Basel3.1 in the UK - Our responses to the CP16/22

This paper provides an overview of the proposed prudential regulations for UK banks, building societies, investment firms, and holding companies. These regulations will impact the firms' capital and are based on the Basel 3.1 framework. Additionally, the PRA proposes further changes to simplify and align the regulations with UK markets while remaining risk-sensitive. The paper's analysis is based on the UK financial system, and it is a valuable resource for anyone interested in the future of the UK financial system.

The Strong and Simple Framework (SSF) initiative in the UK aims to create a robust yet simple regulation and reporting framework that tailors reporting requirements to individual businesses based on various criteria like size, trading activity and domestic operations. The aim is to reduce compliance costs, especially for smaller firms, by providing flexibility in the application of SSF regulation.

This revised Basel3.1 framework, which covers Credit Risk, Market Risk, Operational Risk, and CVA Risk, as well as the associated capital framework, these regulatory changes will signify the simplicity and transparency that this new regulation would bring to the industry, investors, and firms in the market. This will make it easier for everyone to understand the regulations and how they impact the industry. Additionally, the transparency of these regulations will help to promote confidence in the market and ensure that investors feel secure in their financial decisions. Overall, these regulatory changes are a positive step towards a more stable and transparent financial system that benefits everyone involved.

Following are some specific focus area of the changes.

Credit Risk

This section proposes changes to the Standardised Approach (SA) and Internal Rating Based (IRB) approaches for calculating Risk-Weighted Assets (RWA) and capital for Credit Risk. The exposure classes for both approaches will be adjusted to align the classification more closely, allowing for a more accurate calculation of RWA and capital requirements. New sub-classes will also be introduced within the IRB approach, resulting in a more nuanced assessment of Credit Risk. These changes will have a significant impact on the banking industry and require banks to update their internal processes and systems, which may result in additional costs in the short-term. However, the long-term benefits of a more robust and accurate system will be worth it. Overall, these changes are an important step towards improving Credit Risk measurement and management.

This section provides a comprehensive overview of the revised approach for calculating risk weight and RWA across all applicable exposure classes under the Standardized Approach (SA). Moreover, the Basel Committee on Banking Supervision has proposed a wide range of simplified changes for calculating Probability of Default (PD), Loss Given Default (LGD), and RWA under the Internal Ratings-Based Approach (IRB). The IRB Approach provides further details on the rules specified for both, Foundation IRB (FIRB) and Advanced IRB (AIRB), with certain restrictions that apply across the entire portfolio, especially within the AIRB section. The proposed changes focus on appropriate risk sensitivity and the risk factor associated with assets. As a result, there are numerous sections where the Prudential Regulation Authority (PRA) has identified opportunities to further improve the guidelines published in Basel 3.1. These proposed changes aim to enhance the overall risk management framework, ensuring that financial institutions can better identify, measure, and manage their exposure to risk, ultimately resulting in a more resilient banking system.

Credit Risk Mitigation

Credit risk management (CRM) is a crucial aspect of supervisory regulation that has a significant impact on the risk management process within firms. The consultation and proposal for CRM clearly acknowledges the nature of complications that it imposes, resulting in several significant proposed changes in the CRM section of the CP.

The proposed changes include several revised CRM methods such as On Balance Sheet Netting, FCCM, FCSM, Foundation Collateral Method, OFCP, LGD modelling, SFT VaR, and IMM. These revised methods reflect the need for firms to be more prudent in choosing the CRM approach that would apply to their assets and portfolio.

It is important to note that specific links of different CRM methods to the RW approach adopted by the firm exist. For instance, if a firm uses the FIRB approach, a new method has been proposed called the Foundation Collateral method that can be used. Simplification, consistency, and ease of regulation are key factors reflected in the proposed methods.

