CP16/22 – Implementation of the Basel 3.1 standards: Credit risk – standardised approach

Overview

3.1 The Basel 3.1 standards provide two approaches for calculating risk-weighted assets (RWAs) for credit risk – the standardised approach (SA) and the internal ratings based approach (IRB). This chapter sets out the Prudential Regulation Authority’s (PRA) proposals to change SA Capital Requirements Regulation (CRR) requirements and PRA expectations in response to the Basel 3.1 standards. Proposals for updating IRB requirements and expectations are set out in Chapter 4 – Credit risk – internal ratings based approach, including proposed changes to the definition of default that are also relevant to firms using the SA. The proposed changes set out in this chapter are, however, of relevance to firms with IRB permissions that are in scope of the application of the output floor (as set out in Chapter 9 – Output floor).

3.2 The proposals in this chapter would:

• complement HM Treasury’s (HMT) proposed revocation of certain CRR articles;
• introduce a new Credit Risk: Standardised Approach (CRR) Part of the PRA Rulebook relating to the SA approach to replace CRR articles that HMT plans to revoke;
• introduce a new Credit Risk: General Provisions (CRR) Part of the PRA Rulebook relating to general provisions for credit risk to replace CRR articles that HMT plans to revoke;^{footnote [1]}
• amend the existing Credit Risk Part of the PRA Rulebook;
• remove the Standardised Approach and Internal Ratings Based Approach to Credit Risk (CRR) Part of the PRA Rulebook (in so far as it relates to the SA); and
• amend Supervisory Statement (SS) 10/13 – ‘Standardised approach’ and SS13/16 – ‘Underwriting standards for buy-to-let mortgage contracts’.^{footnote [2]}

3.3 RWAs under the SA are determined by assigning exposures to a standardised set of risk weights. For some exposure classes, external ratings can be used as the starting point for assigning SA risk weights.^{footnote [3]} For exposures without external ratings, SA risk weights are generally assigned according to one or more risk drivers, eg loan to value (LTV) in the case of residential mortgages.

3.4 The Basel 3.1 standards enhance the risk-sensitivity and robustness of the SA, with an aim to ensure its continued suitability for calculating RWAs, while also providing a credible alternative (and complement) to IRB. This is particularly important because in some cases where modelling is too difficult or complex, the PRA proposes to remove use of the IRB approaches, meaning that the SA needs to be a credible alternative for IRB firms.

3.5 In designing the proposed changes to the SA set out in this chapter, the PRA has sought to develop SA methodologies that are appropriate both for SA firms and for firms with IRB permissions that would be in scope of the proposed application of the output floor (as set out in Chapter 9) and need to calculate credit risk RWAs using the SA for purposes of the output floor. As set out in Chapter 9, the PRA does not consider it appropriate to tailor the SA methodologies for the purpose of the proposed output floor calculation, because it considers that a robust and consistent application of SA methodologies by IRB firms subject to the floor is necessary to achieve the prudential objectives of the output floor, and to advance the PRA’s primary and secondary objectives. Assessments of how the proposed changes to SA methodologies set out in this chapter advance the PRA’s primary and secondary objectives, and consideration of the various factors to which the PRA must ‘have regard’, have been completed on this basis.

3.6 These changes to the SA are designed to address shortcomings in global prudential standards by:

• reducing mechanistic reliance on external ratings;
• rebalancing standards towards risk-sensitivity over simplicity; and
• promoting comparability between firms (and jurisdictions) by reducing variability of risk weights.

3.7 The PRA supports the aims of the Basel Committee on Banking Supervision (BCBS) in updating the SA, as these are consistent with the PRA’s primary and secondary objectives. However, the PRA considers giving practical effect to the Basel 3.1 standards requires a degree of interpretation, and raises questions around operational realities and local market specificities. Generally, the PRA is seeking to add clarity where it is likely to be beneficial for firms and supervisors, as well as proposing adjustments where appropriate, to reflect the UK market.

3.8 The package of SA rules and expectations proposed by the PRA in this consultation paper (CP) has been calibrated to deliver a level of resilience broadly aligned to the standards agreed by the BCBS, in keeping with the UK’s role as a global financial centre, while addressing UK specificities and operational challenges. Specific benefits in the PRA’s proposed SA package compared with existing CRR requirements include:

• enhanced risk-sensitivity, including lower risk weights for low-risk mortgage lending and the introduction of specific treatments for ‘specialised lending’;
• a more risk-sensitive treatment for exposures to unrated corporates, including unrated funds;
• a simpler, more transparent and prudent mechanism for determining risk weights aimed at supporting lending to small and medium-sized enterprises (SMEs);
• a more risk-sensitive approach to risk-weighting equity exposures, including a prudent treatment for higher risk ‘speculative unlisted equity’;
• off-balance sheet conversion factors (CFs) aligned to local UK market conditions; and
• a proportionate approach to SA operational requirements, including for the new due diligence requirements included in the Basel 3.1 standards.

3.9 The proposals in this chapter are relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial holding companies or mixed financial holding companies (‘firms’). The proposals would 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.^{footnote [4]}

3.10 In this chapter, the PRA has set out details where it proposes substantive changes to requirements and expectations relative to the existing approach. The PRA also proposes to make a number of other amendments in order to enhance the clarity and coherence of the framework. This includes consolidating some existing PRA rules into new Rulebook Parts. To the extent that the PRA does not propose to amend the existing approach, current requirements and expectations would continue to apply.^{footnote [5]}

External credit ratings and due diligence

3.11 This section sets out the PRA’s proposals for implementing the Basel 3.1 standards for the SA to credit risk for the use of external credit ratings and due diligence.

3.12 The BCBS considered the over-reliance on external credit ratings as a weakness of the SA, noting that external credit ratings were often being used by firms to calculate RWAs without the firms having a sufficient understanding of the underlying risks of the exposures. The BCBS concluded that it is important that firms have an understanding of the underlying risks.

3.13 The PRA shares the BCBS’s concerns and proposes changes to reduce the potential for firms to mechanistically rely on external credit ratings without themselves having a robust understanding of the risk of the exposures.

External credit ratings

3.14 The PRA proposes to change the SA requirements for the use of external credit ratings. The PRA considers that most of these changes would not materially affect the substance of the existing CRR requirements, but would align the PRA’s approach more closely with the Basel 3.1 standards. These changes would improve the clarity of the requirements for external credit ratings, which should enhance the consistency of implementation across firms.

3.15 Consistent with the Basel 3.1 standards, the PRA proposes that firms would use the credit ratings of their nominated external credit assessment institutions (ECAIs) consistently for all types of exposures, for risk management and risk-weighting purposes. The PRA considers that the proposal would reduce the potential for firms to ‘cherry-pick’ their use of ECAI ratings to lower RWAs by:

• ensuring that firms use ECAIs consistently for the entirety of their exposures, and preventing firms assigning preferential external credit ratings for certain exposure classes; and
• preventing firms using different ECAIs for risk-weighting than they do for risk management purposes and business decisions.

3.16 The PRA also proposes to add clarity to the SA regarding: i) issuer and issue credit ratings; ii) long-term and short-term credit ratings; and iii) domestic and foreign currency items. The PRA proposes to allow the use of unsolicited credit ratings where the unsolicited credit ratings of an ECAI do not differ in quality from the solicited credit ratings of the ECAI. Firms would not be permitted to use unsolicited credit assessments where the ECAI has used an unsolicited credit assessment to put pressure on a rated entity to place an order for a credit assessment or other services.

3.17 At this stage, the PRA does not propose to amend the mapping of the external credit ratings to the credit quality steps (CQS) set out in Commission Implementing Regulation (EU) 2016/1799 of 7 October 2016, but this will be kept under review.

Due diligence

3.18 The PRA proposes to introduce due diligence requirements comprising two elements: (i) a requirement for monitoring of counterparties; and (ii) for externally rated exposures, a requirement to increase risk weights in cases where a firm’s due diligence indicates that an exposure has higher credit risk than the external credit rating would imply. The proposals are:

• Monitoring counterparties: Firms would need to ensure they have an adequate understanding of their counterparties’ risk profiles and characteristics. The adequate monitoring of counterparties is applicable to all exposures under the SA. Monitoring would need to occur at the level of the group structure at which the exposure is held, and firms would need to take reasonable and adequate steps to assess the operating and financial condition of each counterparty. The due diligence would need to happen at the origination of the exposure and at least annually thereafter. Firms would need to ensure they have regular access to relevant information to perform the due diligence. The sophistication of the due diligence should be appropriate to the size and complexity of the firm’s activities.
• Requirement to increase risk weights: In cases where external credit ratings are used for risk-weighting purposes, due diligence should be used to assess whether the risk weight applied is appropriate and prudent. If the due diligence assessment suggests an exposure has higher risk characteristics than implied by the risk weight assigned to the relevant CQS of an exposure, the firm would assign the risk weight of a CQS at least one higher than the CQS indicated by the counterparty’s external credit rating. This requirement is applicable to exposures to corporates, institutions, and covered bonds.^{footnote [6]}

3.19 At this stage, the PRA does not propose to set an expectation that the PRA would consider the due diligence analysis performed by firms as part of the Supervisory Review and Evaluation Process (SREP), but this may be reviewed at a later date.

Question 3: Do you have any comments on the PRA’s proposed approach to the use of external credit ratings and the proposed due diligence requirements?

PRA objectives analysis

3.20 The PRA considers that the proposals set out in this section further its safety and soundness objective by ensuring that firms take robust but proportionate measures to understand the risk of their exposures. The proposals would help ensure that firms use external credit ratings in an informed and non-mechanistic manner, reducing the likelihood that risk weights are understated and/or do not reflect the underlying riskiness of firms’ exposures.

3.21 The PRA considers the proposals support its secondary objective by promoting more consistent use of external credit ratings, which would promote effective competition in the market.

‘Have regards’ analysis

3.22 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Competitiveness (HMT recommendation letters) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA expects other jurisdictions, for example the EU (based on the European Commission’s proposals), to apply broadly similar requirements for the use of external credit ratings and due diligence, other than the US.^{footnote [7]}

2. Relevant international standards (FSMA CRR rules):

• The PRA’s proposed requirements for external credit ratings and due diligence align with the Basel 3.1 standards.

Exposure values for off-balance sheet items

3.23 This section sets out the PRA’s proposals for determining off-balance sheet exposure values under the SA for credit risk.

3.24 There are two categories of off-balance sheet items: (i) issued off-balance sheet items where a firm has underwritten an obligation to a third-party and stands behind the risk; and (ii) commitments to extend credit, purchase assets, or issue off-balance sheet items at a future date. The PRA proposes to differentiate between these categories more clearly in its rules.

3.25 A conversion factor (CF) is used to convert off-balance sheet items into a credit equivalent amount. The CF represents the likelihood of the exposure coming onto the balance sheet. These are then treated in the same way as an on-balance sheet exposure: (i) they are multiplied by a risk weight, which is based on the credit quality of the counterparty and exposure type, to obtain the RWAs for the exposure; and (ii) they are included in the leverage exposure measure. The proposals in this section would; therefore, impact the PRA’s risk-weighted and leverage ratio frameworks.

3.26 CFs depend on the approach used to calculate RWAs for credit risk. The PRA proposes to align the foundation IRB (FIRB) approach CFs with the SA CFs, so the proposals in this section are relevant to firms using the SA and the FIRB approach. The PRA proposes to limit exposure at default (EAD) modelling under the advanced IRB (AIRB) approach to revolving commitments (see Chapter 4, ‘Exposure at default (EAD) estimation’ section), so the proposals in this section relating to non-revolving commitments and issued off-balance sheet items are also relevant to firms applying the AIRB approach. Where EAD can be modelled, the proposed SA CFs set out in this chapter would also impact the proposed EAD input floors (see Chapter 4, ‘Exposure at default (EAD) estimation’ section). Finally, the PRA proposes to prohibit EAD modelling under the slotting approach (see Chapter 4, ‘Exposure at default (EAD) estimation’ section), so the proposals in this section are also relevant to firms using the slotting approach.

Definition of ‘commitment’ for off-balance sheet items

3.27 The Basel 3.1 standards introduce a revised definition of commitment, which is based on contractual arrangements that have been entered into by firms. The PRA supports the revised definition as it would result in greater consistency across firms and, therefore, proposes to align with the Basel 3.1 standards and specify that a commitment would be considered to exist where a firm has entered into a binding contractual arrangement.

