Series 4 Episode 5: Basel 3.1 - who are the winners and losers?

Transcript

Andrew Strange: Hi everyone, and welcome to our latest episode of Risk and Regulation Rundown, giving you the latest insight and analysis on the hot topics in financial services, risk and regulation. I'm Andrew Strange and I lead our financial services regulatory insights team, and I'm your usual host. Back in 2022 we dedicated an episode to the UK revision of the Solvency II regime which got great feedback as firms grappled with the capital efficiency, but also how the UK was tackling its rulemaking outside of a European framework. Today I'm delighted to say it's the turn of our banking listeners, and we're going to focus on the changes to the banking prudential regime in the UK. Now, unlike Solvency II, the Basel 3.1 changes are global, however the impact on firms and how both the UK and our European regulatory friends choose to implement it will be more than familiar, as will the breadth of impact on everybody. I'm delighted to be joined by two guests, Gordon Kemp and Stefanie Aspden, both of whom work in PwC's risk and regulation practice and specialise in prudential regulation. So, welcome to you both.

Gordon Kemp: Hi.

Stefanie Aspden: Hi, great to be here.

Andrew: So Gordon, perhaps we could start with a quick overview of the PRA's recent proposals. How do they compare to the actual Basel standard, and are there any areas where the PRA has taken a noticeably different approach?

Gordon: So I guess the big picture is that the UK has broadly aligned with the Basel rules, and that's not surprising given the UK was very influential when they were dragging the rules and negotiating with the other counter parties. But the UK has gone further in a number of areas including more model restrictions than there are applied in other countries, and they've taken a UK specific approach for a number of specific areas. Things like unrated corporates, where the UK has come up with a more risk sensitive approach, but as mentioned they've gone further in restricting models for things like exposure to sovereigns. But big picture is alignment with Basel but with a UK super equivalent UK lens on some of the individual aspects. In terms of the big changes though it's, kind of, new standardised approaches across the board. The most material and significant of which for firms is likely to be credit risk.

Andrew: Great, thank you, so that sounds awkwardly different which I think is the phrase for a lot of UK regulation compared to where other jurisdictions are going at the moment. Stef, so as Gordon says, credit risk is an area of significant change, so do you want to just talk us through those proposals?

Stefanie: Sure, so obviously we've got two approaches firms can use to calculate credit risk capital requirements. The standardised approach and the internal modelled or IRB approach. On the standardised side the requirements are becoming much more granular and risk sensitive. What that means is there are winners in terms of lower risk segments, and losers in terms of perceived higher risk segments. So on the winners side we've got product segments like credit cards to borrowers who repay their full balance, and unrated corporate is deemed as being investment grade. While on the losers side we've got a number of more niche higher risk mortgage segments, SMEs, trade finance, and a number of others. Safe to say there's probably more losers than winners. On the IRB side then, we've got significant restrictions on the use of internal models particularly for segments such as banks, financial institutions, large corporates, sovereigns, equity, and we've also got increased floors on the model input parameters. And then tying this all together we have an overall output floor across all risk types that constrains the benefits firms can get from using internal models.

Andrew: That's interesting and thinking about that in the current economic environment if you're rewarding those people that clear their credit cards but potentially have more vulnerable customers actually some of this stuff, you know, will be impacted by where we are in the cycle as well I suppose. So I mean, that approach is that consistent with what we're seeing, say, in the EU compared to the UK? I think I understand that the latter is still going through its legislative process but do we have any views or implications?

Gordon: Yes, I mean a lot of the political aspects of regulation come in here because a lot of countries in the EU such as Poland, Finland, Denmark and others didn't have any opportunity in the Basel process to be able to give their views. And so they're inputting through the EU legislative process in general. Similarly, parliamentarians, council members, others all have vested interests in certain aspects of the package and in certain angles whether that's ESG type stuff or whether it's lending to small, medium enterprise business, there are lots of different views that come through in the EU package. But where they're going directionally is that they're diverging from Basel more than was expected perhaps. And there has been a lot of pressure on them to come back to Basel and come back to the international approach on a lot of these aspects. ECB and EBA have both come out with opinions saying that they're not happy with the direction of travel, saying that there's a risk that the EU will be deemed non-compliant. And, similarly now that we have the UK rules there's added political pressure on the EU because it becomes a bit more of an outlier, a bit more divergent. So certainly as we go into the trilogue process some of the positions from the parliament and the council are trying to bring it back towards Basel compliance in some areas, but that's not going to be across the board. In terms of big picture, what they're doing is they're delaying a lot of the aspects and the rules. They're introducing transitional arrangements which soften the blow from a capital perspective for some time and some of those preferential treatments such as for small, medium enterprises and infrastructure lending, they're wanting to maintain these supporting factors because of the political nature of these and to support lending to these preferential groups.

