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Speech
Introduction
Few things in the banking focused policy making universe seem to have stoked more debate in recent years than the Basel 3.1 package of reforms. This very public discussion has been a feature right across the UK, US and the EU. Thankfully, I can report that I haven’t yet observed any adverts placed by UK finance on the Metropolitan line on my way into work each morning. Even without the aid of daily reminders, in the Prudential Regulation Authority (PRA) we have long been aware that for a significant package like this, it is important to get it right. Overall, the package supports the UK’s growth and competitiveness, the resilience of the banking system, and alignment with global standards.
It has been a sustained effort all round to get it right. We issued our proposals for consultation in November 2022.footnote [1] From the very outset, it was an open consultation and we wanted extensive engagement with firms and other stakeholders. That was in a sincere effort to improve the package where it was needed. Where stakeholders had good evidence, we were open to taking it on board and adjusting our proposals. We had 126 consultation responses, covering 2000 pages, with 600 unique issues identified. We had 70 meetings with firms and associations.
Today, we have published the second and last instalment of our near-final rules. I will take you through the balanced approach we have taken to some of the biggest issues from our consultation paper. The first part of the near-final rules was published in December last year, covering market risk, counterparty credit risk and other areas. Today, I am covering some big pieces of credit risk and the output floor, where it is fair to say we had the greatest volume of feedback. I will also touch on the link with the Strong and Simple regime, where we have also published proposals regarding the capital regime for consultation as well today.
Before we get into the details, there are two things I’d like to put squarely on the record. The first is my gratitude to my colleagues at the PRA who have worked so hard on this package for a long time to get it over the line. They have been totally committed and professional during a process that has certainly had its ups and downs. I would also like to thank all respondents for their time invested in engaging with the PRA because, in my view, the additional evidence base we have been able to draw upon has led to an improved package.
The second is that I should make totally clear right upfront that the adjustments we have made to get it right use UK data and are therefore applicable to the UK alone. They are not in any way a comment on what would be the right approach to implementing the package for any other jurisdiction.
PRA approach
For the PRA, how would I describe our overall approach to landing the near-final rules? What does ‘getting it right’ mean? And why do I think it is an improvement on the consultation paper? I’ll tackle those questions now in the context of the second package published today, but the answers are equally true of the first publication last December.
An appropriate amount of capital
The overall purpose of these Basel 3.1 reforms is to capture risk more accurately, so that firms can then hold a broadly appropriate amount of capital against that risk. The Annex to this speech covers that in a little bit more detail. Broadly appropriate means our aim is to avoid having too little capital for a particular activity, but not aim for more than is necessary either.
The consequences of significantly undercapitalising activities, relative to what the evidence suggests is needed, are a clear lesson from Silicon Valley Bankfootnote [2]. If you do this, then markets and depositors will focus on that weakness in a stress, and in the Silicon Valley case causing depositors to rapidly leave the bank. That in turn can leave the borrowing customers in a very weak position if the bank cannot continue to lend to them. Where borrowers suspect this might happen with their bank, it can sap the confidence of the borrowing businesses to invest and expand, and in turn is bad for growth. In short, customers of relatively weaker firms may be reluctant to take the risk of borrowing to fund and expand their business if their funding needs might be continuing over time. Here the past is no guide to the future; firms specialising in lending to any sector of the economy can in principle be drained of market confidence in a future stress if they are perceived to be undercapitalised.
But as I just indicated, we are not aiming to ask firms to hold too much capital against the risk either. That could make borrowing more expensive and less widely available, which in turn would also be bad for growth.
Looking to achieve the balance – between capital not being too low or too high – fits well with our various objectives, including the new secondary competitiveness and growth objective that will apply to our prudential regime going forwardfootnote [3]. But we’ve still got to operationalise what it means in practice. We’ve done that through three lenses:
- The first lens is a bottom-up assessment of the activities firms undertake, one by one, seeking to ensure the assessment of the risk marries well with the level of capital we ask firms to hold against that activity.
- The second lens is at the level of the package as a whole, by aligning with the overall global standard. We have aimed in our implementation to be alignedfootnote [4] with the Basel standard we had a big hand in creating.
- The third is consideration of the impact of all parts of the package on growth and competitiveness, and the impact on competition.
Implementing this approach necessarily puts a great deal of weight on the collection and assessment of evidence. Without it, maintaining the balance between having neither too little nor too much capital is difficult. That is precisely why the consultation period was extended to four months and has been especially important in executing our strenuously evidence-based approach in the near-final rules.