3.28 The PRA proposes that its revised definition of commitment would be used by firms to determine the point at which they need to calculate RWAs for commitments under all credit risk approaches. For firms using the IRB approach, the PRA also proposes to require firms to make further adjustments to RWAs in certain circumstances (see Chapter 4, ‘Exposure at default (EAD) estimation’ section).

3.29 The Basel 3.1 standards contain a national discretion to exempt certain arrangements for corporates and SMEs which meet specific criteria,^{footnote [8]} including in relation to the execution of drawdown, from the definition of a commitment. The PRA does not propose to exercise this discretion. While the PRA acknowledges that some of these arrangements may be unconditionally cancellable, it considers that there is still a possibility of arrangements becoming on-balance sheet exposures where a contractual relationship exists. Therefore, the PRA considers that applying zero RWAs would be inconsistent with the risk and could result in imprudent outcomes.

CF calibration for commitments

Commitments receiving a 100% CF

3.30 Firms are currently required under the CRR to apply a 100% CF to certain types of commitments that are considered to have certain or near certain drawdown. This is broadly aligned with the Basel 3.1 standards.

3.31 While the PRA does not propose to make any changes to this list of commitments subject to a 100% CF, it does propose to clarify that ‘other commitments’ with certain drawdown would be subject to a 100% CF.

CF calibration for note issuance facilities (NIFs) and revolving underwriting facilities (RUFs)

3.32 Under the CRR, firms using the SA currently apply a 50% CF to NIFs and RUFs, whereas firms using the FIRB approach currently apply a 75% CF. Following analysis conducted by the BCBS, the Basel 3.1 standards reduce the FIRB approach CF for NIFs and RUFs from 75% to 50% in order to align with the SA.

3.33 The PRA proposes to align with the Basel 3.1 standards and implement a 50% CF for NIFs and RUFs.

CF calibration for unconditionally cancellable commitments (UCCs)

3.34 Under the Basel 3.1 standards, UCCs include: (i) commitments that are unconditionally cancellable at any time without prior notice; and (ii) commitments that provide for automatic cancellation due to a deterioration in the borrower’s creditworthiness.^{footnote [9]} The PRA proposes to align with this classification of UCCs.

3.35 The Basel 3.1 standards increase the CF for UCCs from 0% to 10%. The BCBS recognised that while some commitments are unconditionally cancellable by firms, in practice, other factors such as consumer protection laws, risk management capabilities, and reputational risk can prevent or discourage firms from cancelling a commitment. This means that UCCs are not riskless.

3.36 The PRA considers that non-zero RWAs should apply to commitments that are unconditionally cancellable and agrees with the justification provided by the BCBS. The PRA, therefore, proposes to increase the CF for UCCs from 0% to 10%.

CF calibration for ‘other commitments’

3.37 The ‘other commitments’ category in the Basel 3.1 standards refers to commitments that are not NIFs or RUFs, are not subject to a 100% CF under the SA, and are not UCCs.

3.38 Other commitments are currently assigned a 20% CF under the SA if they have an original maturity of less than one year and a 50% CF otherwise. Under the FIRB approach, other commitments are currently assigned a 75% CF if they are classed as ‘credit lines’, otherwise the SA CFs apply.

3.39 The Basel 3.1 standards introduce a CF of 40% for other commitments regardless of maturity under the SA and the FIRB approach. After reviewing the empirical evidence, the PRA considers that a somewhat higher CF than in the Basel 3.1 standards is justified for these commitments.

3.40 First, the PRA considered evidence set out in the BCBS’s 2014 CP, which indicated that a CF in the range of 50% to 75% is justified for other commitments.^{footnote [10]} While the BCBS ultimately decided to set a lower CF, the PRA considers that the evidence in the BCBS 2014 CP is consistent with UK industry experience of realised conversion rates for other commitments.

3.41 Second, the PRA has considered information available to it relating to realised conversion rates for mortgage offers which would typically be allocated to the other commitments category before the loan is drawn down. Based on this information, the PRA considers a 40% CF is likely to be an under-estimation of the risk of these commitments coming on balance sheet.

3.42 In view of the above, the PRA proposes to set a 50% CF for other commitments which would apply under all credit risk approaches, except where modelling is permitted under the AIRB approach.

Question 4: Do you have any comments on the PRA’s proposed definition of commitment and proposed CFs for commitments?

Issued off-balance sheet items

3.43 Under the Basel 3.1 standards, issued off-balance sheet items can be identified under three broad categories: (i) direct credit substitutes, including standby letters of credit serving as financial guarantees for loans and securities; (ii) self-liquidating trade letters of credit (these include those with a maturity less than one year and those with a maturity greater than or equal to one year); and (iii) ‘other transaction-related contingent items’ such as performance bonds, bid bonds, warranties, and transaction-related standby letters of credit that are not credit substitutes.

Direct credit substitutes (including standby letters of credit)

3.44 Firms are currently required under the CRR to apply a 100% CF to certain types of issued off-balance sheet items that are considered to be direct credit substitutes. The PRA proposes to maintain this approach.

Short-term self-liquidating trade letters of credit (maturity less than one year)

3.45 Firms are currently required under the CRR to apply a 20% CF to trade finance documentary credits where the underlying shipment acts as collateral and to other self-liquidating trade finance collateral. The definition of trade finance set out in the CRR means this treatment can generally only be applied to exposures with a fixed maturity of less than one year.

3.46 The Basel 3.1 standards contain a similar provision. A 20% CF is applied to short-term self-liquidating trade letters of credit arising from the movement of goods where short-term is defined as being below one year. The PRA proposes to adopt the Basel 3.1 standards language and state explicitly that the 20% CF should be applied to all short-term self-liquidating trade letters of credit arising from the movement of goods with an original maturity of less than one year. The PRA considers that this proposed revised language would not result in a substantive change from the existing CRR treatment.

Self-liquidating trade letters of credit (maturity greater than or equal to one year)

3.47 The PRA also proposes to clarify the treatment for self-liquidating trade letters of credit with a maturity greater than one year, as this is not specified in the CRR. The PRA considers that these items should be assigned a higher CF than those items with maturity less than one year, in line with that applied to ‘transaction-related contingent items’ (set out below), because it considers that this would align with the Basel 3.1 standards and reflect the additional risk of longer maturity items. The PRA, therefore, proposes that a 50% CF would apply to self-liquidating trade letters of credit with a maturity of greater than one year.

Other transaction-related contingent items

3.48 ‘Transaction-related contingent items’ relate to the movement of goods. Under the Basel 3.1 standards, ‘other transaction-related contingent items’ includes guarantees, warranties, and standby letters of credit that do not have the characteristics of credit substitutes.

3.49 The Basel 3.1 standards apply a 50% CF to ‘other transaction-related contingent items’. This contrasts to the CRR approach where a 20% CF is applied to warranties and guarantees without credit substitute characteristics.

3.50 The PRA proposes to align with the Basel 3.1 standards and apply a 50% CF to the following items which it considers to be transaction-related contingent items:

• documentary credits issued or confirmed;
• documentary credits in which the underlying shipment acts as collateral and other self-liquidating transactions with maturity equal to or greater than one year (as noted above);
• warranties (including tender and performance bonds and associated advance payments and retention guarantees), and guarantees not having the character or credit substitutes;
• irrevocable standby letters of credit not having the character of credit substitutes;
• shipping guarantees, customers, and tax bonds; and
• other issued off-balance sheet items that do not have the character of credit substitutes.

3.51 The PRA has reviewed relevant empirical data and analysis relating to these transaction-related contingent items. In its assessment, the PRA has been mindful of the following considerations:

• the CF should reflect the probability of a ‘trigger event’^{footnote [11]} occurring, which would result in the exposure moving on balance sheet, conditional on a default having occurred; and
• the CF should be reflective of behaviour in downturn conditions.

3.52 Based on its assessment, the PRA considers that the existing 20% CF does not fully reflect the risks of these items, including in relation to the points set out in the prior paragraph.

3.53 Therefore, the PRA proposes to introduce a 50% CF for transaction-related contingent items, in line with the Basel 3.1 standards. The PRA also proposes to clarify that other issued off-balance sheet items that do not have the character of credit substitutes should also be assigned to this category.

Question 5: Do you have any comments on the PRA’s proposed CFs for issued off-balance sheet items? Do you have any additional data that the PRA could assess? In particular, do you have any data relating to the appropriate CF for ‘transaction-related contingent items’ in downturn conditions?

PRA objectives analysis

3.54 The PRA considers that the proposed approaches for determining the appropriate CFs for off-balance sheet items would advance its primary objective of safety and soundness. The PRA’s proposals to increase existing CRR CFs for ‘other transaction-related contingent items’ to align with the Basel 3.1 standards, and to apply higher CFs for ‘other commitments’ than specified in the Basel 3.1 standards, have been formulated in light of available data and reflect what the PRA considers an appropriate calibration to help ensure firms are adequately capitalised against off-balance sheet risks. The PRA also considers that the proposed increase in CFs for UCCs from 0% to 10% would advance its primary objective as it considers a 0% CF for UCCs to be imprudent given the non-zero risk of UCCs coming on balance sheet.

3.55 The PRA considers that the proposals set out in this section should facilitate effective competition, particularly as a result of the proposed revised definition of commitment. This is because the PRA has an existing expectation that firms currently using the AIRB approach need only recognise an exposure once a customer can drawdown the facility. By withdrawing this expectation and proposing a new definition of commitment based on the contractual obligation, the PRA would bring firms applying the AIRB approach more in line with firms applying the SA or the FIRB approach. As a result, the introduction of a common definition of commitment across the SA and the IRB approaches is expected to remove an existing competitive advantage for firms that use the AIRB approach.

‘Have regards’ analysis

3.56 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Sustainable growth (FSMA regulatory principles) and growth (HMT recommendation letters):

• The PRA does not expect the proposals in this section to adversely impact sustainable growth. The proposed higher CFs for other commitments, other transaction-related contingent items, and UCCs are likely to increase RWAs for these items. However, the PRA considers this to be justified in order to help ensure adequate risk capture. If RWAs do increase, this may benefit sustainable growth to the extent that RWAs are currently too low. This is because the PRA considers that applying RWAs that adequately reflect risk is essential for sustainable lending and, therefore, sustainable growth.

2. Competitiveness (HMT recommendation letters) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA expects other jurisdictions to apply broadly similar CFs for off-balance sheet items and, therefore, the proposals should not adversely impact competitiveness. The proposal to apply a CF for other commitments that is somewhat higher than that set out in the Basel 3.1 standards could potentially impact the relative standing of the UK. This is because the commitments to which the other commitments CF would be applied include wholesale commitments, which are typically international in nature. The PRA considers that the potential impact on relative standing is justified from a safety and soundness perspective. The PRA also notes that it expects other jurisdictions, for example the EU (based on the European Commission’s proposals), to apply a 50% CF for ‘transaction-related contingent items’ in line with the Basel 3.1 standards.

3. Relevant international standards (FSMA CRR rules):

• The PRA considers its proposals to be broadly aligned with the Basel 3.1 standards. While the PRA proposes a CF for other commitments that is higher than that set out in the Basel 3.1 standards, the PRA considers that this aligns with international standards because the Basel 3.1 standards envisage that national supervisors may choose to set stricter requirements.

4. Finance for the real economy (FSMA CRR rules):

• The PRA considers that the proposed changes in CFs for other commitments and other transaction-related contingent items may have some impact on certain business lines. For transaction-related contingent items, there is a risk that the increase in CFs may impact firms’ willingness to provide these facilities which, in turn, may impact economic activity. For other commitments, the proposed CF would result in an increase in RWAs for short-term commitments under the SA and a reduction in RWAs for credit lines under the FIRB approach.

Exposures to central governments and central banks, regional governments and local authorities, public sector entities (PSEs), and multilateral development banks (MDBs)

3.57 This section sets out the PRA’s proposals for implementing the Basel 3.1 standards for the SA to credit risk for exposures to ‘central governments and central banks, regional governments and local authorities, public sector entities (PSEs), and multilateral development banks (MDBs)’.

