The near-final PRA Rulebook PS9/24 published on 12 September 2024 includes substantial changes in credit risk regulation compared to the Consultation Paper CP16/22. While these amendments enhance clarity of Basel 3.1 implementation, institutions should conduct in-depth impact analysis to efficiently manage capital requirement. 

PRA has published draft proposal CP16/22 aligning closely with Basel 3.1 reforms. In response to industry feedback, the PRA has made material adjustments in PS9/24, which are aimed at better balancing alignment with international standards and maintaining the competitiveness of UK regulated institutions.  

Key takeaways 

1- Scope for a ‘Backstop’ revaluation every 5-years for valuation of real estate exposures 

2- SME and Infrastructure support factor is maintained, yet firm-specific adjustments will be introduced in pillar 2A. 

3- Despite industry concern on international competitiveness, the risk-sensitive approach for unrated corporate exposure is maintained. 

The implementation timeline is extended to 1 January 2026 with a 4-year transitional period, which is a one-year delay from the proposed implementation date of 1 January 2025 from CP16/22.

Real Estate Exposures  

According to the final regulations, the risk weights associated with regulatory real estate exposure will be calculated based on the type of property, the loan-to-value (LTV) ratio, and whether the repayments rely significantly on the cash flows produced by the property. In place of the potentially complex analysis proposed in CP16/22, the rules for determining whether a real estate exposure is materially dependent on cash flows have been significantly simplified and there is now a straightforward requirement for the classification of real estate exposures.  

One major change in the proposals relates to loans that are secured by commercial properties. The PRA has dropped the 100% risk weight floor for exposures backed by commercial real estate (CRE), provided that the repayment is not 'materially dependent on cash flows from the property' and that the exposure fits the 'regulatory real estate (RRE)' definition. Consequently, under the new rules, firms may, in some instances, benefit from low risk weights for commercial real estate, depending on the loan's loan-to-value (LTV) ratio and the type of counterparty involved. 

Additionally, the final rules regarding the revaluation of real estate have become more risk-sensitive. Although firms are still required to use the original valuation to calculate LTV, there is now a provision allowing for a ‘Backstop’ revaluation after five years. Going forward, the PRA has eliminated the need for firms to adjust valuations to reflect the 'prudent value' sustainable throughout the loan's duration. The requirements for downward revaluation have been simplified, mandating firms to reevaluate properties when they estimate a market value decline of over 10%. Furthermore, the PRA has specified that valuations can be conducted using a robust statistical model, such as an automated valuation model (AVM). 

SME support factor 

The PRA has maintained the draft proposal to remove the SME support factor under SA and IRB (Pillar 1), but has applied a firm-specific structural adjustment to Pillar 2A (the ‘SME lending adjustment’). The ‘SME lending adjustment’ aims to absorb the impact of removing the SME support factor in overall capital requirement.  

The PRA plans to communicate the adjusted Pillar 2 requirements to firms, ahead of the implementation date of the Basel 3.1 standards on 1 January 2026 (‘day 1’), so that firm-specific requirements will be updated at the same time as the Basel 3.1 standards are implemented. 

Infrastructure support factor 

The PRA has maintained the draft proposal to remove infrastructure support factor under SA and IRB approach, but has made two material changes which will diminish the impact on overall capital requirement.  

i. apply a firm-specific structural adjustment to Pillar 2A (the ‘SME lending adjustment’), which will minimize disruption in overall capital requirement. 

ii. introduce a new substantially stronger category in the slotting approach for IRB. PRA proposed lower risk-weight on the ‘substantially stronger’ IPRE exposures in CP16/22. The new definition of ‘substantially stronger’ is expected to include broader scope of IPRE exposures, thus lowering overall capital requirement. 

Unrated corporate exposures 

The PRA has maintained the draft proposal of introducing a two-way method on unrated corporate exposures: risk-sensitive and risk-neutral approach. Since the new approach does not apply in other jurisdictions, additional operational challenge is expected. Also, the 135% risk-weight on Non-IG(non-Investment Grade) unrated corporate exposure is higher than 100% in other jurisdictions, implying higher lending cost for UK regulated banks compared to its internationally regulated peers.

i. risk-sensitive approach : The PRA has proposed a risk-sensitive approach additional to the Basel III reforms. Exposures assessed by firms as IG would be risk-weighted at 65%, while exposures assessed by firms as Non-IG would be risk-weighted at 135%. This is a more risk-sensitive approach which aims to maintain an aggregate level of RWAs broadly consistent with the Basel III reforms.  

ii. risk-neutral approach: 100% risk weight is applied where the risk-sensitive approach is too costly or complex.  

In conclusion, the PRA's near-final Rulebook (PS9/24) reflects significant revisions to credit risk regulation that enhance clarity and alignment with Basel 3.1, while addressing industry feedback. The introduction of a five-year 'backstop' revaluation for real estate exposures, firm-specific adjustments for SMEs and infrastructure support factors, and the maintenance of a risk-sensitive approach for unrated corporate exposures underscore the PRA's commitment to balancing regulatory requirements with maintaining the competitiveness of UK institutions.  

The extended implementation timeline to 1 January 2026, along with the transitional period, allows firms adequate time for adjustment. Overall, these changes aim to foster a more robust and competitive banking environment, while also navigating the complexities introduced by differing international standards.  

How can Zanders help?  

We have extensive experience of implementation and validation of Pillar 1 & 2 models which allows us to effectively support our Clients managing the change process to full compliance with the latest regulations. 

From our experience, as the following are key areas on which our services can add most value: 

1- Carry out thorough self-assessment against new requirements including an impact analyses of new regulations on their capital requirements. 

