Series 6 Episode 6: Basel 3.1 and Strong & Simple - the new capital and liquidity blueprint

Transcript

Tessa Norman
Hi everyone, and welcome to this episode of Risk and Regulation Rundown. A podcast where we share our views and insights on financial services risk and regulatory issues. Today we'll be turning the spotlight on the evolving landscape of the UK's banking prudential regime. Over the last few months, we've seen a flurry of activity from the PRA, with the regulator publishing final rules to implement the Basel 3.1 reforms and setting out its latest consultation on the Strong and Simple Framework for small domestic deposit takers. Both publications mark a major milestone in the development of the prudential regulatory landscape for banks and building societies in the UK. And these new frameworks have important implications across areas such as competitiveness and risk appetite. They also pose some strategic and operational challenges, as well as opportunities for firms to work through. To help us unpack all these impacts, I'm delighted to be joined by two expert guests. PwC Partner, Michael Snapes, and Director Gordon Kemp, both of whom work in our risk and regulation practice specialising in prudential regulation. Welcome to the podcast.

Gordon Kemp
Thank you.

Michael Snapes
Hi Tessa.

Tessa
Gordon, perhaps you could start us off with a bit of a reminder for our listeners of the UK's journey towards Basel 3.1 implementation. How did we get to these final rules that the PRA set out in September?

Gordon
It depends on how far you want to go back. But there's a long road to get to there. This represents the last of the post-crisis reforms, and now we're focused on the risk-weighted assets. That's the denominator in the capital ratios. And in terms of the scope of this and the things that the regulators have been focused on, what they want to do is to restore credibility to those capital regimes. And they're doing that by reducing or removing reliance on internal models, by increasing risk sensitivity in the standardised approach, and by removing unwarranted variability in the capital ratios. So there's more likely to be a consistent comparison across banks in terms of their riskiness.

Tessa
And what are the headline impacts for firms and the key takeaways from the final rules?

Gordon
This varies a lot by business model and portfolio. Because of the removing of internal models from a number of cases, this affects big banks mostly. Those banks with a universal business model with lots of model permissions, those are the ones that would be most negatively affected from a macro perspective. But even within portfolios, or within banks, there will be a number of different impacts given the risk weights and the relative RWAs for different portfolios or different things will change. One of the things that they were going to make a significant change in was SME lending, so small and medium enterprises. But the final rules have drawn back on that to ensure that we continue to have enough financing for SMEs. And that's just one example of where there has been a shift in the political environment to more of a growth agenda, supporting the economy. And you see that theme through a number of the different changes in the proposals versus the consultation.

Tessa
Michael, as I mentioned at the start, at the same time as we had the publication on the Basel 3.1 rules, there was also a consultation on the Strong and Simple Framework. Can you give us a bit of an introduction to that regime and some of the rationale behind it? Are there some of those political growth drivers playing out in that too?

Michael
Absolutely. And look, Gordon touched when he talked about Basel 3.1 on the fact that that was targeted mainly at larger firms. The Strong and Simple regime is very much a differentiated, lighter touch regime, targeted at smaller UK-focused banks and building societies who inherently pose less risk to the financial stability objective, than the larger, more internationally active banks do. But historically, they've been subject to the same regime. And so, it speaks to the PRA's secondary competition objective here in reducing the compliance burden on those smaller firms. They've typically got more limited resources available than the larger banks, but doing so in a way that preserves the financial stability and doesn't unduly reduce the level of capital liquidity that those firms hold. And this whole thing has been enabled by the fact that post-Brexit, the PRA is able to have more ownership and control of its rulebook and able to differentiate between the larger banks and the smaller firms in the way that the EU is not currently able to do.

Tessa
And what are some of the headline proposals on that regime? And at a high level, how does it compare to both the current rules and the Basel 3.1 framework?