Exposures to central governments and central banks, regional governments and local authorities, and PSEs

3.58 The Basel 3.1 standards do not introduce material changes to the existing Basel standards for risk-weighting exposures to central governments and central banks, regional governments and local authorities, and PSEs, although there are some structural changes in how the risk weights are presented. Risk weights in the Basel 3.1 standards are generally based on external ratings where available; however, some risk weight ‘overrides’, which typically result in lower risk weights being applied, are permitted at national discretion subject to certain conditions being met.

3.59 The CRR broadly aligns with the Basel 3.1 standards for risk-weighting exposures to UK central governments and central banks, regional governments and local authorities, and PSEs that are denominated and funded in Pound Sterling (GBP). The risk weights for third-country exposures to these counterparties are also generally determined by external ratings. However, a preferential treatment for third-country exposures is available in certain circumstances, based partly on an equivalence assessment of each third-country’s banking regulation, which is determined by HMT. This preferential treatment broadly aligns with the national discretion permitted within the Basel 3.1 standards to override risk weights that are based on external ratings. For PSEs, the CRR equivalence assessment determines whether a ratings based approach can be used instead of a flat 100% risk weight.

3.60 HMT does not intend to revoke the relevant CRR sub-articles that contain the equivalence-related tests for central governments and central banks (Article 114(7)), regional governments and local authorities (Article 115(4)), and PSEs (Article 116(5)). Therefore, the equivalence-related sub-articles, including the parts relating to both the equivalence assessment itself and the risk weight treatment for exposures in jurisdictions that are deemed equivalent, would remain in the CRR.

3.61 The PRA understands that HMT intends to transfer the remaining parts of CRR Articles 114, 115, and 116 to the PRA. The PRA does not propose any substantive policy changes to these sub-articles.^{footnote [12]}

3.62 The PRA, however, proposes not to maintain the option in CRR Article 116(4) to treat exposures to UK PSEs as exposures to the central government, regional government or local authority of the UK where, in the PRA’s opinion, there is no difference in risk between such exposures because of the existence of an appropriate guarantee by the central government, regional government, or local authority. The PRA does not currently identify any such exposures, as it considers UK PSE exposures to not be of the same risk as central government, regional government, or local authority exposures. Therefore, the proposal not to maintain this option would result in no change to risk weight treatments.

3.63 The PRA also proposes that sub-paragraph 2 of CRR Article 115 is amended to only capture the UK’s devolved administrations. This maintains the PRA’s view that the UK’s devolved administrations are the only regional governments or local authorities that should be treated as exposures to the UK central government.

3.64 The PRA has concerns that the proposed SA risk weights for exposures to central governments, central banks, regional governments, and local authorities can potentially result in an underestimation of RWAs. Such undercapitalisation can stem from the 0% risk weight applied to highly rated central government and central bank exposures and the equivalence-based risk weight overrides.

3.65 The PRA currently has a Pillar 2A methodology for central government and central bank exposures that are risk-weighted under the SA. The methodology is based on IRB benchmark risk weights and is designed to address the potential undercapitalisation of risk arising from the SA. The PRA’s proposal in this CP to remove the IRB modelling of central government and central bank exposures (see Chapter 4) would mean this benchmark cannot be updated in future as there would be no IRB risk weights on which to base the benchmark. The PRA’s existing Pillar 2A methodology also does not cover regional governments and local authorities. The PRA, therefore, intends to consult in the future, as part of the wider Pillar 2 review discussed in Chapter 10 – Interactions with the PRA’s Pillar 2 framework, on a potential Pillar 2 methodology to help ensure the adequate capitalisation of these exposures.

3.66 The PRA also intends to consider whether it would be appropriate to consult on any changes to the treatment of these exposures under the large exposures regime.

Exposures to multilateral development banks (MDBs)

3.67 The PRA proposes to introduce a definition of MDBs which clarifies the scope of MDB exposures.

3.68 The PRA proposes to retain the CRR list^{footnote [13]} of MDBs that are eligible for a 0% risk weight. The PRA also proposes to maintain the CRR approach that the Inter-American Investment Corporation, the Black Sea Trade and Development Bank, the Central American Bank for Economic Integration, and the CAF-Development Bank of Latin America shall be considered MDBs.

3.69 The PRA proposes a change to the treatment of MDBs that are not eligible for a 0% risk weight to align with the Basel 3.1 standards. Under the CRR, exposures to MDBs that are not assigned a risk weight of 0% are treated in the same manner as exposures to institutions. Unrated MDBs are risk-weighted based on the external rating of the sovereign.

3.70 The PRA proposes that externally rated MDB exposures that are not eligible for a 0% risk weight would be classified as ‘exposures to other MDBs’ and that their risk weights would be determined by the applicable CQS.^{footnote [14]} For exposures to all other MDBs that are unrated, the PRA proposes to apply a flat risk weight of 50% in order to align with the Basel 3.1 standards.

Question 6: Do you have any comments on the PRA’s proposed approach to exposures to central governments and central banks, regional governments and local authorities, PSEs, and MDBs?

PRA objectives analysis

3.71 The PRA proposes to maintain the existing approach (in substantive terms) under the CRR for exposures to central governments and central banks, regional governments, and local authorities in order to advance the PRA’s primary objective.

3.72 The PRA’s proposals for MDBs support the PRA’s primary objective as the changes should maintain risk-sensitivity in RWAs as risk weights would be based on external ratings where available. While the proposed flat 50% for unrated MDBs could reduce RWAs for riskier MDB exposures, the PRA does not expect the impact to be material.

3.73 By broadly aligning with the Basel 3.1 standards, the PRA considers that the proposals set out in this chapter are consistent with its secondary competition objective as all firms using the SA would be subject to consistent requirements. As set out in Chapter 4, the PRA also proposes to require all central government and central bank exposures to be risk-weighted under the SA and, therefore, prohibit modelling of these exposures under the IRB approach. This should improve competition between firms using the SA and firms with IRB permissions.

‘Have regards’ analysis

3.74 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Competitiveness (HMT recommendation letters) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA expects other jurisdictions to apply broadly similar requirements to exposures to central governments banks and central banks, regional governments and local authorities, PSEs, and MDBs. As a result, the proposals set out in this section should support the competitiveness of the UK. The European Commission proposes to maintain the status quo position in the CRR.

2. Relevant international standards (FSMA CRR rules):

• The PRA considers that its proposals would be broadly aligned with the Basel 3.1 standards, so the proposed changes should help ensure that the UK meets international standards. For PSEs, the PRA proposes not to treat any exposures to UK PSEs as exposures to the UK central government, a regional government, or a local authority in the UK. This aligns with the Basel 3.1 standards, as the PRA proposes to not implement the Basel 3.1 national discretion to treat PSEs as exposures to the sovereign in certain circumstances.

3. Finance for the real economy (FSMA CRR rules):

• The PRA considers that the proposals should have no adverse impacts on the provision of finance for the economy as they broadly maintain the existing approach. The PRA proposes changes to the treatment of MDBs but does not consider these changes to have adverse impacts on the provision of finance for the economy.

Exposures to institutions and covered bonds

3.75 This section sets out the PRA’s proposed changes to the SA to credit risk for exposures to ‘institutions’ and ‘covered bonds’.

Exposures to institutions

Rated institutions

3.76 The PRA proposes to retain the CRR external credit rating approach (ECRA) for institutions. Under this approach, exposures to institutions are assigned a risk weight according to the CQS. The PRA also proposes to continue to permit a more favourable treatment for exposures to institutions that are short-term exposures.

3.77 The PRA proposes to introduce a new requirement that aligns with the Basel 3.1 standards, such that external credit ratings used for regulatory purposes should not incorporate assumptions of implicit government support, unless the rating refers to an institution owned by or set up and sponsored by its central government, regional government, or local authority.

3.78 The PRA proposes to maintain the same risk weights for rated institutions (including for short-term exposures) as in the CRR, with the exception of a lower risk weight for exposures to institutions in CQS 2 (a 30% risk weight compared to a 50% risk weight under the CRR) in order to introduce greater risk-sensitivity. This aligns with the Basel 3.1 standards.

Table 1: Overview of the proposed SA risk weights for exposures to rated institutions

3.79 The PRA also proposes to make the following changes to the SA treatment for exposures to institutions:

• to base maturity on original maturity rather than residual maturity for determining short-term exposures;
• to allow exposures to institutions to receive risk weights for short-term exposures, where the original maturity of the exposure is six months or less and the exposure arose from the movement of goods across national borders;
• to require firms to conduct due diligence. If a firm’s due diligence analysis identifies higher risk characteristics than implied by a counterparty’s external rating(s), the firm would be required to assign the exposure to a CQS at least one higher than determined by the external rating. Proposed requirements for undertaking due diligence are covered in the ‘External credit ratings and due diligence’ section of this chapter;
• to not maintain the CRR provision^{footnote [15]} that exposures to institutions of a residual maturity of three months or less that are denominated and funded in the national currency of the borrower shall be assigned a risk weight that is one category less favourable than the preferential risk weight assigned to exposures to the central government in the jurisdiction that the institution is incorporated; and
• to not maintain the CRR provision^{footnote [16]} that no exposures with a residual maturity of three months or less that are denominated and funded in the national currency of the borrower shall be assigned a risk weight less than 20%.

Unrated institutions

3.80 For exposures to an institution for which an external credit rating is not available (an ‘unrated institution’), the PRA proposes to introduce a new approach: the standardised credit risk assessment approach (SCRA). Under this approach, institutions are categorised into one of three grades (A, B, or C) depending on the institution’s ability to meet or exceed published minimum regulatory requirements,^{footnote [17]} and the firm’s internal assessment of the credit risk of the counterparty. The exposure is then assigned a risk weight depending on the grade, which in turn reflects its riskiness (see Table 2 below). The proposed treatment for exposures to unrated institutions removes the link between the risk-weighting of institutions and their sovereigns.

3.81 The PRA proposes that the SCRA would include a general preferential treatment for short-term exposures to unrated institutions, but one which is less preferential than under the CRR. The CRR currently applies a risk weight of 20% for exposures with an effective original maturity of three months or less, whereas under the SCRA the proposed risk weight applied to these exposures would be 20% for Grade A, 50% for Grade B, or 150% for Grade C.

Table 2: Overview of the proposed SA risk weights for exposures to unrated institutions

3.82 The PRA also proposes to make the following changes to the SA treatment for exposures to unrated institutions:

• to allow exposures to unrated institutions to receive risk weights for short-term exposures, where the original maturity of the exposure is six months or less and the exposure arose from the movement of goods across national borders; and
• to require that risk weights assigned to unrated institutions may not be less than the risk weight applicable to sovereign exposures in the jurisdiction where the unrated institution is incorporated, subject to certain conditions.^{footnote [19]}

Treatment of covered bonds

3.83 The PRA proposes to make two changes to the CRR treatment of covered bonds impacting: (i) the risk weight treatment for unrated covered bonds; and (ii) the application of due diligence requirements. These proposed changes align with the Basel 3.1 standards on the treatment of covered bonds under the SA.

The risk weight treatment for unrated covered bonds

3.84 Both the CRR and the Basel 3.1 standards base the risk weights for unrated covered bonds, in cases where the covered bonds meet the requirements for preferential treatment, on the risk weights that would apply to an exposure to the issuing institution. Consistent with the Basel 3.1 standards, the PRA proposes to introduce changes to risk weights for unrated covered bonds through a more risk-sensitive mapping from the issuing institution’s risk weight to the unrated covered bond risk weight. This is consistent with the proposal for the treatment of institutions, and the risk weight depends on whether the issuing institution is rated or not (as set out in the tables below). The PRA proposes that the risk weight for unrated covered bonds issued by rated institutions in CQS 2 is reduced from 20% to 15%, and that the risk weight for unrated covered bonds issued by rated institutions in CQS 3 is increased from 20% to 25%. The PRA considers this would introduce greater risk-sensitivity that aligns with the proposed ECRA and SCRA treatment for exposures to institutions.

Table 3: Proposed risk weights for exposures to unrated covered bonds (issuing institution: rated)

Table 4: Proposed risk weights for exposures to unrated covered bonds (issuing institution: unrated)

3.85 The PRA does not expect that the proposed risk weights for unrated covered bond exposures would have a material impact as SA firms’ unrated covered bond exposures are not material. Firms’ implementation costs would likely be small as the change relates purely to the assignment of exposures to CQS.

