Bank of England to push ahead with Basel reforms
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As the world economy continues to recover from the COVID-19 pandemic, the UK banking sector has grown in recent years. Our previous post “S&P: Global Banks Back on Course” reported how the global banking sector has stabilised since 2020. However, inflation pressures remain a primary concern within the UK, making it critical that banks actively observe consumer and market trends.
Aside from increased operating costs due to inflation, financial institutions must also invest in new or modified approaches to stay on top of new banking laws and regulations. As of 7th December 2022, the Bank of England (BoE) has put forward plans to implement Basel 4 reforms.
The road to Basel 4
First established in 1988, the Basel framework has since expanded its list of standardised rules for banks to mitigate risks in the global banking system. The recently established Basel 4, also known as Basel 3.1, tweaks the provisions of Basel 3, which was originally conceived by the Basel Committee on Banking Supervision (BCBS) in 2017 to fight against potential financial crises. Major changes include favouring external risk models, introducing a leverage ratio buffer, and increase in capital ratios. In the UK, the BoE has mandated that banks comply with Basel by 1st January 2025, a date that aligns with the EU.
With the shift from Basel 3, banks need to pave the way towards compliance through financial reallocations and new technology. Basel 4 reporting is a critical part of the process, done through platforms that combine data, calculations, and reporting in line with requirements around proportionality. These compliance solutions will cover standardised approaches across all risk types and bank sizes, in line with how Basel 4 aims to enhance banking growth, competitiveness, and profitability.
UK-tailored version of global standard
Published on 30 November 2022, the Prudential Regulation Authority (PRA) published its plans to implement Basel 4 with a UK-tailored approach. The reforms “were conceived in response to the 2008 global financial crisis and are designed to standardise risk measurement and the comparability and consistency of capital ratios”.
One of the most significant changes introduced in the Basel framework is limiting internal capital models. Referred to as the ‘output floor’, it serves as a ‘backstop’ that requires modelled risk-weighted assets (RWAs) to not fall far below the standard. Listed below are some considerations when looking at the EU and UK’s approaches:
- The EU is working towards a consolidated EU-level output floor in all groups. UK groups working in the EU are subject to this. However, the output floor of the UK will not apply to EU-headquartered groups.
- When calculating the output floor, the UK implementation of Basel will drive firms towards standardised models rather than internal models. In the EU, firms are being given several transitional arrangements to shift towards external models until 2032.
In addition to shifts in risk models, banks also face problems in approaching corporate loans. Basel 4 is imposing new rules on lending to businesses that don’t have credit ratings, which many UK and EU corporations lack, especially in the post-Brexit period. Banks have to choose between 100% risk weighing on unrated corporations or a hybrid approach of 65% risk weight to high-quality unrated corporates and 135% risk charges on lending to lower-quality ones.
The PRA has opened consultations for parties interested in giving quantitative and qualitative feedback on the Basel guideline proposals. This consultation period will close on 31st March 2023 to provide time for sufficient data and evidence gathering.