Andrew: Yes, that's really interesting, I suppose again, based on economic cycle point and the politics that you talked about we had Michael Huertas who's a PwC partner from Germany on in January this year talking about some of the European views of what the UK is doing and I think I would characterise it as a bit of, sort of, FOMO really. So, if the UK is settling itself on a good position and Europe is doing something slightly different some of the policy makers at the European level might find that slightly uncomfortable actually. And obviously we have elections next year which potentially slow down some of that process.

Gordon: But the UK has definitely had more freedom in terms of the PRA, they've been given a strong mandate from the UK politicians and so far, the UK politicians are getting less involved in trying to, kind of, impose their will. Which is a difference to the EU definitely.

Andrew: Yes, it's interesting that that political landscape in the UK is very alive at the moment. So, Europe's very interesting, UK is very interesting, I don't think we've heard about the US yet. What's happening over there?

Gordon: So, we haven't seen the US proposals yet. They're expected in the first quarter of this year, and they have a challenge in that they have a slightly different regulatory framework. They have a US standardised approach that's not consistent with the international one. There are key aspects of it that are missing from their standardised approach and those include operational risk and the credit valuation adjustment charge. And they have an output floor already which is inbuilt into their legislative framework, so it's called the Collins floor. It came from the Dodd-Frank Act and the post crisis reforms but they have a very difficult challenge of being able to implement these new reforms whilst also keeping that capital floor that they already have in place. It's difficult to see exactly where they're going to go. What they want to do is maintain the overall quantum of capital and have a differentiation of approach for internationally active banks, and the community or state banks that are more common in other areas of the US. But they may do something drastic like completely remove the IRB advance credit risk approach and simplify the system just down to two ratios but we're all waiting to see what they're going to do. They were definitely waiting as well for the UK and EU to publish to understand where divergences were going to go in an international context.

Andrew: Again, fragmented is the word that springs to mind here but, okay, interesting.

Gordon: And just to say we're at a very different political environment now to where we were before. I mean, it was Trump that was in power, his reign has been between the two periods of when the rules were finalised and now we have US agencies all filled with political appointees from the Biden administration. So, very different environment to where we were when these rules were finalised.

Andrew: Let's see where we get to next year. So, Stef, I know that as part of our roles we often spend time talking to regulators and talking to regulatory affairs functions in our clients and so on as well. Have we got any insights that we're hearing from regulators?

Stefanie: I think as the conversation has just alluded to, we are at a really interesting juncture here. This is really the first time in a long time that the PRA has had autonomy in making rules in the potential context outside of the European environment. So, I think the PRA has really reiterated that this is an open consultation and they're very open to receiving data and ideas from the industry on key aspects of the proposals. In particular, I think this specifically relates to elements where they've been tougher than the EU, so aspects like unrated corporates, SMEs, trade finance, or the approach the property valuations. And they're also specifically interested in understanding the impacts on firms that might have more niche business models and how they can mitigate those impacts for certain sectors of the industry that might be more affected. So, I think they're really engaged, they're looking for data and evidence to substantiate changes to the rules and hopefully we see that play out over the next couple of months.

Andrew: Okay, great, and again consistent with a lot of the messaging we're hearing around a range of regulatory issues where regulators are really looking for solutions and evidence to do the right thing. I mean it's really useful, so from a firm's perspective though is this about just changing capital requirements or do firms need to think about wider angles to this reform package?

Stefanie: I mean, absolutely not. It's absolutely not just a compliance change, I think this is the most fundamental change to bank capital requirements in over fifteen years. So, obviously that means the implementation challenge is going to be significant. Against that backdrop there's a huge importance of aligning Basel 3.1 implementation with broader strategies priorities so integrating with wider regulatory changes, risk management changes, data and technology priorities. We know we're in a market where the PRA has had a huge focus in recent years on controls on data governance systems, the reliability of regulatory reporting and banks' capital numbers that are being reported. So, obviously there's a huge amount of change going on and firms need to be tackling this in an integrated manner. The other aspect is, I think, given the increased complexity and granularity of the rules, firms now need to manage new potential banding constraints like the output floor which constraints the benefit firms can get from using internal models. So, in tackling the reforms I think firms will really need to think about how they do capital planning, how they do pricing, how they structure their products in order to optimise returns on capital in the new world. And these processes might need to be reviewed and set up at a much more granular level to capture differential risk requirements and capital requirements, and to incentivise behaviours that could potentially be beneficial from a regulatory perspective.