3.86 The PRA also proposes to clarify in a rule that the obligation to meet certain credit risk mitigation (CRM) requirements relating to immovable property collateralising covered bonds are only applicable where a firm is seeking to apply the preferential SA risk weight treatment for covered bonds. The PRA also proposes minor changes to the relevant CRM requirements themselves, which are set out in Chapter 5 – Credit risk mitigation.

Due diligence requirement for covered bonds

3.87 The PRA proposes to introduce new requirements under the SA that are designed to reduce firms’ mechanistic use of external credit ratings for risk-weighting covered bond exposures. The PRA proposes that firms should perform due diligence on covered bond exposures, in accordance with the ‘External credit ratings and due diligence’ section in this chapter. If a firm’s due diligence analysis identifies higher risk characteristics of an exposure than implied by a counterparty’s external rating(s), the firm would be required to assign the exposure to a CQS at least one higher than determined by the external rating.

Question 7: Do you have any comments on the PRA’s proposed changes to ECRA, the proposed introduction of SCRA for exposures to unrated institutions, and the proposed treatment of covered bonds?

PRA objectives analysis

3.88 The PRA considers its proposals in this section to further its primary objective of promoting safety and soundness. The proposed introduction of the SCRA removes the reliance on sovereign ratings when risk-weighting unrated institution exposures, removing an implicit assumption of government support. Instead, firms would be required to assess the direct credit risk of exposures to institutions. This should help ensure that risk weights better reflect the risk of the counterparty itself. Additionally, the introduction of new due diligence requirements for exposures to institutions and covered bonds should reduce the risk of firms mechanistically relying on external credit ratings and should help ensure risk weights more accurately reflect the actual risk of the exposures.

3.89 The PRA considers its proposals for exposures to institutions to facilitate its secondary competition objective. Increased risk-sensitivity in the SA risk weights for institutions may improve competition between SA and IRB firms to the extent that the SA firms would benefit from lower risk weights for lower risk exposures. The PRA considers its proposals for covered bonds would have limited impact on competition.

‘Have regards’ analysis

3.90 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Efficient and economic use of PRA resources (FSMA regulatory principles):

• The PRA expects the SCRA would increase the operational burden on firms relative to the existing approach in the CRR. That means supervisory resource may be required to help ensure that firms are conducting assessments correctly. The PRA does not expect this would be material as firms using the SA have limited exposures to unrated institutions. Costs to the PRA are estimated to be outweighed by safety and soundness benefits as the risk weights should better capture risk. The PRA does not expect the proposed risk weight treatment for covered bonds to have a significant impact on PRA resources.

2. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The PRA considers the proposals in this section to be proportionate. Where the PRA proposes measures that would increase RWAs, it considers this to be justified as it expects the revised requirements to better reflect the risks faced by firms.

3. Sustainable growth (FSMA regulatory principles) and growth (HMT recommendation letters):

• The PRA considers the proposals set out in this section would be unlikely to have a material impact on firms’ RWAs or balance sheet structures. The proposals should help to ensure that firms are able to continue lending and, therefore, support growth in the economy throughout the economic cycle, and that firms can be successfully resolved, if necessary, without significant disruption to the wider economy.

4. Competitiveness (HMT recommendation letters) and relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA considers that its proposals for exposures to institutions would not have a significant impact on the relative standing of the UK. The PRA expects other major jurisdictions to adopt the same reforms, in line with the Basel 3.1 standards. There may be instances of jurisdiction-specific adjustments (such as in the European Commission’s proposals)^{footnote [21]} that result in some of the PRA’s proposals being more conservative than in other jurisdictions. For example, the PRA’s proposal for short-term exposures to Grade C unrated institutions is more conservative than the European Commission’s proposal. However, the PRA’s proposals are aligned with Basel 3.1 standards and the PRA expects firms’ exposures to Grade C unrated institutions to be small so any difference in approach should have limited impact.

5. Relevant international standards (FSMA CRR rules):

• By implementing the reforms in the Basel 3.1 standards for exposures to institutions faithfully, and by removing existing deviations from the Basel standards in the CRR, the proposed changes would help to ensure that the UK meets international standards. The PRA’s proposal to apply due diligence requirements to covered bonds aligns with international standards and the PRA considers it be justified on safety and soundness grounds.

Exposures to corporates and specialised lending

3.91 This section sets out the PRA’s proposals for the treatment of ‘corporate’ and ‘specialised lending’ exposures under the SA to credit risk.

3.92 The PRA proposes to enhance the risk-sensitivity of the SA for calculating RWAs for corporate exposures. It seeks to achieve this by utilising the risk-sensitive ECRA approach where corporates are rated, by introducing greater risk-sensitivity for risk-weighting corporate exposures that are not rated, and by introducing a specific treatment for specialised lending exposures. The PRA also proposes some additional minor changes.

Corporate exposures

Approach to externally rated corporate exposures

3.93 The PRA proposes to continue to allow the use of external credit ratings for determining the RWAs applied to corporate exposures. The PRA also proposes to enhance risk-sensitivity by reducing the risk weight applicable to counterparties assigned to CQS 3 from 100% under the CRR to 75%. This proposal aligns with the Basel 3.1 standards, and continues to produce a risk-sensitive outcome where credit ratings are available. While the PRA does not propose changes to the risk weight treatment for exposures to corporates with a short-term credit rating, these existing requirements would be moved into Article 122 of the Credit Risk: Standardised Approach (CRR) Part for further clarity.

Table 5: Proposed risk weights for externally rated corporate exposures

3.94 As set out in the ‘External credit ratings and due diligence’ section, the PRA proposes to require firms to conduct due diligence on their corporate exposures. If a firm’s due diligence analysis identifies higher risk characteristics of an exposure than implied by its external rating(s), the firm would be required to assign the exposure to a CQS at least one higher than determined by the external rating.

Approach to unrated corporate exposures

3.95 The PRA proposes to permit two possible approaches to risk-weighting unrated corporate exposures: (i) a risk-sensitive approach that would be available where a firm has sound, effective and comprehensive strategies, systems and due diligence processes to accurately assess the risk of unrated corporate exposures, and (ii) a risk-neutral approach of a 100% risk weight where the risk-sensitive approach is too costly or complex for a firm to implement, or the firm lacks the capability to robustly assess the risk of unrated corporate exposures.

3.96 The PRA considers that the risk-sensitive approach would allow firms to distinguish, according to their internal credit rating systems, between ‘investment grade’ (IG) and ‘non-investment grade’ (Non-IG) unrated corporate exposures (including for direct credit exposures to unrated corporates and counterparty credit risk exposures to counterparties including funds).

3.97 The PRA proposes that under the risk-sensitive approach, 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%. The proposal aims to increase risk-sensitivity in the framework and better reflect the underlying risk of different unrated corporate exposures, while seeking to maintain an aggregate level of RWAs which is broadly consistent with that calibrated under the Basel 3.1 standards. That is, it is anchored around an average risk weight of 100% according to the PRA’s analysis of available firm data.^{footnote [22]}

3.98 Firms would be required to apply a consistent approach to risk-weighting all unrated corporate exposures meaning firms would either apply a 100% risk weight to all unrated corporate exposures, or would apply the risk-sensitive approach to all unrated exposures and assign a 65% or 135% risk weight depending on whether the exposure was IG or Non-IG.

3.99 The PRA proposes that a corporate entity should be deemed to be IG if it has adequate capacity to meet its financial commitments in a timely manner and that its ability to do so should be robust against adverse changes in the economic cycle and business conditions. Firms would be required to take into account the complexity of the corporate entity’s business model, performance against industry and peers, and risks posed by the entity’s operating environment. A corporate entity would not need to have securities outstanding on a recognised exchange to be assessed as IG. However, firms would need to have sufficient information to conduct adequate due diligence for the assessment of whether the corporate entity is IG. The PRA proposes to introduce an expectation that a firm’s determination of whether a counterparty is IG should broadly reflect a similar level of creditworthiness and risk as an exposure that has an external rating that would map to CQS 1, 2 or 3.

3.100 For unrated corporates that are classified as ‘corporate SMEs’, an 85% risk weight would apply as set out in the ‘Exposures to individuals and small and medium-sized enterprises’ section. Therefore, the two options above would not be available.

3.101 The PRA recognises that this proposal is a particularly important element of the package given the range of unrated corporate exposures held by firms. It is, therefore, important that the risk-sensitive approach is calibrated to apply appropriate risk weights to IG and Non-IG exposures. As set out in the ‘have regards’ analysis below, the PRA has used the data it has available to develop a proposal that it considers would in aggregate achieve a similar outcome to the Basel 3.1 standards, while introducing risk-sensitivity and allowing firms to benefit from a lower risk weight for IG unrated corporate exposures. However, it would particularly welcome any additional empirical evidence that firms, both those currently using the SA and those using the IRB approach, can provide in respect of the appropriateness of the proposed calibration of risk weights for both IG and Non-IG unrated corporate exposures.

3.102 The PRA proposes that the risk-sensitive approach can only be used by a firm using the SA where it has applied for permission and permission has been granted by the PRA. Permission to use the risk-sensitive approach would only be granted where a firm can evidence sound processes, systems, and due diligence practices for credit risk that enable it to adequately identify and manage credit and counterparty credit risk.

3.103 The risk-neutral approach of a flat 100% risk weight would be available to firms that choose not to apply for permission to use the risk-sensitive approach, or where the PRA deems that the conditions to grant permission are not met.

3.104 The PRA proposes that for the purposes of calculating the proposed output floor (see Chapter 9), a firm with an existing permission to use the IRB approach for the corporate exposure class may use either the risk-neutral approach (100% risk weight) or the risk-sensitive approach (65% or 135% risk weight) without having to apply for a separate permission. These firms would need to notify the PRA of the approach they choose to apply, notify the PRA if they change the approach they use, and apply the chosen approach consistently for all unrated corporate exposures.

3.105 Firms with IRB permission for risk-weighting the corporate exposure class may use their approved IRB model as one of the inputs to determine whether an unrated corporate entity should be deemed to be IG. However, the IRB model should not be the sole determinant of whether the exposure is IG and these firms would still be required to make the IG assessment based on the proposed definition of IG. The PRA notes that this is not intended to change the approach to modelling these exposures under IRB or the PRA’s standards for IRB approval.

3.106 The PRA proposes to add expectations to the proposed SS10/13 – ‘Credit risk: Standardised approach’ regarding the proposed approach to the permission process and the identification of IG exposures.

Question 8: Do you have any comments on the PRA’s proposed approach for exposures to unrated corporates? Do you have any evidence – quantitative or qualitative – to support your comments, particularly in respect of the proposed 135% risk-weight for Non-IG exposures?

Specialised lending exposures

3.107 The PRA proposes to introduce a definition of specialised lending exposures and to define sub-classes of specialised lending exposures (‘commodities finance’, ‘object finance’, and ‘project finance’) to more closely align the SA with the IRB approach.

3.108 Consistent with the Basel 3.1 standards, the PRA also proposes new risk weights for certain specialised lending exposures to increase risk-sensitivity. These are dependent on whether an issue-specific external rating is available.^{footnote [23]}

3.109 Where an issue-specific external rating is available, the PRA proposes that the risk weight should be determined by the issue-specific external rating (see Table 5 above for the proposed risk weights). If an issue-specific external rating is not available, the firm would risk-weight the specialised lending exposure based on the sub-class of the exposure: commodities finance, object finance, or project finance.

3.110 For object finance and commodities finance exposures that are unrated, the PRA proposes that a 100% risk weight should be assigned. The PRA considers that these risk weights reflect the broad universe of underlying assets with different risk profiles that could fit within the sub-classes of specialised lending exposures and, broadly, should help ensure an adequate level of RWAs relative to the risk.

3.111 For project finance exposures that are unrated, the PRA proposes to differentiate between exposures that are within a pre-operational versus operational phase. To be deemed to be in the operational phase, a project finance entity would have: a positive net cash flow covering all contractual obligations relating to the completion of the project, and declining long-term debt. If these criteria are not met, the exposure would be classified as being in the pre-operational phase. The PRA proposes that an unrated project finance exposure in the operational phase should be risk-weighted at 100% and an exposure that is in the pre-operational phase should be risk-weighted at 130%, reflecting the greater risk.