Michael
It's called Strong and Simple. I might take it in simple and then strong, in that order. From a simplicity perspective, there's a big benefit in there around operational efficiency. There's a lower volume, a lower frequency, and a lower complexity of regulatory reporting in all of its guises. That's, the COREP reporting for Pillar 1, the ICAAP and the ILAAP, the core capital and liquidity assessment documents for Pillar 2, and then the published Pillar 3 reports, which for many firms, they would no longer need to do at all. So a lot of operational savings there available to firms. On the strength part of Strong and Simple, the Pillar 1 capital requirements remain the same substantially for credit and operational risk, because they will be under the Basel 3.1 regime. The difference to today being a slight different calculation for operational risk, and to Gordon's point, more risk sensitivity in the calculation of capital requirements for credit risk. Another key area that's going to change though are the Pillar 2 capital requirements, where these are now simplified but they might increase or decrease for individual firms depending on their specific risk position. It's definitely an area that firms will need to do an assessment to understand whether their overall capital requirements might go up or down, even though in aggregate this has tended to be a capital neutral exercise.

Tessa
I think I'm hearing on both regimes, there are definitely different impacts according to type and nature of different firms, which firms are going to have to work through. What's the practical starting point for firms which are eligible for the Strong and Simple regime? What do they need to do next?

Michael
First and foremost, they need to decide whether they can opt into the regime and whether they should opt into the regime. And on the can part, that is around evaluating their business both today and where they're going in the future, against what I refer to as the entry criteria for Strong and Simple. So things like you need to be less than £20 billion balance sheet size, you can't have an internal ratings based model for credit risk, you can't have a trading book, you can only have a minimum level of exposure outside of the UK both in terms of country of lending and currency of lending. Things like that. Working out, do I meet the criteria today and am I expecting to meet the criteria in the future as well? Because there's a risk of being able to be compliant today and then outgrowing those criteria in the future. And then on the should part, coming back to the point about each firm will be impacted differently, they need to conduct their own impact assessment and understand what are my Pillar 1 and Pillar 2 capital requirements in particular are likely to be under a Strong and Simple regime based on what the PRA's put out in its proposal against under the Basel 3.1 regime? And then work out whether I would be net neutral, or potentially benefitting under the Strong and Simple. Or whether there are some capital costs there that then need to be weighed against the operational savings I touched on earlier with regards to the reduced reporting. That's a critical piece of analysis that I'd expect firms to be doing. And as a general rule, you might expect if you're a small firm with relatively modest growth ambitions, you might lean towards opting in. And if you're a firm, maybe someone like the neobanks and the recent challenger banks who are very keen to grow and expand, they might lean towards opting out because they might fail to meet those criteria in the future. But it very much is an individual firm assessment.

Tessa
You've both touched on already the potential impacts in terms of competitiveness. But it would be great to dig into that a little bit more. Gordon, what are your thoughts on how this is likely to impact competitiveness in the UK market?

Gordon
Some of the capital rules can have a big impact on where banks position themselves in the market and the type of lending they do. For example, the banks with the internal model approvals for credit risk have typically tended to focus on the prime residential real estate lending and they've had a big advantage over some of the standardised approach banks for that type of activity. Similarly, when you look at the standardised approach banks, they've quite often moved up the risk curve and done riskier lending at standardised approach risk weights which are relatively or have been relatively insensitive to the riskiness of the lending. That gap has been narrowed to some extent, and we might see a little bit of change in the activity. Maybe more competition from the challenger banks, for example, with the big banks with the model permissions. But that gap has not been narrowed as much as in the consultation. Certainly, larger banks may be happy with some of the changes that come through in the final proposals on certain things like parental support, or the treatment of unrated corporates, or even the permissions and how there's more flexibility in terms of the moral permissions. But that's an area that challenger banks and others may also benefit from.

In the past, if you had a model permission, you had to be compliant with all parts of the rules for that. And you also had to apply that approach across all portfolios. There's now going to be more flexibility so that firms can be partially compliant. There's more flexibility so they can have just part of their portfolio on internal models. And similarly, there are more tools for the regulator to be able to manage non-compliance and to deal with that on a firm-by-firm basis. So some more flexibility there. But these things will have an impact on competition and where banks position themselves on that risk curve and the extent to which they're able to justify certain returns on RWAs.