The Foundation Collateral method, for example, uses a very similar methodology that applies to the LGD under FIRB approach. The proposed changes aim to enhance the effectiveness of the CRM approach, resulting in a more efficient and effective risk management process within firms. Firms must consider the proposed changes and adopt the most suitable CRM approach for their assets and portfolio, ensuring that they remain compliant with the supervisory regulations.

Market Risk

The Prudential Regulation Authority (PRA) is proposing several changes as part of Market Risk. These changes include new requirements for determining which positions should be allocated to the trading book, a recalibrated version of the existing standardised approach called the Simplified Standardised Approach (SSA), and two new calculation methodologies: the Advanced Standardised Approach (ASA) and the Internal Model Approach (IMA). The proposed new market risk framework and methodologies are intended to replace the existing calculation methodologies for market risk capital requirements.

The proposed changes aim to improve risk management for financial institutions, resulting in a more resilient banking system. To achieve this, the proposals will amend the existing Trading Book (CRR) Part of the PRA Rulebook and introduce new parts such as Market Risk: Simplified Standardised Approach (CRR), Market Risk: General Provisions (CRR), and Market Risk: Advanced Standardised Approach (CRR). The Market Risk Part of the PRA Rulebook will also be deleted, with its contents transferred to Market Risk: Simplified Standardised Approach (CRR) and Market Risk: General Provisions (CRR). These changes will enable financial institutions to more accurately calculate risk-weighted asset (RWA) and capital requirements, assess market risk more accurately with the recalibrated Simplified Standardised Approach (SSA), and provide greater flexibility in determining their market risk exposure with the Advanced Standardised Approach (ASA) and the Internal Model Approach (IMA).

Overall, the proposed changes are an important step towards improving the accuracy and consistency of market risk measurement and management.

Operational Risk

The Basel Committee on Banking Supervision (BCBS) found during the global financial crisis that many firms experienced losses that were not covered by their operational risk capital requirements, which are intended to protect them against unexpected losses. The problem was that the sources of these losses were difficult to predict, and could include fines for misconduct or poor controls. This meant that the existing methods for measuring operational risk, such as the basic indicator approach (BIA), the standardised approach (SA), the alternative standardised approach (ASA), and the advanced measurement approach (AMA) were not accurate enough for many types of firms.

To address this issue, the BCBS developed a new standardised way of measuring operational risk called the SA, which all firms now have to use. This was a significant change that was welcomed by the Prudential Regulation Authority (PRA), which oversees the regulation and supervision of banks, building societies, and investment firms that are authorised by the PRA. The PRA believes that the new standardised approach will make firms safer by ensuring that they are better protected against operational risks, and will also make it easier to compare different firms.

However, it should be noted that the proposals in this chapter do not apply to UK banks and building societies that meet the Simpler-regime criteria and choose to be subject to the Transitional Capital Regime proposals. These proposals are only for banks, building societies, and investment firms that are authorised by the PRA, and are aimed at ensuring that they have adequate capital to cover operational risks.

Reporting

Proposed changes in regulations for different types of risk have led to new requirements for supervisory reporting. The regulatory authorities have been working on the changes to ensure a better alignment of the reporting templates with the current risk landscape. As a result, a range of modifications to the existing templates used for reporting have been introduced.

To specify some examples, the regulatory authorities have proposed that the Equity Risk templates C10 be removed from Credit Risk, while C24 and FSA005 be removed from Market Risk, and C25 from CVA, C16 and C17 from Operational Risk. This means that a large number of new templates have been proposed for Market Risk, CVA, and Operational Risk, while existing templates have been modified to align with the proposed new regulations.

The changes are intended to enhance the comprehensiveness and accuracy of the supervisory reporting process, and to ensure that the regulatory authorities have a better understanding of the risks faced by financial institutions. In addition, the new templates will provide a more granular view of the underlying risks, enabling the regulatory authorities to identify potential issues at an early stage.

Overall, the proposed changes in regulations for different types of risk are a positive development for the financial industry, as they will help to improve the quality and transparency of supervisory reporting, and enhance the resilience of the financial system as a whole.