3.112 The PRA also proposes to introduce further risk-sensitivity for unrated project finance exposures that are in the operational phase and are considered ‘high-quality’. The criteria for being considered ‘high-quality’ include whether the exposure is to an entity that is able to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions; and that conditions covering the entity’s revenue and creditor protection are satisfied. Where this is the case, the PRA proposes that the exposures should be risk-weighted at 80%.

Question 9: Do you have any comments on the PRA’s proposed approach for specialised lending exposures, or data that is relevant to this analysis?

CRR infrastructure support factor

3.113 The CRR infrastructure support factor allows firms to apply a 0.75 multiplier to RWAs for certain exposures that are allocated to the corporate exposure class or specialised lending exposure class. Defaulted exposures are excluded and the criteria in CRR Article 501a need to be satisfied. It applies to exposures under the SA and IRB approaches.

3.114 As noted above, the PRA proposes to apply a more risk-sensitive approach to project finance exposures – largely the same exposures to which the CRR infrastructure support factor may be applied. The more risk-sensitive approach includes a 20% lower risk weight – similar in magnitude to that of the infrastructure support factor – for ‘high-quality’ project finance exposures in the operational phase.

3.115 The PRA considers that, given the proposed project finance treatment includes a broadly similar discount to the infrastructure support factor, maintaining the support factor could result in an unjustified reduction in RWAs for qualifying exposures. It would result in a ‘doubling-up’ of risk weight concessions if firms apply both the preferential risk weights for high-quality project finance and the support factor. The PRA considers that the proposed project finance treatment would set reasonably lower but prudent risk weights for exposures to infrastructure projects and the proposed approach may in fact broaden the scope of the lower risk weight compared to the existing support factor. Therefore, the PRA proposes not to maintain the infrastructure support factor under the SA. However, the PRA has a relatively small evidence base for the calibration of risk weights in this area, including on the impact of the support factor on lending to infrastructure (partially because the support factor is relatively new), and considers it important to help ensure that it has a broad range of evidence on which to support its analysis. Therefore, it particularly invites firms to present quantitative or qualitative evidence on this topic during the consultation.

Question 10: Do you have any comments on the PRA’s proposed removal of the infrastructure support factor? Do you have any evidence – quantitative or qualitative – to support your comments?

PRA objectives analysis

3.116 The PRA’s overall proposals for corporate exposures aim to increase risk-sensitivity in the approach for rated and unrated corporate exposures. The PRA considers its proposal relating to unrated corporate exposures furthers the PRA’s primary safety and soundness objective by introducing additional risk-sensitivity ie balancing lower risk weights for lower risk exposures with higher risk weights for higher risk exposures. The proposed introduction of a permission process to allow SA firms to apply the risk-sensitive approach for unrated corporates is intended to help ensure that only those firms that have adequate risk management capability to robustly distinguish between IG and Non-IG exposures would be permitted to use the approach. This should help ensure it is applied prudently.

3.117 The PRA considers that the proposal to introduce new definitions and risk weights for specialised lending advances its primary objective of safety and soundness through enhanced risk-sensitivity, and that the proposed risk weights should be broadly reflective of the relative risks across different specialised lending categories. The proposal to remove the infrastructure support factor would also advance the PRA’s primary objective given that the PRA considers the proposed approach for project finance exposures is more risk-sensitive, and removing the support factor avoids an unwarranted double-discount on RWAs.

3.118 The PRA considers that the proposals regarding corporate exposures support the PRA’s secondary competition objective of facilitating effective competition. The proposals would provide all SA firms the possibility of risk-weighting rated and unrated corporate exposures using the same method, and the same approaches would be available to SA firms and firms with IRB permissions using SA for the purpose of calculating the proposed output floor. The risk-neutral proposal for unrated corporate risk weights would provide a simple low-cost method for firms where assessing the IG and Non-IG distinction is deemed too complex and costly.

3.119 The proposals to introduce new definitions relating to specialised lending should also facilitate effective competition by achieving greater consistency in approach between firms using the SA and those using the IRB approach to calculate RWAs.

‘Have regards’ analysis

3.120 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules):

• The proposal for rated corporate exposures would align with the Basel 3.1 standards for corporate exposures where an external credit rating is available.
• For unrated corporate exposures, the Basel 3.1 standards require that jurisdictions that allow the use of external credit ratings for regulatory purposes (as proposed by the PRA) should require firms to risk-weight unrated corporate exposures at 100%. The PRA’s proposed approach for unrated corporate exposures aims to maintain a broadly similar overall level of resilience to the 100% risk weight in the Basel 3.1 standards (based on data submitted to the PRA and public information) while increasing risk-sensitivity. The consistency between the PRA’s proposed calibration and the calibration in the Basel 3.1 standards at an aggregate level would depend on how many SA firms are granted permission by the PRA to use the risk-sensitive approach, and the split between IG and Non-IG exposures in those firms’ portfolios.
• The proposal to not maintain the infrastructure support factor would align the PRA with the Basel 3.1 standards. The PRA expects and understands that most other jurisdictions would also align with the Basel 3.1 standards as they do not have an infrastructure support factor.
• All other proposals in this section align with the Basel 3.1 standards.

2. Relative standing of the UK as a place to operate (FSMA CRR rules) and competitiveness (HMT recommendation letters):

• The PRA considers that its proposals support the competitiveness of UK firms in lending to rated corporates. The proposal for rated corporate exposures aligns with international standards for jurisdictions that allow the use of external credit ratings for regulatory purposes, and, therefore, should support the relative standing of the UK. The proposed risk weights assigned to some rated corporate exposures may be lower than those in jurisdictions that do not allow the use of external credit ratings for regulatory purposes (eg the USA) given that the Basel 3.1 standards apply a minimum 65% risk weight in such cases (if identified as IG). It is also the case that the proposed risk weights assigned to some rated corporate exposures may be higher than those in jurisdictions that do not allow the use of external credit ratings for regulatory purposes, particularly if the corporate is mapped to CQS 3 or above.
• For unrated corporates, the PRA’s risk-sensitive proposal for IG exposures would support the UK’s relative standing as it applies a similar risk weight as being proposed in some other jurisdictions for unrated corporate exposures that are assessed as IG. However, the PRA acknowledges that where a firm uses the risk-sensitive approach for Non-IG exposures, it would apply a higher risk weight for these exposures than in some other jurisdictions, for example, in the EU, based on the European Commission’s proposals,^{footnote [24]} and a lower risk weight than in others, for example Canada, based on the Office of the Superintendent of Financial Institutions’ (OSFI’s) policy.^{footnote [25]}
• While there may be instances of jurisdiction-specific adjustments (such as the European Commission’s proposals), the PRA’s proposals for specialised lending should be broadly consistent with the likely approach of most other jurisdictions, which would support the relative standing of the UK. The UK treatment of specialised lending may be more conservative, but the PRA considers that this is necessary for safety and soundness.

3. Different business models (FSMA regulatory principles):

• The PRA acknowledges that where firms apply the risk-sensitive approach to risk-weighting unrated corporate exposures, the proposal is likely to have a greater impact on firms with material lending to Non-IG unrated corporates. This is because they would apply a 135% risk weight to such exposures instead of the 100% risk weight in the Basel 3.1 standards. However, firms have the option to apply the risk-neutral approach, which applies a 100% risk weight, instead of seeking to use the risk-sensitive approach. Also, it is likely that firms that apply for permission to use the risk-sensitive approach would incur operational costs. However, the optionality in the possible approaches should allow firms to select an approach that they deem to be most appropriate for their business model, subject to obtaining permission from the PRA.

4. Climate change (FSMA CRR rules, HMT recommendation letters):

• The PRA considers that the climate change considerations are nuanced and complex for the specialised lending proposals. The proposal for object finance does not distinguish between high or low emission objects and, therefore, while there would be no preferential treatment for exposures that directly contribute to net zero emissions, there would also be no active encouragement of lending to high emission object finance. The proposal for project finance should capture financing of environmental infrastructure projects, and the PRA considers that the proposed approach may apply to a wider range of exposures than covered by the CRR infrastructure support factor. Therefore, the project finance proposal could make a positive contribution towards the net zero emissions target.

5. Finance for the real economy (FSMA CRR rules):

• The PRA considers that for unrated corporates that primarily seek finance from firms that use the SA, the impact of the proposals on finance for the economy would depend both on: (i) the credit quality of the corporate itself; and (ii) whether the firm uses the risk-neutral (100% risk weight) or risk-sensitive (65% or 135% risk weight) approach. If the firm uses the proposed risk-sensitive approach, risk weights for IG unrated corporates would reduce compared to the position under the CRR while risk weights for Non-IG unrated corporates would increase. This could potentially increase the provision of finance by SA firms to lower-risk unrated corporates and decrease the provision of finance to higher-risk unrated corporates. There would be no change to the existing position in respect of firms that use the 100% risk weight for all unrated corporate exposures.
• For firms with IRB permissions applying the SA risk weights for the purpose of the proposed output floor, the impact of the PRA’s proposals on risk weights, and the potential impact on finance for the economy, would depend on how the SA risk weights compare to the firm’s modelled risk weight for any given unrated corporate exposure, and whether the output floor is binding on an aggregate RWA basis (see Chapter 9). For very low-risk unrated corporate exposures, the PRA expects the proposed 65% or 100% SA risk weights would often be higher than modelled risk weights. For very high-risk unrated corporate exposures, the PRA expects that the proposed 100% or 135% SA risk weights would often be lower than modelled risk weights. The aggregate impact on RWAs would depend on whether a firm has more exposure to relatively lower- or higher-risk unrated corporate exposures. The provision of finance to any specific unrated corporate could, however, be impacted. For unrated corporate exposures around the IG/Non-IG boundary, the difference between the SA risk weights under the risk-sensitive approach and modelled risk weights is likely to be case-specific with the SA risk weights being higher than modelled risk weights for some exposures and lower for others.
• Overall, while the PRA considers that there is some potential for its proposals to impact finance to the economy, it expects the impact at the system-wide level would be relatively limited. The impact of the PRA’s proposal would likely vary across corporates of different levels of risk, depending on the relative conservatism of the PRA’s proposed risk weights compared to existing SA or IRB risk weights for any specific exposure.
• The PRA also considers that the impact of changes in RWAs on lending to corporates is nuanced and that there is not a direct relationship between RWAs and lending decisions. The provision of finance to mid-market unrated corporates is also dependent on other factors such as relationships, locality, and sector-expertise, which influence borrower and lender decisions and create competitive advantages separate to the impact of the regulatory capital regime.

Exposures to individuals and small and medium-sized enterprises

3.121 This section sets out the PRA’s proposed changes to the SA to credit risk for lending to individuals and small businesses. This section is split into three parts:

• exposures to small and medium-sized enterprises (SMEs);
• the SA treatment of ‘regulatory retail’ exposures (excluding real estate); and
• the SA treatment for ‘retail’ exposures with currency mismatch.

Exposures to SMEs

3.122 The PRA proposes changes to the treatment of exposures to SMEs, reflecting the Basel 3.1 standards, including the introduction of a new ‘corporate SME’ exposure sub-class and the introduction of a new risk weight treatment for regulatory retail exposures. The PRA proposes to not maintain the CRR SME support factor under both the SA and IRB approaches for credit risk (see Chapter 4). In turn, the PRA proposes to maintain the lower CRR risk weight for retail SME exposures and to introduce a new lower risk weight for unrated corporate SME exposures to align with the Basel 3.1 standards.

CRR SME support factor

3.123 The CRR SME support factor was originally introduced to limit disruption to the flow of credit to small businesses during the phase-in of stricter requirements following the 2008 global financial crisis. For exposures to businesses with a turnover below €‎50 million and total amount owed to the institution (excluding residential property) not exceeding €‎1.5 million, a support factor equal to 0.7619 could be applied to RWAs. This calibration was designed to broadly offset the additional capital required for the capital conservation buffer.