Tessa
Michael, was there anything that you'd add to that in terms of the impacts that you see?

Michael
This credit risk sensitivity point, is key for the Strong and Simple firms as well, and in particular, linked to that, the PRA's plan to retire what they've previously referred to as the refined approach adjustment. This used to be an adjustment that firms could benefit from as part of their ICAAP in the Pillar 2A assessments whereby if they could demonstrate that the capital they held for credit risk under Pillar 1 was excessive in relation to the risk, they could essentially have a negative capital requirement and offset it against other Pillar 2 requirements, like operational risk, concentration risk, interest rate risk, etc. Now, the PRA's view is because they've made the Pillar 1 credit risk framework more risk sensitive, the chances of over capitalising for risk under Pillar 1 are much reduced, and therefore they can retire this methodology. And that is certainly true directionally. But it's not perfectly risk sensitive. For example, firms could be doing lending that is collateralised by something which is very much risk reducing economically but doesn't qualify as eligible collateral under the regulations and therefore economically they're holding too much capital under Pillar 1, but they can't do anything about it under Pillar 2 in the new regime going forward. There might be some competition effects at the margin for those lending products that are collateralised by ineligible collateral.

More generally, stepping back and thinking about competition, I touched on the entry criteria for Strong and Simple firms. That creates some form of cliff, if you like, between firms that are inside and firms that are outside of scope. And I look at that a little bit similar to other regulatory cliffs that exist in the overall framework, for example, the £15-25 billion balance sheet threshold for firms subject to MREL requirements in excess of their capital requirements. And I know that the Bank of England's currently consulting to increase that threshold, but that doesn't derail the point. What we've seen with that is that the consequence of exceeding that threshold is essentially a doubling of capital requirements, or more formally loss absorbing requirements. And therefore, it can be very costly to jump over that, and therefore we've seen firms either slow down their growth or look to leapfrog that through acquisition M&A rather than just to grow slowly over that threshold. Now, the strong and simple threshold, or the impacts of crossing it, are more operational in nature. Being able to comply with the greater complexity of reporting, like offsetting all the benefits I spoke about earlier. I don't think it will have quite the same impact, but it's certainly worth monitoring, to understand whether firms that might want to grow out of the Strong and Simple regime are actually deterred from doing so because of that cliff risk effect.

Tessa
Yes. I think it'll be interesting to see how that plays out. And I imagine that as well as those impacts on UK competition, there are also potential impacts in terms of international competitiveness that's certainly worth reflecting on. Particularly given that Basel 3.1 is clearly a global reform. Gordon, how does the UK's approach compare to other jurisdictions?

Gordon
Their aim was to be defined as materially compliant with Basel as opposed to being compliant with every single Basel version of the rule. And I think the UK is broadly coming out there in terms of the final rules. Different approaches have been taken in other jurisdictions. The EU, for instance, is one of those where they've probably watered down the rules, delayed and deferred some aspects of them. It does undermine a little bit the consistency across borders. In other areas, the US had previously proposed quite stringent rules which had gone further than Basel. But they have had to repropose those rules. And, at the time of this podcast, they haven't issued those re-proposals, but they have indicated the direction of travel in terms of rolling back towards something that's more consistent with the global Basel agreement and the global rules. But there are certainly pockets where all the regulators have diversion on certain things, which make it difficult for firms to implement, but also will affect competition. Derivatives would be one example, where even though it's a global market, the UK, the US and the EU have all decided to implement slightly different versions of the Basel rules, which is unhelpful in terms of making sure we have globally consistent rules. It is good that the UK has tried to align as much as possible, and then where they have the differences, they use a Pillar 2 framework. Which they've done for things like SME lending and infrastructural lending. So that type of approach, I think, is sensible.

