-balance sheet items, potentially leading to higher capital requirements for firms. This may impact firms' pricing and appetite for certain off-balance sheet exposures.

The differentiated treatment for UK residential mortgage commitments recognises the specific characteristics of the UK market.

Real estate exposures

The regulator introduces more risk-sensitive risk weights for residential (20% to 105%) and commercial properties (60% to 150%). The rules also refine definition of residential and commercial real estate, and the treatment of self-build loans and land acquisition, development, and construction (ADC) exposures.

Impact

The rules better align capital requirements with underlying risks – this may lead to changes in lending strategies and pricing for real estate loans.

The revised treatment of self-build loans and ADC exposures recognises their unique risk profiles, promoting more targeted risk management.

Equity exposures

The PRA assigns 400% risk weight to venture capital exposures and a 250% risk weight to other equity exposures, with a five-year phase-in period.

Impact

Higher risk weights for equity exposures reflect their inherent risk and potential volatility. This may impact firms' appetite for and pricing of equity investments.

The phase-in period allows firms to gradually adjust to the new requirements, mitigating potential market disruption.

The PRA has removed the SME support factor and introduces updated risk weights for SME and corporate exposures, enhancing risk sensitivity.

Key changes:

Removal of the SME support factor: The previously available SME support factor, which reduced capital requirements by 23.81% for eligible SME exposures, has been removed, aligning with the broader shift towards risk-based capital requirements.

New risk weights for SME and corporate exposures: Updated risk weights have been introduced, including an 85% risk weight for unrated corporate SMEs, a 75% risk weight for qualifying retail

SME exposures, and a 45% risk weight for retail SME transactor exposures, reflecting a more nuanced approach to different types of SME lending.

Simplified SME definition: A revised definition of SMEs has been implemented, focusing on turnover assessments based on accounting consolidation practices, which broadens the range of exposures eligible for SME treatment while reducing operational burdens.

Adjustment in risk weights for unrated corporates: For unrated corporates, investment-grade exposures now have a 65% risk weight, while non-investment grade exposures receive a 135% risk weight, reflecting increased sensitivity to credit quality.

Impact:

Increased capital requirements for SME lending: The removal of the SME support factor leads to higher capital charges for SME exposures, potentially impacting the availability and pricing of SME loans.

Enhanced risk sensitivity for corporate exposures: Updated risk weights better reflect the credit risk associated with unrated corporate and SME exposures, encouraging banks to adopt a more precise approach to risk management.

Operational simplification but greater need for accurate classification: While some requirements are simplified, banks must ensure accurate classification of SME exposures to maximise the benefits of the new risk weights.

Recommendations:

Reassess SME lending portfolios: Evaluate current SME and corporate lending strategies to align with the new risk weights, focusing on higher-quality exposures to optimise capital efficiency.

Leverage Pillar 2A adjustments: Utilise the new Pillar 2A adjustments to offset increased capital requirements resulting from the removal of the SME support factor, ensuring continued support for SME lending. As per earlier, the details of how the offset will work are to be determined for each firm with the PRA where it’s expected firms will need to provide supporting data for their Pillar 1 capital increase.

Enhance credit risk models: Update credit risk models to accurately assess and categorise SME and corporate exposures, taking advantage of preferential risk weights where applicable.

Focus on high-quality borrowers: Prioritise lending to investment-grade corporates and qualifying retail SMEs to benefit from lower risk weights, adjusting pricing strategies to reflect the increased cost of capital.

The PRA has removed the 100% risk weight floor for certain commercial real estate exposures and new requirements for periodic revaluations using Automated Valuation Models (AVMs).

Key changes:

Risk-sensitive approach to real estate valuation: changes introduce a more nuanced method of assessing and weighting real estate exposures based on type, LTV ratio, and reliance on property cash flows.

Removal of the 100% risk weight floor for certain CRE: exposures not materially dependent on cash flows are no longer subject to the 100% floor, potentially reducing capital requirements.

Permitted use of AVMs: AVMs are allowed under specific conditions, supporting efficient and accurate property valuations.

Regular revaluations

Properties that account for 3% or more of a firm’s exposure or RWA must undergo regular revaluations. This ensures that the valuations remain current and reflective of the market conditions.

Trigger events

There’s a new requirement for firms to revalue properties if the property market falls by 10% or more. This is part of a broader effort to ensure a more risk-sensitive approach to valuing residential real estate. The rules mandate that firms obtain a new valuation at least once every five years to ensure that products without natural revaluation events aren’t disadvantaged.

Inclusion of self-build mortgages and other property types: new guidelines broaden the scope of regulatory ease, ensuring timely and relevant property value adjustments, and real estate exposures, including previously excluded property types under certain conditions.

Simplification of revaluation triggers: a simplified 10% threshold for downward revaluations enhances operational ease, ensuring timely and relevant property value adjustments.

Expectations for classification of property types: guidance clarifies when properties can be treated as residential real estate, particularly in cases where they can be resold as standard residential dwellings.

Specific risk weight adjustments for real estate exposures: detailed criteria outline how to apply risk weights based on LTV and counterparty type, offering more precise capital requirement calculations.

Removal of sustainability adjustments in valuations: requirements to adjust property valuations for sustainability over the loan's life have been removed, simplifying the assessment process.