3.124 The SME support factor applies to all credit risk exposures included in the retail, corporates, or ‘secured by mortgages on immovable property’ exposure classes which satisfy a set of criteria (exposures in default are excluded). It applies to the SA and IRB approaches and was identified as a material deviation from the Basel standards in the 2014 BCBS Regulatory Consistency Assessment Programme (RCAP) assessment of the EU CRR.^{footnote [26]}

3.125 CRR II^{footnote [27]} expanded the scope of the SME support factor. The ceiling on total amount owed to the institution (excluding residential property) was raised to €‎2.5 million, and a new discount rate of 15% was made available in connection to any lending exceeding this threshold. These changes were nationalised into the CRR when the UK left the EU.

3.126 The CRR also allows certain qualifying SME exposures^{footnote [28]} to be risk-weighted as retail exposures, with a risk weight of 75% applied instead of the 100% risk weight applied to other unrated corporates. The PRA proposes to retain the existing lower 75% risk weight. This means there is currently a ‘doubling-up’ of preferential risk weights between the SME support factor, which is applied to exposures after they have been risk-weighted, and the existing lower risk weights in the CRR for SMEs. For example, firms can apply an SA risk weight as low as 57% to certain SME exposures by applying the SME support factor to the 75% risk weight for retail-qualifying SME lending. The PRA considers this to be imprudent and not risk-sensitive.

3.127 As noted in paragraph 3.133 below, the PRA proposes to implement a new risk weight treatment for unrated corporate SMEs^{footnote [29]} that is included in the Basel 3.1 standards. This would result in a lower risk weight of 85% for corporate SME exposures that do not qualify for the retail class. Given that this new discounted risk weight would apply to the same exposures as the SME support factor, maintaining the SME support factor would cause a ‘doubling-up’ effect for these exposures, which the PRA considers would result in imprudent risk weights.

3.128 The PRA also proposes to implement a new approach for ‘transactor exposures’ (discussed further in the ‘Transactors, non-transactors and other retail exposures’ part of this section) in the regulatory retail exposure class whereby a preferential risk weight treatment of 45% would be applied. Maintaining the SME support factor and introducing this new preferential risk weight would also cause a ‘doubling-up’ effect for these exposures, resulting in risk weights for unsecured SME lending as low as 34%, which the PRA considers imprudent.

3.129 The PRA has considered existing analysis on the effectiveness of the SME support factor, and while the PRA recognises conceptually the SME support factor could be a stimulus for supporting sustainable lending to SMEs, it considers the available evidence is mixed and inconclusive at a system level. For example, the European Banking Authority (EBA) analysis found that there was no conclusive evidence that the SME support factor provided additional stimulus for lending to SMEs compared to large corporates.^{footnote [30]}

3.130 On balance, the PRA is of the view that retaining the SME support factor could be inconsistent with the PRA’s primary objective, and, therefore, proposes to remove it under the SA. When combined with the lower SA risk weights for SME exposures, it would result in RWAs that do not adequately reflect the risk of the exposures, which the PRA considers could pose a threat to the safety and soundness of firms.

3.131 Given the new risk weights the PRA proposes to introduce for corporate SME exposures and ‘retail transactor’ exposures, the combined impact of the proposals would likely be to increase RWAs for some SME exposures and reduce them for other SME exposures. The impact on any given firm would depend on its lending mix.

3.132 The non-capital benefits of removing the SME support factor are also relevant to the PRA’s proposal. Removing the existing ‘mixing and matching’ between the BCBS and CRR risk weights would result in a simpler and more transparent approach for determining RWAs for SME exposures. Firms are currently required to calculate a support factor for individual SME counterparties that can vary over time depending on lending mix, exposure amounts, and amortisation profiles. The PRA considers the existing CRR approach unnecessarily complex and increases the risk of firms miscalculating RWAs.

Question 11: Do you have any comments on the PRA’s proposed removal of the SME support factor? Do you have any evidence – quantitative or qualitative – to support your comments?

Corporate SMEs

3.133 The PRA proposes introducing a new treatment for unrated corporate SME exposures.^{footnote [31]} Exposures to unrated corporate SMEs would receive a risk weight of 85%. This is a 15% reduction on the baseline 100% risk weight for unrated corporate exposures,^{footnote [32]} and would effectively replace the lowest end of the variable discount rate provided by the CRR SME support factor (also set at 15%). This change would also align the SA risk weights for these exposures more closely with the average risk weights that are typically derived under the IRB approach.

3.134 The PRA recognises that this new concession would not represent a full replacement for the SME support factor, as the SME support factor applies a variable discount rate – between 15% and 24% – determined by the type and total amount borrowed by a specific SME. The SME support factor can also apply to an eligible counterparty with an external rating, which the PRA considers inherently contradictory, whereas the new corporate SME sub-class would cover unrated SME corporates only. Nevertheless, the proposed corporate SME preferential risk weight would offset a material part of the impact of the proposed removal of the SME support factor.

3.135 Notwithstanding the mixed evidence around the effectiveness of SME concessions in supporting lending to SMEs, the PRA recognises the importance in avoiding potential disruption to the supply of credit to smaller businesses. In the context of the proposed removal of the SME support factor, and taking into account other existing operational requirements within the prudential framework, the PRA considers overall safety and soundness can be maintained while introducing an 85% risk weight for unrated corporate SMEs.

Treatment of regulatory retail exposures (excluding real estate)

Criteria for identifying regulatory retail exposures

3.136 The PRA proposes to introduce a number of changes to the criteria for identifying regulatory retail exposures (excluding real estate). Specifically, the PRA proposes to clarify the definition of ‘regulatory retail’ to further its primary objective of safety and soundness by contributing to greater consistency in application.

3.137 The PRA proposes to update and clarify the criteria for identifying regulatory retail exposures and introduce three qualifying requirements. A retail exposure^{footnote [33]} would qualify as a regulatory retail exposure if it meets the conditions set out below:

a. product criteria – the exposure needs to take the form of any of the following types of exposures:

• • revolving credits and lines of credit (including but not limited to credit cards, charge cards, and overdrafts);
  • personal term loans and leases (including but not limited to instalment loans, vehicle financing arrangements and auto loans and leases, student and educational loans, and personal finance); or
  • credit card facilities and commitments to corporate SMEs.

b. value criteria – the value of the exposure (either individually or when aggregated with all other retail exposures) to a single obligor or group of connected clients should not exceed £0.88 million.^{footnote [34]}

c. granularity criteria – the exposure shall be one of a significant number of exposures with similar characteristics such that the risks associated with such lending are substantially reduced.

3.138 Exposures to corporate SMEs that meet all of the above criteria would receive the risk weight treatment proposed under paragraph 3.139. Exposures to corporate SMEs that do not meet each of the above criteria may be treated as unrated corporate SME exposures and risk-weighted at 85% as described in paragraph 3.133. Exposures to natural persons that do not meet these criteria are treated as ‘other retail’ exposures.

Transactors, non-transactors and other retail exposures

3.139 The PRA proposes to introduce, in line with international standards, more granularity within the retail exposure class, by breaking it down into three sub-exposure classes for the purpose of determining the appropriate risk weight:

• regulatory retail exposures that are ‘transactor exposures’– subject to a 45% risk weight;
• regulatory retail exposures that are ‘non-transactor exposures’– subject to a 75% risk weight; and
• ‘other retail’ exposures – subject to a 100% risk weight.

3.140 ‘Transactors’ refers to regulatory retail exposures that are to: (i) obligors in relation to revolving facilities such as credit cards and charge cards where the balance has been repaid in full at each scheduled repayment date for the previous 12 months; and (ii) obligors in relation to overdraft facilities if there have been no drawdowns over the previous 12 months.

3.141 The PRA proposes to introduce a preferential risk weight treatment of 45% for transactors. Due to the characteristics and performance of these exposures, the PRA considers a lower risk weight to be warranted, ie the individuals eligible for these concessionary risk weights are typically considered low risk given their payment history. In addition, the PRA proposes to maintain the 75% risk weight for regulatory retail exposures that are ‘non-transactors’ and the 100% risk weight for ‘other retail’ exposures.

3.142 The PRA proposes that the most recent 12 months’ consecutive payment history, demonstrating consistent transactor behaviour at an exposure level, would have to be available before the concessionary risk weight for transactors could be applied. The PRA considers this to represent the necessary time required to calibrate a robust data series for an account, especially given the short-term and volatile nature of these products.

Treatment for retail exposures with currency mismatch

3.143 The Basel 3.1 standards introduce a new treatment for retail exposures with currency mismatch, ie exposures where a mismatch is identified between the currency of the loan and that of the obligor’s main source of income.

3.144 The PRA proposes to introduce a risk weight multiplier of 1.5x for unhedged foreign exchange retail exposures to individuals, up to a maximum risk weight of 150%. This multiplier would be applied to exposures where a mismatch is identified (at origination and throughout the loan term) between the currency of the loan and that of the obligor’s main source of income. The rationale for the introduction of the new treatment is to mitigate the risk of foreign exchange volatility that can affect an obligor’s debt-servicing capacity, which is not currently addressed in the CRR.

3.145 The PRA has identified operational challenges firms may face in identifying these exposures, particularly for existing loans. Therefore, the PRA also proposes an ‘alternative approach’ to identifying currency mismatch where information about an obligor’s main source of income is unavailable. Firms would instead need to use (as a proxy) any currency mismatch between the currency of the exposure and the domestic currency of the country of residence of the obligor.

3.146 The PRA proposes that the ‘alternative approach’ would only be available where the currency of an obligor’s main source of income cannot be verified for stock/back book lending. The alternative approach would not be available for new lending following the proposed implementation date of the new rule, and firms would be required to collect and maintain the necessary data on their obligors’ income in respect of such exposures.

Question 12: Do you have any comments on the PRA’s proposals for retail exposures?

PRA objectives analysis

3.147 The PRA considers the proposals set out in this section would advance its primary objective of safety and soundness as follows:

• The PRA’s proposed removal of the ‘double discount’ between the SME support factor and the existing preferential treatment for retail-qualifying SME lending, and the proposed preferential treatment for corporate SMEs, would reduce the potential for undercapitalisation of risk.
• The PRA considers that there is a strong case from a safety and soundness perspective for updating and clarifying the requirements and risk weights for regulatory retail exposures. Specifically, it would improve the risk-sensitivity of the SA and help ensure firms’ RWAs are appropriate given the risks to which they are exposed. The PRA considers that where existing RWAs are being reduced by the proposals set out in this section, this is warranted from a risk perspective, and the proposals would not have a detrimental impact on the PRA’s safety and soundness objective.
• The proposed introduction of the currency multiplier for unhedged retail exposures reflects the increased risk of these exposures due to currency mismatch and the risk of exchange rate volatility.

3.148 The PRA considers that its proposals set out in this section support or maintain its secondary competition objective as follows:

• The proposal to remove the SME support factor is consistent with the PRA’s secondary competition objective, as the PRA proposes the same change under the SA and IRB approach (see Chapter 4 for detail of the IRB proposal). The PRA considers that its proposal to introduce the new SME corporate exposure sub-class would improve competition, as it would partially offset the removal of the SME support factor under the SA, whereas the PRA does not propose any offsetting changes in IRB. This could facilitate greater competition between the typically smaller SA firms and the larger IRB firms.
• The PRA considers that the introduction of the transactors sub-exposure class could have an impact on the competition between firms. As the PRA proposes that these exposures are granted a lower risk weight, firms with a lower risk unsecured retail portfolio may benefit from being able to apply lower risk weights to these exposures. This may encourage competition between firms with respect to lending to borrowers who are transactors rather than non-transactors.
• The PRA considers its proposal to implement the currency mismatch multiplier would not have material implications for competition. While the proposed multiplier would only be applicable to firms under the SA, the PRA would expect IRB firms to consider potential currency mismatch in their modelling.

‘Have regards’ analysis

3.149 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules):

• The PRA considers its proposals to support its international standards have regard as they align with the Basel 3.1 standards. Removing the SME support factor would also remove potential non-compliance with the Basel 3.1 standards for the treatment of SME exposures.

2. Different business models (FSMA regulatory principles):

• The PRA’s proposals on the treatment of regulatory retail are likely to have a greater impact on firms focused on retail lending. There would be operational costs for retail business lines, particularly relating to the assignment of risk weights at exposure level for non-transactors and transactors. The PRA considers these costs to be justified given the improvement in risk-sensitivity.