Substantial changes in the final package
The bottom line is that we have made substantial amendments to our proposals in response to consultation feedback and evidence. I will come back to the specifics of these in a moment, but the changes are particularly notable in the areas of lending to small firms and for infrastructure lending.
In some cases we have made changes where the evidence suggested too much conservatism in our original proposals. We have also made changes where the proposals would have been too difficult or costly to implement in practice, aiming instead for rules that work more proportionately and at lower cost to firms, whilst maintaining levels of safety and soundness. And we have also made changes based on the possible impact on growth and competitiveness.
I would argue that the presence of all these types of improvement is strong evidence that the FSMA framework works. The framework, designed by the Treasury and implemented by Parliament, puts rules in regulators rulebooks rather than legislation, subject to clear objectives chosen by Parliament, with a very strong emphasis on a high level of engagement with stakeholders and greatly beefed up accountability. The primary objective of promoting safety and soundness, as well as the secondary competitiveness and growth, and competition, objectives all shape the Basel 3.1 outcome. The result is that there are strong examples – for example on SME lending – where competitiveness and growth considerations have played an important role. In line though with my second lens from earlier, the overall package remains aligned with the underlying international Basel standard.
Impact of the proposals
In terms of the capital impact, we think there will only be a very small impact on requirements, on average, across UK firms. Once we have accounted for the offsetting effect from ensuring we don’t double count in areas such as operational risk where we were already asking firms to hold additional capital in Pillar 2A, we think the impact will be less than 1% in aggregate on capital requirements phased in over 4 years. This is smaller than for our consultation proposals, and is clearly very small compared with the roughly 300%footnote [5] increase we needed over the decade from the GFC to Covid. It is a smaller impact than in other major jurisdictions, in part because some of the risks that will now be addressed in Pillar 1 capital requirements were already captured elsewhere in the UK’s Pillar 2 framework.
What changes have we made since the consultation stage?
I obviously don’t have the time today to cover all of the issues in the package: there were 600 of them raised in the consultation feedback! You probably didn’t sign up for a ten hour speech, and that level of detail is available in the Policy Statement. Instead, I’ll cover some of the key themes.
SME (Small and Medium Enterprises) lending
The first is the important topic of SME lending. We understand this matters for growthfootnote [6], and it has been one of the most commented upon parts of our consultation. We have made a number of significant changes.
The first is the introduction of a new definition of an SME, where feedback and supervisory evidence suggested that the definition we proposed was overly complex to implement. Our new simplified definition should reduce the operational burden on firms and slightly broaden the scope of exposures which qualify for the preferential treatment SME lending receives in our package.
We have also made changes to the proposals on secured SME lending on the standardised approach. Right from the beginning, we had a lot of questions in this area, as firms raised concerns the proposed risk weights were too high. Looking closely at the data, we have found it does support a change to policy for some secured commercial real estate (CRE) lending to SMEs. So, we have removed the risk weight floor – which we had proposed to maintain at today’s level of 100% – for loans classified as regulatory real estate and which are not materially dependent on cashflows from the property. This will enable firms to reflect the benefit of holding real estate collateral against the secured SME loans. We have maintained the proposed 100% risk weight floor, however, where the repayment of the loan is dependent on the cash flow from the property. The PRA continues to consider CRE to be risky and for such exposures the firm is reliant on the CRE collateral for repayment of the loanfootnote [7].
Finally, there is the much debated issue of the SME support factor. Basel includes a new lower standardised approach risk weight for unsecured corporate SME lending. We had proposed to adopt that in our 3.1 proposals. The support factor, which was retained from our time as EU members, offers an additional risk weight reduction over and above that. Our assessment is that – purely using evidence based on an assessment of the risk of SME lending and its correlation with the business cycle – we should remove the EU-specific SME support factor under the standardised and IRB approaches. The analysis does, however, support adopting the new lower risk weight of 85% for corporate SME exposures and the other existing Basel risk weights in Pillar 1 calculations.
The net effect of that package for SME lending would be for only a small increase in capital requirements compared to today. But we do also understand, in line with the consultation feedback we received, that even though the change is small, SME lending matters for growth. So, we are making an additional change as we bring in the Basel package. Mindful of competitiveness and growth considerations we will take steps through an ongoing structural adjustment to Pillar 2 requirements to ensure that the removal of the support factors does not result in an increase in capital requirements for SME lending. The change will be available for all firms, including mid-tier and banks eligible for the ‘Strong and Simple’ regime, and further details on how we implement this will be available in due course.