2- Support model development activities to align models to new rules; we could be done either on an advisory basis or via direct supply of additional resources 

3- Support amendments to Pillar 2 models (which will have to reflect changes to Pillar 1 models) 

4- Support Internal Validation activities across Pillar 1 & 2 

5- Carry out quality assurance on final models & documentation before final submission to the PRA

6- Support adoption of solutions for prudential valuation of (real estate) collateral while integrating climate risk information. 

Please reach out to Paolo Vareschi or Suneet Dutta Roy to find out more about how we could support you on your journey to Basel 3.1 compliance. 

References

[1] Bank of England (2024), PS9/24 – Implementation of the Basel 3.1 standards near-final part 2 URL PS9/24 

[2] Bank of England (2022), CP16/22 – Implementation of the Basel 3.1 standards 
URL CP16/22 

The Basel IV reforms published in 2017 will enter into force on January 1, 2025, with a phase-in period of 5 years. These are probably the most important reforms banks will go through after the introduction of Basel II. The reforms introduce changes in many areas. In the area of credit risk, the key elements of the banking package include the revision of the standardized approach (SA), and the introduction of the output floor. 

In this article, we will analyse in detail the recent updates made to real estate exposures and their impact on capital requirements and internal processes, with a particular focus on collateral valuation methods. 

Real Estate Exposures 

Lending for house purchases is an important business for banks. More than one-third of bank loans in the EU are collateralised with residential immovable property. The Basel IV reforms introduce a more risk-sensitive framework, featuring a more granular classification system. 

Standardized Approach 

The new reforms aim for banks to diminish the advantages gained from using the Internal Ratings-Based (IRB) model. All financial institutions that calculate capital requirements with the IRB approach are now required to concurrently use the standardized approach. Under the Standardized Approach, financial institutions have the option to choose from two methods for assigning risk weights: the whole-loan approach and the split-loan approach. 

Collateral Valuation  

A significant change introduced by the reforms concerns collateral valuation. Previously, the framework allowed banks to determine the value of their real estate collateral based on either the market value (MV) concept or the mortgage lending value (MLV) concept. The revised framework no longer differentiates between these two concepts and introduces new requirements for valuing real estate for lending purposes by establishing a new definition of value. This aims to mitigate the impact of cyclical effects on the valuation of property securing a loan and to maintain more stable capital requirements for mortgages. Implementing an independent valuation that adheres to prudent and conservative criteria can be challenging and may result in significant and disruptive changes in valuation practices.  

Conclusion  

To reduce the impact of cyclical effects on the valuation of property securing a loan and to keep capital requirements for mortgages more stable, the regulator has capped the valuation of the property, so that it cannot for any reason be higher than the one at origination, unless modifications to that property unequivocally increase its value. Regulators have high expectations for accounting for environmental and climate risks, which can influence property valuations in two ways. On the one hand, these risks can trigger a decrease in property value. On the other hand, they can enhance value, as modifications that improve a property's energy performance or resilience to physical risks - such as protection and adaptation measures for buildings and housing units - may be considered value-increasing factors. 

Where Zanders can help 

Based on our experience, we specialize in assisting financial institutions with various aspects of Basel IV reforms, including addressing challenges such as limited data availability, implementing new modelling approaches, and providing guidance on interpreting regulatory requirements.  

For further information, please contact Marco Zamboni. 

The European Banking Authority (EBA) published its roadmap on the Banking Package, which implements the final Basel III reforms in the European Union. This roadmap develops over four phases, and it is expected to be completed as follows:

• Phase 1: Covers 32 mandates in the areas of credit, market and operational risk, which predominantly result from the transition to Basel III. In addition, this first phase will also see the first mandates under the Capital Requirements Directive (CRD) in the area of ESG.
• Phase 2: This phase will further progress in covering Capital Requirements Regulation (CRR) mandates related to credit, operational and market risk. Furthermore, a considerable number of CRD mandates related to high EU standards in terms of governance and access to the single market with regard to third-country branches will be developed in this phase.
• Phase 3: It includes most of the remaining mandates related to regulatory products as well as a number of reports, whereby further perspectives and initial monitoring efforts regarding banking regulation implementation are worth considering.•      
• Phase 4: In this last phase, a number of products, mostly consisting of reports, will be developed, providing information on the implementation progress, results and challenges.   

In addition, there are some mandates that are ongoing and reoccurring and are not part of any of the four phases but will be made operational at the date of implementation in 2025. As part of phase 1, the EBA has published multiple consultation papers, which form the first step in the implementation of the Banking Package. The three main consultation papers published are: 

1. A public consultation on two draft ITS amending Pillar 3 disclosure requirements and supervisory reporting requirements. The suggested amendments on the reporting obligations cover a wide range of topics such as the output floor, standardized and internal ratings-based models (IRB) for credit risk, the three new approaches for own funds requirements for CVA risk and the (simplified) standardized approach for market risk.
2. A public consultation launched by the EBA on the Regulatory Technical Standards (RTS) determining the conditions for an instrument with residual risk to be classified as a hedge. This consultation, on the standardized approach under the FRTB framework, focuses on the residual risk add-on (RRAO). Introduced by the Capital Requirements Regulation (CRR3), the RRAO framework allows exemptions for instruments hedging residual risks. The proposed RTS outline criteria for identifying hedges, distinguishing between non-sensitivity-based method risk factors and other reasons for RRAO charges.
3. A public consultation on two draft Implementing Technical Standards (ITS) amending Pillar 3 disclosures and supervisory reporting requirements for operational risk. These revisions align with the new Capital Requirements Regulation (CRR3) and aim to consolidate reporting and disclosure requirements for operational risk and broader CRR3 changes. These consultation papers should be read in conjunction with the consultation papers on the new framework for the business indicator for operational risk, published at the same time.