3. Finance for the real economy (FSMA CRR rules):

• The PRA considers evidence that the SME support factor has supported lending to SMEs to be inconclusive. Therefore, the PRA does not expect its proposed approach to SMEs, when considered in the round including the proposed implementation of the lower risk weight for corporate SMEs in the Basel 3.1 standards, would materially reduce lending to the economy. The introduction of the categories of transactors and non-transactors under regulatory retail could introduce some volatility in risk weights as exposures could move from being classified as transactors to non-transactors over time. This greater risk-sensitivity could result in some procyclicality of risk weights during a stress as more transactors would likely become non-transactors. However, given the proposed risk weights for non-transactors would remain the same as under the CRR (and so risk weights for transactors would at worst increase to the current level in stress), the PRA does not expect this would have a material impact on firms’ financing of the economy.

4. Sustainable growth (FSMA regulatory principles) and growth (HMT recommendation letters):

• The PRA considers its proposals would likely have an impact on firms’ RWAs. Some of the changes would be likely to increase RWAs, and some reduce them, and the impact on any given firm would depend on its business mix. Where existing RWAs reduce, the proposals would allow firms to reallocate this capital to investments that promote sustainable growth. The proposed approaches should help to ensure firms’ RWAs are appropriately calculated for the risks that they are taking on and that firms are able to continue lending throughout the economic cycle, and that if necessary, they can be successfully resolved without disruption to the wider economy.
  

5. Relative standing of the UK as a place to operate (FSMA CRR rules) and competitiveness (HMT recommendation letters):

• While the PRA’s proposals set out in this section should improve safety and soundness and are more aligned to the Basel 3.1 standards than some other jurisdictions have proposed, there could potentially be some impact on the UK’s competitiveness. While acknowledging there could be some impact, the PRA does not consider the overall proposals in this section would materially impact the relative standing of the UK as a place for internationally active credit institutions and investment firms to operate, for the reasons set out below:
  • The proposed removal of the SME support factor could be perceived to negatively impact the UK’s relative standing, as it would weaken a direct subsidy to SME lending. However, the PRA considers that the proposals to introduce additional risk-sensitivity in the underlying SA risk weights (ie the new 15% reduction for corporate SME exposures and the preferential risk weight treatment of 45% for transactors) would partially offset this impact. The PRA understands that the European Commission proposes to retain the SME support factor, and not to introduce the preferential 85% risk weight for corporate SME exposures.^{footnote [35]} While this is not consistent with the PRA’s proposal, the PRA considers the different approaches are unlikely to result in materially dissimilar aggregate RWAs. The PRA anticipates most other jurisdictions would implement the Basel 3.1 standards in a similar manner to the UK, and understands that other jurisdictions do not have an SME support factor. Additionally, the PRA considers SME lending is predominantly undertaken within national markets, with limited cross-border lending. The PRA considers that removal of the SME support factor, alongside the introduction of the new corporate SME risk-weight, would be unlikely to have a significant impact on UK competitiveness.
  • The PRA expects other jurisdictions to also implement the Basel 3.1 standards for regulatory retail exposures.

6. Proportionality (FSMA regulatory principles):

• The PRA considers the proposed removal of the SME support factor to be a proportionate measure to avoid ‘double-discounting’ of risk weights, and to reduce operational complexities given the proposed introduction of changed approaches for corporate SMEs and regulatory retail exposures.

7. Efficient and economic use of resources (FSMA regulatory principles):

• The PRA considers its proposals would have some impact on the efficient and economic use of PRA resources but does not expect this to be significant. Most of the proposals would potentially require supervisory resources to monitor firms and help ensure the proposed new approaches have been adequately implemented. In particular, supervisors would be required to understand and monitor the split of regulatory retail exposures across transactors and non-transactors and ensure the appropriate risk weight is applied. In the short-term, the PRA expects there would be some additional resource requirement to check firms are applying the appropriate risk weights across regulatory retail. However, the overall incremental increase in supervisory resource required compared to now is unlikely to be material.

Residential and commercial mortgages

3.150 This section sets out the PRA’s proposals for the treatment of real estate under the SA to credit risk. The PRA proposes to increase the risk-sensitivity of the treatment for real estate and to introduce a more structured and granular exposure class allocation, which broadly aligns with the taxonomy set out in the Basel 3.1 standards. The overall effect of these changes would bring SA RWAs for real estate closer to those under IRB, particularly for low-risk residential mortgages, while introducing new requirements to help ensure RWAs for real estate exposures are appropriate.

3.151 The diagram below sets out the proposed exposure class allocation structure (see the ’Risk-weighting for real estate sub-classes’ part of this section for further information on the proposed risk weights applicable to each sub-class):

Chart 1: Real estate exposure class allocation structure

3.152 In order to meet the definition of a ‘regulatory real estate’ exposure, exposures would need to meet certain requirements (see paragraph 3.154). These exposures should then be classified as a ‘residential real estate’ exposure or a ‘commercial real estate’ exposure.^{footnote [36]} The PRA proposes to introduce additional clarity on the definition of a residential real estate exposure and a commercial real estate exposure to help ensure greater consistency of exposure allocation across firms.

3.153 The PRA proposes that a residential real estate exposure would mean an exposure secured by property that predominantly has, or will have, the nature of a dwelling and where the property satisfies the applicable laws and regulations enabling it to be occupied for housing purposes. The PRA proposes a list of exposures that would not qualify as a residential real estate exposure, on the basis that the use of these properties is not consistent with residential real estate. The list includes care homes, purpose-built student accommodation, and property that is predominantly used for holiday lets. Where the real estate exposure is not secured by property qualifying as a residential real estate exposure, it would be classified as a commercial real estate exposure, unless it meets the definition of a ‘land acquisition, development and construction’ (ADC) exposure.

Requirements for ‘regulatory real estate’

3.154 The PRA proposes to implement the criteria in the Basel 3.1 standards for a loan to be classified as a ‘regulatory real estate exposure’ as it considers them to be proportionate and prudent. This includes six requirements, which helps ensure that exposures are secured on property where: (i) it is finished; (ii) there is legal certainty on claims over the property; (iii) the exposure is secured by a first charge over the property;^{footnote [37]} (iv) an assessment is made on the ability of the borrower to repay; (v) it is prudently valued;^{footnote [38]} and (vi) adequate documentation is maintained.^{footnote [39]}

3.155 In cases where the requirements are not met, the PRA proposes that the exposures would be classified as ‘other real estate’ and receive a higher risk weight, given the elevated risks associated with collateral that does not fully meet the regulatory real estate requirements.

Valuation of real estate collateral

3.156 The PRA proposes that the value of the property should be the value at origination, which it considers to be the valuation obtained by a firm when it issues a new mortgage loan for the purchase of the property, or when the firm issues a new mortgage loan to an existing or new borrower for the property securing the loan (eg when an obligor refinances their mortgage at the end of a fixed period). The PRA considers this approach to strike an appropriate balance between ensuring an accurate valuation is used while mitigating the risk of excessive cyclicality in values that could lead to excessive cyclicality in risk weights.

3.157 The PRA considers it appropriate to allow exceptions for firms to use updated valuations, aligning with the exceptions stated in the Basel 3.1 standards, and proposes to require a new valuation of the property when:

• an event occurs that results in a likely permanent reduction in the property’s value;
• there is a significant decrease in the market value of the property as a result of a broader decrease in market prices; or
• modifications are made to the property that unequivocally increase its value. In these instances, firms would be required within a reasonable time to obtain an updated valuation that confirms the new value of the property.

3.158 The PRA acknowledges the potential operational challenges with the implementation of value measured at origination compared to current practice. The PRA proposes that firms would need to make reasonable efforts to access the relevant information for existing loans. If information is unavailable for older loans, firms should use the valuation obtained for the purposes of the most recent revaluation event as set out above, and collect the relevant information going forward. However, because the PRA proposes to allow valuation to be reset when a loan is re-mortgaged, or where an event stated in the prior paragraph occurs, these operational challenges should be greatly mitigated.

3.159 The PRA proposes that the valuation of a property would need to be appraised using prudently conservative valuation criteria, and this valuation would need to be undertaken by an independent valuer who possesses the necessary qualifications, ability, and experience to execute a valuation. These proposed requirements are important to help ensure that the valuation of the collateral securing the loan is prudent given the proposed key role of LTV to calculate the SA risk weight for real estate exposures. Also, the proposal includes further clarity on the definition of loan amount to help ensure there is greater consistency of application across firms.

3.160 The PRA proposes that these valuation requirements apply to residential real estate and commercial real estate.

Question 13: Do you have any comments on the PRA’s proposal that the value of the property shall be measured at origination and on the proposed approach to determining origination value? Do you have any comments on the proposed prudent valuation criteria?

Definition of real estate where repayment is materially dependent on cash flow generated by the property

3.161 The PRA proposes to implement an exposure class allocation structure with different risk weight treatments depending on whether repayment of the loan is materially dependent on the cash flows generated by the property. The PRA proposes that the criteria for determining ‘materially dependent on the cash flows generated by the property’ set out in the Basel 3.1 standards should be implemented, with targeted additional guidance to help ensure there is consistent implementation by firms.

3.162 The PRA considers that firms would need to determine whether the payment of a mortgage loan is materially dependent on cash flows generated by the property over a representative period that should be of sufficient length, and include a mix of good and bad years.

3.163 The PRA considers, based on its observations of the UK market, that a property in multiple occupation does not have the same characteristics as exposures that are not materially dependent on cash flows generated by the property. Therefore, an exposure to a property in multiple occupation would be treated as an exposure that is materially dependent on the cash flows generated by the property.^{footnote [40]}

3.164 The PRA proposes exceptions to the definition of materially dependent on cash flows generated by the property. This would include an exposure to an individual who has no more than three mortgaged residential properties in total (ie a three property limit), regardless of which firm provides the loan on those other properties. The three property limit does not include the individual’s primary residence unless the individual depends on cash flows generated by their property portfolio to meet the mortgage payments on that primary residence. If the three property limit is not exceeded, the exposure to the borrower would be treated as a residential real estate exposure that is not materially dependent on cash flows generated by the property. Furthermore, the PRA considers it important for safety and soundness that where a firm becomes aware that an individual breaches the three property limit subsequent to the exposure being originated, the firm should re-classify the exposure as materially dependent on cash flows generated by the property.

3.165 The PRA considers that the proposal promotes the safety and soundness of firms, given the increased risk associated with individuals that have four or more residential property exposures that are materially dependent on cash flows generated by the property.^{footnote [41]}

Risk-weighting for real estate sub-classes

Treatment of ‘regulatory residential real estate’

3.166 The PRA proposes to introduce more risk-sensitive risk weights for regulatory residential real estate exposures, based on the outstanding loan amount relative to the value of the residential real estate collateral (ie the LTV), with value calculated as set out above. The PRA considers this would support its primary objective of promoting the safety and soundness of firms given evidence that suggests that the likelihood of a borrower’s default and the loss incurred in the event of a default are higher if the LTV is higher. RWAs under this proposal would; therefore, better reflect the risk of such exposures, where lower LTV exposures would be assigned a risk weight that is relatively lower than exposures with higher LTV. The PRA considers these improvements to be one of the most important developments in the SA, and to particularly advance the PRA’s competition objective.

3.167 The PRA proposes implementing a loan splitting approach for regulatory residential real estate exposures that are not materially dependent on cash flows generated by the property, which aligns with the approach available in the Basel 3.1 standards, as the approach increases the risk-sensitivity of the risk weight treatment.

3.168 For regulatory residential real estate exposures that are not materially dependent on cash flows generated by the property, the loan splitting approach would assign a 20% risk weight to the part of the exposure up to 55% of the property value. The risk weight of the counterparty^{footnote [42]} would be applied to any residual part of the exposure.^{footnote [43]} This introduction of greater risk-sensitivity is a key part of the PRA’s package. A residential real estate loan with an LTV of less than 55%, for example, would see the risk weight fall from 35% under the CRR to 20% in the proposed new approach.

3.169 The PRA also proposes to implement a more conservative risk weight treatment for exposures that are materially dependent on the cash flows generated by the property than the risk weight applicable to exposures that are not materially dependent on the cash flows generated by the property. The PRA considers that these exposures are generally higher risk than where the borrower can service the debt from other sources, due to a positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of a default.