Infrastructure lending
The second area to pick out is infrastructure lending. This is another area where we inherited an EU support factor that offers a risk weight reduction. While we did not receive convincing data to justify retaining the support factor purely based on an assessment of the risk, we did receive feedback on changes that would make our framework more risk sensitive. So, we are proceeding with removing the support factor, but we have also introduced a new, lower risk weight of 50% for ‘substantially stronger’ project finance exposures that are subject to the so-called IRB slotting approach. This new lower risk weight represents a reduction that is greater than the support factor would provide for higher quality lending. And it is in addition to the lower standardised risk weight that we proposed for high quality project finance exposures in the ‘operational’ phase.
These arguments are purely based on an assessment of the risk of infrastructure lending. But in parallel with the approach for SME lending, we are also very aware of the wider considerations around the impact on growth for infrastructure lending. So, mirroring the approach and rationale for SME lending, we have also introduced a similar ongoing structural adjustment to Pillar 2 requirements to ensure that the removal of the support factors does not result in an increase in capital requirements for infrastructure lending. As with the approach to SME lending, this will be available for all firms engaged in infrastructure lending, including mid-tier and banks eligible for the ‘Strong and Simple’ regime.
Conversion factors
The third area is conversion factors, which reflect the extent to which off balance sheet items are likely to come on to a firm’s balance sheet. We received convincing data regarding the calibration of certain trade finance related conversion factorsfootnote [8], which demonstrated that our proposal of 50% was too conservative and not commensurate with the risk. So, we have followed the evidence. We are lowering this conversion factor from 50% to 20%. Similarly, we are lowering the conversion factor for the ‘other commitments’ category to 40%, except for UK residential real estate commitments where I think it fair to say that firms agreed with us that the 50% we proposed was more appropriate. The data suggest both adjustments are prudent and appropriately reflect the risk, as per our aim of having conversion factors that are neither too low nor too high. In doing so, these choices will also benefit our international competitiveness.
Residential mortgages
Fourth, we have made several changes to our residential mortgage policy proposals under the Standardised Approach.
We received persuasive arguments to make our proposals on origination valuation more risk sensitive and operationally simpler. This is another good example of where feedback from firms has helped to make our proposals more efficient, while maintaining the basic principles around using origination loan-to-value. We are making a number of changes, including:
- to improve the risk sensitivity of mortgage valuations, we have added a ‘backstop’ revaluation event every three or five years, depending on the specifics of the property. This avoids disadvantaging long-term products like lifetime mortgages by ensuring their valuations are not too stale.
- we are reducing the operational burden of the valuation proposals by removing, completely, the requirement to adjust valuations to reflect a property value that would be sustainable over the life of the loan. Feedback suggested that ‘sustainability’ would be very difficult to implement.
- the need for downward revaluations will now be identified through a much more mechanistic, and therefore easier to implement, threshold of a 10% fall in house prices since the last valuation.
- one area that isn’t changing, but is worth mentioning because we’ve had a lot of questions, is over the use of Automatic Valuation Models that allow the desk based generation of housing valuations. We had not intended to prevent firms using them, and are clarifying that their use is permitted.
Changes have also been made to our proposals for self-build mortgages – a small but important market – where based on the helpful evidence received, we think the risk weights we proposed were too high. We will allow self-build exposures to be treated as ‘regulatory real estate exposures’ provided certain criteria are met, meaning the loan-splitting approach can be used to risk weight these exposures. This will be subject to an adjustment to the property value, given remaining uncertainty about the robustness of the valuation of unfinished properties.
We think this set of adjustments to the housing part creates a package that achieves the right balance between risk-sensitivity, prudence and cyclicality. Striving for that balance is clearly essential for such an important segment of our economy.
Output floor
Finally, we’ve made a technical change – but an important one – to the way firms calculate the output floor (see Annex for explanation of what the output floor does). This change is intended to improve the consistency between the standardised approach and the output floor calculation.
The issue revolves around how literally we should treat an Internal Ratings Based (IRB) firm bound by the backstop of the output floor as a standardised approach firm. Our initial proposals had prioritised simplicity, requiring no additional work from IRB firms to adjust their capital resources to reflect differences in the treatment of provisions in the standardised and IRB approaches. During the consultation, we heard from a number of firms who appreciated the intention of keeping the output floor simple, but who pointed out that in some cases the floor would be a less accurate measure of the capital needed under the standardised approach and IRB approaches. So, we’re fixing that by introducing an adjustment to risk weighted assets when the output floor binds that mimics the standardised accounting treatment of provisions. The output floor is a key part of Basel 3.1, helping to level the playing field between SA and IRB firms, so if we need a slightly more complex approach to achieve that outcome, then it’s the right thing to do.
