Implementation of Basel 3.1: How to efficiently manage reforms

Unveiling Basel 3.1: Navigating the reforms in the EU and in the UK

The Basel Committee on Banking Supervision (BCBS) responded to the 2008 global financial crisis by introducing Basel III, a series of reforms designed to enhance banks' resilience throughout economic cycles. Indeed, the financial crisis exposed significant flaws in the calculation of risk-weighted assets (RWAs) and capital ratios, which represent the ratio of capital held by firms to RWAs. The BCBS therefore identified three crucial factors for reducing the severity of future financial crises: increasing the quantity of capital in the financial system relative to risk, improving the quality of capital held by firms, and enhancing the accuracy of risk measurement by firms.

While many of the Basel III standards have been adopted in the EU and in the UK, through the EBA Capital Requirements Regulation (CRR) 3 legislative package and the PRA PS22/21 and PS21/21, there are still outstanding elements to be implemented. In the UK, these are referred to as the "Basel 3.1 standards," while in the US, they are known as the "Basel III Endgame." These remaining reforms primarily focus on revising the calculation of RWAs, including improving the measurement of risk in internal models (IMs) and standardised approaches (SAs), as well as ensuring comparability of risk measurement across firms.

Although the EU has not faced financial turmoil on the same scale as the US, recent collapses of institutions like Silicon Valley Bank, Signature Bank, and Credit Suisse have prompted EU policymakers to adopt the Basel III Endgame reforms quicker. The proposed implementation date for these reforms, excluding transitional provisions for the output floor, is January 1, 2025. As the EU and the UK prepare for these changes, it is crucial for banks to familiarize themselves with the proposed updates, assess their impact, and strategize for a successful transition. In this article, we will explore the key updates and examine how these changes will affect financial institutions, considering the variations between the BCBS guidelines, EU CRR3, and UK Basel 3.1 requirements.

Upcoming updates to Basel standards

a. Deviations and Implications

The introduction of output floors for internal ratings-based (IRB) banks, the revised credit conversion factors, and updated probability of default (PD), loss given default (LGD), and exposure at default (EAD) input floors require careful consideration. The EU's unique treatment of unrated corporate exposures under IRB and Standardized Approach (SA) risk-weight floor calculations adds another layer of complexity.

b. Data Collection

The implementation of Basel 3.1 necessitates the collection of new types of data, including external ratings, granular collateral and exposure data for loan-to-value (LTV) ratio calculations, and borrower information for income-producing properties. Additionally, the application of new standardized risk-weight by Grades A, B, or C requires information on unrated banks.

Banks must navigate the complexities associated with the loan-splitting approach for real-estate exposures under the SA and be aware of the whole-loan approach, which is prohibited under EU EBA CRR3 rules.

c. Trading Book Treatment

IRB banks using the internal model method (IMM) for assessing derivatives counterparty credit-risk exposures must also compute derivatives EAD using the SA-CCR approach. Revised regulatory collateral haircuts and a new net EAD formula for securities financing transactions (SFTs) add to the operational considerations.

d. Streamlining Operational Risk: A Simplified Approach

The calculation of operational risk has undergone significant changes, with a shift towards a single SA approach that requires extensive historical income-statement data and ensures robust risk capital requirements. The advanced Credit Valuation Adjustment (CVA) and S-CVA methodologies have been replaced by BA-CVA and SA-CVA approaches, demanding pre-bucketed CVA sensitivities as input.

e. Adapting to Market Risk: A Revised Approach

The Fundamental Review of the Trading Book (FRTB) regulation, incorporated into EU EBA CRR3 and UK PRA Basel 3.1, revamps the market-risk framework. Banks need to navigate the refinements and ensure compliance with FRTB-SA rules. The PRA's proposals introduce the Simplified Standardized Approach (SSA), Advanced Standardized Approach (ASA), and Internal Model Approach (IMA) to cater to different business models.

f. Credit Risk Reforms: A Paradigm Shift

The PRA's proposed changes under Basel 3.1 encompass three crucial areas:

i. Revised Standardized Approach (SA): The PRA is considering replacing the internal ratings-based approach with the SA in complex situations. This change will have a significant impact on various aspects, including the use of external credit ratings, exposure values, and lending to different entities.

ii. Revisions to the IRB Approach: The IRB approach, a key component of Basel 3.1, is undergoing an overhaul. This reform introduces new exposure sub-classes, restrictions on modelling, and updated general requirements.

iii. Revisions to Credit Risk Mitigation (CRM) Techniques: Changes are on the horizon for credit risk mitigation techniques. The PRA is introducing new frameworks for recognizing credit risk mitigation, impacting funded credit protection and unfunded credit protection methods. The proposed alterations include modifications to collateral eligibility, risk weight substitution, and general principles for unconditional guarantees.

g. Strengthening the Foundation: The Output Floor

To ensure resilience, Basel 3.1 introduces an output floor, which sets a minimum level of RWAs for banks with internal model permissions. The PRA is proposing a minimum floor of 72.5% of RWAs calculated using standardized approaches, providing a safeguard against excessive variations.

h. A Strong and Simple Regime: Exploring the Path Ahead

In its quest for a "strong and simple" regime, the PRA aims to streamline the regulatory framework for small, non-systemic domestic UK banks and building societies while ensuring their resilience through a robust and straightforward framework. Firms meeting the criteria for the simpler regime would not be required to apply Basel 3.1 standards for capital ratio calculations. Instead, they can opt for a transitional interim regime known as the Transitional Capital Regime, similar to the existing regime under the CRR.

Basel 3.1: The Journey Begins

As the dust settles on the proposed reforms, banks are encouraged to embark on their Basel 3.1 journey with confidence. With the implementation slated for January 1, 2025 both in the EU and in the UK, it is paramount to assess the potential implications and adapt internal processes and systems accordingly.

As the implementation deadline approaches, banks must take proactive steps to address the deviations and challenges presented by Basel 3.1. To successfully navigate the road to Basel 3.1 compliance, banks must undertake a comprehensive review of their data sourcing and architecture. This involves ensuring tight lineage, transparency into results, direct integration with reporting, and the ability to run various scenarios. The upcoming rule changes may require the replacement of legacy systems or vendors lacking end-to-end coverage and impact analytics.

Our team of experts is here to provide customized guidance and unwavering support throughout your Basel 3.1 implementation journey. Together, we will help you decode the reforms, align your operations, and construct a resilient foundation for the future. At Suade, our clients gain a distinct advantage in implementing regulatory changes swiftly. Through our comprehensive data standardization and mapping capabilities, their data is already primed, reducing the impact of new reports such as cells shifting to different templates or changes in naming conventions. We can notably offer a reporting engine that can perform SA calculations seamlessly alongside their existing infrastructure.

Stay ahead of the curve and partner with Suade today to unlock the full potential of regulatory compliance in the ever-evolving financial landscape. Contact us now to discover how Suade can revolutionize your reporting and compliance efforts in the era of the new taxonomy. Together, we'll pave the way for a sustainable and resilient future!