And similarly, a discussion we've had on tailoring is something that comes up in other jurisdictions as well, where you see the US tailoring their regime so that Basel only applies to internationally active global banks. And they have a different regime for banks with smaller balance sheets. That tailoring approach plus a Pillar 2 approach gives some flexibility for taking into account country specificities but also trying to stay close to the global agreement.

Tessa
At a practical level for international banks, what does that divergence mean for how they need to approach implementation? And then more broadly, it would be great if you can highlight for us the key challenges and considerations for firms in terms of how they should be approaching Basel 3.1 implementation?

Gordon
One of the obvious things is the timeline differences. The UK is going to go live 1st January 2026. The EU has a split timeline. For the market risk rules, they're going to be the same date, January '26. But for the credit risk rules, they're going to be January '25, so a whole year earlier. And then there are other jurisdiction in Asia such as Japan, Singapore, Hong Kong, that have already gone live with the Basel rules. That timing difference presents a problem for firms, particularly those that try to use one centralised system for data and risk management. Because you have to have different versions, or different entities running on different systems at the same time. That's definitely a problem. In terms of the models as well, what we have found is that there are examples where even for similar portfolios, the banks need to implement more than one version of model for the different regulators. Some of the large banks which operate in both the UK and the EU have a model that they built for the ECB and one that they built for the PRA. That is clearly duplication of effort that's not necessarily required, but also, it's not helpful in terms of reducing that unwarranted variability in the risk weight. It’s certainly a big overhead for the firms.

And then one of the other things is data, where firms have challenges throughout their business. Regulatory reporting is right at the end of the process. Any other problems that they might have with data capture, sourcing, completeness upstream, so whether that's in tray capture systems or whether it's in, client reference data or any other areas, that all filters through to the regulatory reporting and the prudential returns at the end. And that's the area that causes a problem where you have different rule sets for different banks at different times as well. Managing all of that is something firms need to focus on.

Tessa
Michael, on the Strong and Simple side, you spoke earlier about that crucial decision for firms about whether or not they want to opt in. Once they have made that decision, what are the practical next steps and what are the considerations in terms of approaching implementation?

Michael
It sounds a lot simpler than it is for the international firms. As a starting point, it's really focusing on updating the operating model to align with those new requirements. In some cases, they might be able to take advantage of the fact there's this regime change and use that as a trigger for re-evaluating technology, processes, governance and controls and making them fit for purpose for that new regime. That might mean implementing new technology, it might mean redeploying some resources that are freed up by some of the operational relaxations I talked about earlier, to redeploy those in more insightful or risk management type activities. And on a risk management perspective as well, there's an opportunity to bolster what firms do in that space, because the quid pro quo of relaxing some of the regulation is it's putting a greater onus on risk management to make sure that it is there, acting as an active control on the business. And Gordon touched on the twin track regime in the US. And we saw some of the negative implications of that on Silicon Valley, for example, where it was subject to lighter touch regulation. But that wasn't particularly well deployed and the risk management within the firm, from what I've read publicly, also was not fully up to speed and up to scratch on where it should be. It's an extreme example, but it is an example of where, in a lighter touch regime, there's that greater emphasis on risk management and supervision within that regime given the underlying rules are that much lighter.

Tessa
I think what I'm hearing there, there's going to be plenty of work for firms to do. And it sounds like as well as those challenges to overcome, there are opportunities there. You've talked about, kind of, operational efficiency gain, so I'm sure that will be welcome to firms as they think through how they can maximise that. Thank you both very much for joining us on the podcast today, for sharing your insights. It’s been interesting to hear about those broader competition and market impacts that this could have, as well as those practical considerations. To our listeners, I hope you found this conversation useful and interesting and thank you for listening. As always, please subscribe to the podcast so you can automatically get downloads of future episodes. And please rate and review this series, as it helps other listeners to find us. If you'd like to hear more from us on risk and regulation, please look out for our regular publications on our website, which we'll link to in the show notes. We'll be back next month with our next episode.