Link with strong and simple
When we published our near final Basel 3.1 rules this morning, we also released a range of related consultation documents on our work to create a ‘Strong and Simple’ regime for domestically focused lenders. These propose meaningful simplifications to the capital regime for Small Domestic Deposit Takers, without weakening it. I won’t cover those here because my colleague David Bailey will do them much greater justice in a forthcoming speech, but I did want to describe how the strong and simple approach is making use of the Basel 3.1 changes given the close links.
In our Basel 3.1 proposals, we had said that we were minded to use the Basel 3.1 risk weights as the starting point for the strong and simple capital regime. In the strong and simple consultation, we have proposed that, subject to a small number of simplifications described in the package, we will use the 3.1 risk weights in that regime.
The reason for the proposal is that in adopting our Basel 3.1 rules, we have assessed, activity by activity, how risky various types of business are. And then we have set risk weights appropriately, in our view neither too low nor too high. We have taken the view that if Basel 3.1 is our best estimate of the risk weights, then that is going to be true whether large firms or small firms are doing the activity. The risk is the risk in other words. As part and parcel of this view, the standardised approach to credit risk, used by all small firms in the strong and simple regime, is now much more risk sensitive and includes a significant narrowing of the gap between the standardised and modelled approaches for determining risk weights, which helps to facilitate competition.
Timeline and the plan for implementation
I said at the start of this talk that Basel 3.1 has been a long journey. Necessarily. But publishing near final rules is not the end of the story, because we need an implementation process which works for firms and works for the PRA.
On the timetable for implementing, the PRA has continued to monitor the implementation timelines of other jurisdictions and assessed the adequacy of the period between publication of PRA rules and their implementation. We have decided to move the implementation date for the Basel 3.1 standards by a further six months to 1 January 2026 with a transitional period of 4 years to ensure full implementation by 1 January 2030, in line with the proposals originally set out in CP16/22.
Conclusion
Let me wrap up.
First up, I know you will have more questions on the details of the topics I have covered today as well as other issues that I haven’t touched on. Those are covered in the near-final Policy Statement and I’ll be happy to take some questions.
Second, to re-iterate my thanks for the strong engagement we have had from stakeholders. It has helped to improve our package, in my view.
Third, our approach has been to listen to the feedback of stakeholders and engage extensively. We have aimed for risk weights that are neither too high nor too low, and in doing so provide a balance across a range of considerations. This includes advancing our primary objective and aligning with international standards. And it includes a significant role for considerations around competitiveness and growth and competition. Taking all of these factors as a whole, it has produced, in our view, a balanced approach to finishing Basel 3.1 in the UK.footnote [9]
Annex: What does Basel 3.1 deliver?
The package is the last element of the Basel III set, which the PRA played an active and influential role in designing. The parts of Basel III that remain to be implemented focus on the calculation of risk-weighted assets (RWAs). These elements may be the final piece of the reform jigsaw, but they are essential. Without better risk capture, the overall package of Basel III reforms will not be as effective.
What does the Basel 3.1 package aim to achieve?
The high-level aims are twofold:
Improve risk-sensitivity and reduce excessive variability
The first is to improve the robustness of RWAs by improving risk-sensitivity and reducing excessive variability:
The global financial crisis revealed significant shortcomings in the calculation of risk weights. The standardised approaches should of course be simple, but not too crude or risk-insensitive. Basel 3.1 makes the standardised approaches better reflect the risk of firms’ exposures. An added benefit of this improvement – which is particularly important for the PRA in its longstanding effort to meet its secondary competition objectivefootnote [10] – is that the playing field is further levelled between the large number of smaller firms, the typical users of the standardised approaches, and larger firms using internal models.
The BCBS also noted a ‘worrying degree of variability’ in the calculation of modelled risk weights. A number of studies have found material differences in the risk weights calculated by firms’ internal models for the same hypothetical portfolios of assets. Importantly, excessive variability in RWAs reduces the consistency and comparability of firms’ risk-weighted capital ratios. This is confidence draining. To improve matters, Basel 3.1 makes internal models unavailable to firms in areas where modelling is too difficult to perform robustly. In other areas, such as parts of the credit risk framework, the standards reduce the flexibility in modelling approaches. And in others, like market risk, there is an entirely new type of model measure.
Introduce the output floor to backstop modelled risk weights
The second aim is to contain the capital benefits of using internal models because of concerns about model risk and uncertainty. To achieve this, Basel 3.1 introduces an ‘output floor’ – a ‘backstop’ that stops modelled RWAs from falling too far below those of the standardised approaches.
Overall, the proposals make significant changes to the way firms calculate risk weights and, in doing so, address many of the issues that came to the fore during the global financial crisis.