Andrew: Yes, thanks Stef, and I was recently reading some of the supervisory priorities from the regulators and financial resilience was clearly up there but you're right, there's a very long list of other things that firms need to think about holistically. So, Gordon, I mean it's not technically been settled yet but the PRA and the FCA look like they're going to get their new secondary international competition objectives alongside their existing requirements to consider the impacts on the UK's domestic market. So, what does that mean for the future of banking from a competition perspective?

Gordon: I mean, we talked a little bit about winners and losers with respect to different products or asset classes, but there’s definitely winners and losers in terms of banks and banking models. If you think of the large universal banks with a full suite of model permissions, they're the losers in this. The ones that benefit the most are the banks that are on standardised approaches or the smaller banks that are maybe IRB aspirants. So, they want to apply for some of the advanced model approaches. And it's going to be a narrowing of a gap between those standardised approach banks and the advanced approach banks. So, from a competition perspective, from a UK market, it's probably beneficial I think overall. But as you said the UK needs to balance that international versus domestic competition angle. Broadly, I think from this perspective is that they've done that relatively well, because it's always a difficult challenge to meet. If you're negatively affecting the large banks from a UK perspective, you still need to think about the international angles as well.

Stefanie: I think for smaller and mid-tier banks there's also the additional challenge of having the potential choice between adopting the Basel 3.1 regime or moving onto the PRA's proposed Strong and Simple regime, many of the details of which remain unknown at this stage. So, I think some of the smaller firms are certainly in an interesting position right now where capital planning is quite challenging given they don't know what their capital requirements will look like in three to five years time. But they'll ultimately have to make a choice between a simpler regime which is likely to be much more conservative and the fundamental changes that the Basel 3.1 regime bring.

Andrew: Brilliant, thank you, so I mean thinking about some of the numbers here. I do like my regulatory geekdom, so we've got Basel 3.1 reforms here and it's taken us quite a while to get here. Yes, I think this was originally agreed maybe five years ago, something like that. And actually also we've also commented on some of the economic cycle we're facing at the moment too where stuff is changing. So, when do we get to Basel 3.2 or Basel 4 or are we just going to skip Basel 4 and go to Basel 6 like we did with UCITS? I mean what's next, Stef?

Stefanie: I mean, consultants had been calling this package Basel 4 for years much to regulators' dismay but we've settled on Basel 3.1 for now. I think the focus internationally, certainly as the Basel level, is about full and timely implementation of this current suite of reforms. We've got phase in of some of the measures including the output floor, extending until 2030 which will be more than twenty years after the original crisis these reforms were designed in response to. We are also in a fundamentally different economic environment, political environment as you said since these reforms were agreed. But ultimately there are aspects that were very specifically designed in response to issues observed in the last crisis. But in general, the framework is deemed to be complete and fit for purpose going forward. It will be interesting to see how procyclical some elements of the proposals could end up being in a downturn environment. Things like the internal ratings for the approach unrated corporates or the requirement that property valuations are not updated upwards but are reduced when property prices fall. So, there are some elements that might play out over coming years there. Internationally, I think in the next few years we're going to see a focus on evaluating the consistency of jurisdictions' implementation of this package through the RCAP programme, and then we know the focus is on other emerging risks like crypto, and AI and machine learning.

Gordon: It's probably worth saying that this package just about broke the Basel process, like, in terms of getting to an agreement there are some areas like sovereigns, they just couldn't agree on and they just didn't come up with anything at all. But certainly, we have some obscure numbers in the package, like a floor of 72.5 percent because they couldn't get to a number that they all agreed on. And a number of national discretions in the package which can undermine some of the arguments about it being a consistent and comparable package across jurisdictions. And there's some topics or areas such as calibration of derivatives where again they couldn't agree, they didn't get to the right outcome, and what we get is divergence in each of the different countries as they try to resolve that separately. The EU, UK and US are all diverging from the Basel standards in that area because Basel couldn't agree ultimately. So, not much appetite for things going back to the Basel committee in the short time but they do definitely need to deal with those emerging issues or new risks like crypto, digital finance because that's where some of the future risks are going to be for the banking sector.

Andrew: If they can't work out their 72.5 percent floors then I'm sure the thorny issue of AI and machine learning is going to be something they'll absolutely have no problems with at all over the next twenty years. That's really interesting, thank you. Well, thank you both, that was a really insightful and interesting conversation. To our listeners I hope you've enjoyed this conversation too and thank you for joining us. As always, please do subscribe to future episodes, and rate and review the series as it helps other listeners to find us. If you'd like to hear more from us on risk and regulation, please do look for our regular publications on our website where you can also subscribe to our monthly newsletter on regulatory developments. We'll be back next month with our next episode, thank you.