Impact:

Increase lending capacity: removal of the 100% risk weight floor for certain CRE exposures can reduce capital requirements and increase lending capacity.

Simplified valuation process: use of AVMs simplifies the valuation process but requires compliance with accuracy standards.

Increased operational demands: new backstop revaluation requirements add operational demands, particularly for high-value real estate exposures.

Recommendations:

Implement AVMs: implement AVMs to streamline property valuations while ensuring compliance with regulatory standards.

Periodic revaluations: establish periodic revaluation schedules to meet new backstop requirements, especially for high-value properties.

Refocus on real estate lending: focus on real estate lending that benefits from reduced risk weights and aligns with the updated regulatory framework

The rules introduce the Standardised Credit Risk Assessment Approach (SCRA) for unrated institutions and updates changes to conversion factors (CCFs) for off-balance sheet items.

Key changes:

Introduction of the SCRA for unrated institutions: the SCRA provides a structured framework for categorising unrated institutional exposures into grades (A, B, or C), with corresponding risk weights ranging from 20% to 150%, enhancing the risk sensitivity of these exposures.

Decoupling of institutional risk weights from sovereign ratings: institutional risk weights are now determined independently of sovereign ratings, promoting a more accurate assessment of institutional creditworthiness without reliance on the associated sovereign’s credit quality.

CCFs for off-balance sheet exposures: updated CCFs include a reduction to 20% for trade finance-related contingents and a new 40% CCF for other commitments with an original maturity of more than one year, aligning CCFs more closely with observed risk levels.

10% CCF for unconditionally cancellable commitments: the PRA hasn’t applied the 0% CCF discretion for unconditionally cancellable commitments, requiring banks to apply a 10% CCF, ensuring a conservative approach to managing potential off-balance sheet exposures.

Enhanced treatment of financial collateral and netting agreements: revised guidelines on the recognition of financial collateral and netting agreements adjust how off-balance sheet items are treated in risk-weighted asset calculations, supporting more precise capital management.

Impact:

More granular risk weighting for institutional exposures: the SCRA introduces a more nuanced approach to risk weights for unrated institutions, allowing banks to better align capital requirements with the actual risk profile of institutional exposures.

Potential increase in capital charges for certain off-balance sheet exposures: changes in CCFs and updated treatment of collateral may lead to higher capital requirements, particularly for banks with significant off-balance sheet activities.

Greater complexity in managing institutional and off-balance sheet risks: the decoupling of institutional risk weights from sovereign ratings and updated CCFs require banks to enhance their internal risk management frameworks to accurately capture and mitigate these risks.

Recommendations:

Enhance internal credit assessment models for institutional exposures: develop sophisticated internal models to evaluate unrated institutional exposures independently of sovereign risk, ensuring accurate categorisation and compliance with the SCRA.

Adjust off-balance sheet exposure strategies: review and update exposure limits and pricing for off-balance sheet items to reflect the revised CCFs, focusing on optimising the capital impact of contingent liabilities.

Invest in systems to manage financial collateral and netting arrangements: upgrade internal systems to effectively manage and document financial collateral and netting agreements, ensuring compliance with the new risk-weight treatments and maximising capital efficiency.

Monitor and adapt to changes in risk weight assignments: continuously assess the impact of new risk weights and CCFs on overall capital adequacy, making strategic adjustments to exposure management as needed.

The regulator has introduced of a wider range of risk weights, updated exposure thresholds, and a new currency mismatch factor to enhance the risk sensitivity of retail exposures.

Key changes:

Broader range of risk weights: a new set of risk weights provides a more granular approach, better reflecting the varying risk profiles of retail exposures.

Currency mismatch risk sensitivity factor: this new factor addresses additional risks arising from lending in currencies different from the borrower’s income, enhancing risk sensitivity.

Updated thresholds for retail exposures: the threshold has been adjusted from EUR 1 million to GBP 0.88 million, reflecting current economic conditions and market practices.

New risk weights for retail SME transactor exposures: a new 45% risk weight is introduced for retail SME transactor exposures, replacing the previous 75% weight, enhancing alignment with risk levels.

Exclusion of undrawn commitments from value calculations: only exposures that are drawn count towards size criteria, focusing capital requirements more accurately on actual credit exposure.

Revised definition of retail exposures: expands the types of exposures eligible for retail treatment, potentially reducing capital requirements and supporting more competitive lending.

Simplification of compliance requirements: changes streamline the processes for identifying and managing retail exposures, making compliance more straightforward and efficient.

Enhanced monitoring and reporting obligations: firms must continuously monitor retail portfolios to ensure accurate application of revised risk weights and thresholds.

Impact:

Adjustments to capital allocation and pricing strategies: changes in risk weights may require adjustments to capital allocation and pricing strategies for retail products.

Added complexity: introduction of the currency mismatch factor adds complexity to managing cross-currency exposures.

Operational costs rise: potential increase in operational costs due to enhanced monitoring and compliance requirements.

Recommendations:

Re-evaluation: re-evaluate retail lending portfolios and adjust pricing models to reflect new risk weights and associated capital costs.

Strengthen systems: strengthen currency risk management systems to accurately capture and mitigate currency mismatch risks.

Refocus: focus on high-quality retail exposures to optimise capital efficiency and reduce the impact of increased risk weights.