3.170 For regulatory residential real estate exposures that are materially dependent on cash flows generated by the property, firms would be required to risk-weight the whole exposure amount of such exposures using the relevant risk weight determined by the LTV of the exposure. Risk weights for these exposures would range between 30% and 105%. In cases where the firm has a junior charge and there are senior charges not held by the firm, the risk weight would be multiplied by 1.25 (unless the LTV is ≤50%, in which case the multiplier need not be applied). The PRA’s proposal aligns with the Basel 3.1 standards.

3.171 Social housing exposures^{footnote [44]} would be exempt from the ‘materially dependent on cash flows generated by the property’ condition, aligning to the exemption set out in the Basel 3.1 standards, and, therefore, would be risk-weighted under the loan splitting approach. To promote the safety and soundness of firms, the PRA considers that for social housing exposures, the risk weight assigned through the loan splitting approach should not be lower than a regulatory residential real estate exposure to an individual. Therefore, the minimum risk weight to be applied to the residual part of the exposure would be 75%.

3.172 Chart 2 below presents the risk weights across LTVs for regulatory residential real estate exposures where the obligor is an individual for: (i) exposures that are materially dependent on cash flows generated by the property; and (ii) exposures that are not materially dependent on cash flows generated by the property. These proposed treatments are presented with the existing CRR treatment for retail mortgages.

Chart 2: Risk weights – Regulatory residential real estate exposures

Treatment of ‘regulatory commercial real estate’

3.173 Given default experience in stressed environments and broader factors such as market price stability, the PRA continues to consider that the risk associated with commercial real estate lending warrants an SA risk weight that is no lower than 100%. The PRA considers this is warranted in order to promote the safety and soundness of firms and address potential financial stability concerns.

3.174 The PRA, therefore, proposes to assign a 100% risk weight floor to the loan splitting approach for regulatory commercial real estate exposures that are not materially dependent on cash flows generated by the property. This means that the risk weight should be calculated using the loan splitting approach, and if the resulting risk weight is less than 100%, it should be floored at 100%. The PRA considers this proposal to be clearer and simpler to implement than the existing approach to risk-weighting commercial real estate under SA in the CRR and PRA Rulebook.

3.175 For the purpose of the loan splitting approach for regulatory commercial real estate exposures that are not materially dependent on cash flows generated by the property, the PRA proposes that firms would risk-weight the exposure by assigning the risk weight of the counterparty or 60%, whichever is lower, to the part of the exposure up to 55% of the property value where the value is the origination value, as calculated in accordance with the valuation of real estate collateral section above. The risk weight of the counterparty^{footnote [45]} would be applied to any residual part of the exposure. If the resultant risk weight is lower than 100%, a risk weight of 100% would be applied to the exposure.^{footnote [46]}

3.176 For exposures that are classified as regulatory commercial real estate exposures that are materially dependent on cash flows generated by the property, firms would apply a 100% risk weight, unless the LTV of the exposure is greater than 80%, in which case the risk weight would be 110%. In cases where a firm has a junior charge and there are senior charges not held by the firm, the applicable risk weight would be multiplied by 1.25 (unless the LTV is ≤60%, in which case the multiplier need not be applied).

Treatment of ‘other residential real estate’

3.177 Where a residential real estate exposure does not meet all of the requirements for regulatory residential real estate, the PRA proposes that the exposure would be classified as ‘other residential real estate’ (for example, if the property is incomplete or under construction). These exposures would receive a higher risk weight given the elevated risks, such as those relating to the quality of the collateral or the property being incomplete or under construction.

3.178 The PRA proposes that firms would be required to risk-weight ‘other real estate’ exposures that are residential real estate exposures and not materially dependent on cash flows generated by the property according to the risk weight of the counterparty.^{footnote [47]}

3.179 To ensure consistency with regulatory residential real estate, social housing exposures would be subject to a minimum risk weight of 75%.

3.180 For ‘other real estate’ exposures that are residential real estate exposures and materially dependent on cash flows generated by the property, the PRA proposes to apply a risk weight of 150%, as the PRA considers that these are generally higher risk than exposures where the borrower can service the debt from other sources.

Treatment of ‘other commercial real estate’

3.181 Where a commercial real estate exposure does not meet all of the requirements for regulatory commercial real estate, the PRA proposes that the exposure would be classified as ‘other commercial real estate’.

3.182 The PRA proposes that for ‘other commercial real estate’ exposures that are not materially dependent on cash flows generated by the property, the risk weight assigned would be the risk weight of the counterparty,^{footnote [48]} with a risk weight floor of 100%.

3.183 For ‘other commercial real estate’ exposures which are materially dependent on cash flows generated by the property, the PRA proposes to apply a risk weight of 150%, aligning with the Basel 3.1 standards.

Land acquisition, development, and construction exposures

3.184 The Basel 3.1 standards introduce a specific treatment for ‘land acquisition, development, and construction’ (ADC) for properties where the source of repayment at origination of the exposure is either the future and uncertain sale of the property, or cash flows whose source is substantially uncertain.

3.185 The PRA proposes higher risk weights for ADC exposures compared to most non-ADC exposures to support the PRA’s primary objective of safety and soundness and to reflect the higher risk of these exposures, given that the source of repayment of the loan is a planned, but uncertain sale of the property, or substantially uncertain cash flow.

3.186 The PRA proposes to classify an ADC exposure as an exposure to a corporate or special purpose entity financing any land acquired for development and construction purposes, or financing development and construction of any residential or commercial real estate.

3.187 The PRA proposes that firms risk weight an ADC exposure at 150%, except for residential real estate where certain conditions^{footnote [49]} are met and a risk weight of 100% may be assigned.

Currency mismatch multiplier

3.188 The PRA proposes a new treatment for unhedged residential real estate exposures with a currency mismatch, operating in a similar manner as noted in the ‘Treatment for retail exposures with currency mismatch’ part of the ‘Lending to individuals and small and medium-sized enterprises’ section (see paragraphs 3.143–3.146).

3.189 The PRA proposes to introduce a risk weight multiplier of 1.5x for unhedged residential real estate exposures to individuals, up to a maximum risk weight of 150%. This multiplier would be applied to exposures where a mismatch is identified (at origination and throughout the loan term) between the currency of the loan and that of the obligor’s main source of income.

3.190 The PRA proposes that the ‘alternative approach’ to identifying exposures with currency mismatch would also be available for unhedged residential real estate lending (see paragraph 3.146).

Question 14: Do you have any comments on the PRA’s proposed approach to risk-weighting real estate exposures?

PRA objectives analysis

3.191 The PRA considers that the introduction of a more risk-sensitive SA approach for real estate exposures, as proposed in this section, including the requirements that would need to be met in order to qualify for lower risk weights, promotes the safety and soundness of firms. The PRA also considers that the proposed risk weight approach for commercial real estate exposures promotes the PRA’s primary objective. Given the default experience in historical stressed environments and broader factors such as market price stability, the PRA considers that the risk associated with commercial real estate lending warrants a risk weight that is no lower than 100%.

3.192 The PRA considers the proposed approach to the valuation of real estate to strike the right balance between ensuring an accurate valuation is used, while mitigating the risk of excessive variability in values which could lead to cyclicality in risk weights (given the duration before re-mortgaging takes place in the UK is, on average, around three years).

3.193 The more risk-sensitive treatment for real estate exposures should help ensure RWAs are reflective of the relative risk of the exposure and the PRA considers that where existing RWAs increase or decrease, this is warranted based on risk.

3.194 The PRA’s proposals set out in this section would advance its secondary competition objective as they aim to introduce clarity and consistency in the application of the SA approach to real estate, and reduce the gap in SA risk weights relative to those modelled under the IRB approach, particularly for low-risk residential mortgages. The PRA acknowledges that there would be some differences between the classification and allocation criteria of real estate exposures across firms using the SA and IRB. However, the application of the SA for real estate exposures should be consistently applied across firms, and firms using IRB for the calculation of credit risk RWAs would have to apply the SA proposed in this section for the purpose of the output floor (subject to the PRA’s proposal on implementation of the output floor; see Chapter 9).

‘Have regards’ analysis

3.195 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Relevant international standards (FSMA CRR rules):

• The proposals for the overall treatment of real estate exposures are intended to be aligned with international standards set out by the BCBS, with clarification on certain operational considerations that should achieve a proportionate approach that meets the aims of the Basel 3.1 standards. The PRA considers that it has proposed a pragmatic and balanced approach for valuation requirements and the definition of residential real estate that aligns with the Basel 3.1 standards while minimising the potential unintended consequences of a non-risk-sensitive approach. The PRA acknowledges that the proposal for commercial real estate exposures is more prudent than the baseline recommended by the Basel 3.1 standards; however, the approach aligns with the BCBS national discretion to increase risk weights where national authorities deem it appropriate. In the case of the UK market, the PRA considers that UK firms’ historical loss experience continues to justify the higher risk weight.

2. Relative standing of the UK as a place to operate (FSMA CRR rules) and competitiveness (HMT recommendation letters):

• The proposed approach would implement the prudent valuation requirements set out in the Basel 3.1 standards, and, therefore, prudent valuation practice should align with other major jurisdictions. The proposed approach for calculating origination value should help ensure that valuations of property collateral appropriately reflect risk, including when valid re-valuation events occur. Proposals from other jurisdictions may implement origination value requirements in somewhat different ways, appropriate to their residential and commercial real estate markets, but the PRA generally expects that the outcomes produced would be broadly comparable. Also, the PRA considers that mortgage lending is generally undertaken within national markets, with limited cross-border lending. The proposal aims to implement the intended principles set out in the Basel 3.1 standards with adjustments to address operational and prudential concerns.
• The proposed allocation of exposures aligns with the Basel 3.1 standards and should align with other major jurisdictions. For exposures deemed materially dependent on cash flows generated by the property, the PRA proposes to apply a three property limit to the borrower’s total portfolio, rather than to exposures to a single institution as proposed by the European Commission, as the PRA considers its proposed approach is more reflective of the risk.
• For most commercial real estate exposures,^{footnote [50]} the proposal is not a change from the existing CRR requirements, and the PRA considers the proposal would best advance its primary objective. The PRA acknowledges that other jurisdictions may apply lower risk weights for commercial real estate exposures, which may raise questions around competitiveness, but considers that its proposal is appropriate and necessary to support the safety and soundness of firms, which over the longer term would underpin the competitiveness of the UK sector.

3. Different business models (FSMA regulatory principles):

• The allocation of real estate exposures would have a varied impact on different business models. For example, firms that specialise in financing buy-to-let properties are likely to experience a larger impact, given the proposed higher risk weights for exposures with material dependence on cash flows generated by a property than for exposures that do not have material dependence on cash flows generated by the property. However, the PRA considers this to appropriately reflect the relative risk of the exposures and to be prudentially justified. The PRA also notes that the proposed buy-to-let risk weights for lower LTV exposures are lower than under the CRR.
• The PRA acknowledges that the proposed approach may affect self-build property mortgages, as these would not meet the ‘finished property’ requirement during the construction phase, but considers the greater risk of these exposures justifies a higher risk weight. The PRA’s proposal to include a list of properties that do not meet the proposed residential real estate definition may also impact firms that specialise in these markets, but is designed to promote a consistent and robust implementation.
• The PRA proposes to not materially change the risk weight treatment for commercial real estate in the CRR, except for the increased risk-sensitivity on high LTV commercial real estate exposures. Where firms are concentrated in high LTV commercial real estate lending, there would be a greater impact, as the PRA would expect higher RWAs for this lending than under the CRR, consistent with the aim to increase risk-sensitivity across the SA.
• Different business models would overall be impacted according to the concentration of business in different types of real estate lending. Firms that are highly concentrated in lower LTV owner-occupied residential lending would likely experience a reduction in RWAs compared to today, while those firms that are focused on higher risk lending may see increased RWAs. This reflects the more risk-sensitive nature of the proposed approach compared to the CRR which, as set out above, supports the PRA’s primary and secondary objectives.

4. Sustainable growth (FSMA regulatory principles) and growth (HMT recommendation letters):

• The PRA considers that the proposals should help ensure that firms’ RWAs are sufficient given the risks to which they are exposed. That, in turn, would help ensure that financing is available over a cycle and that growth is sustainable. The proposed implementation of origination valuation requirements is intended to strike a pragmatic balance between risk-sensitivity and achieving the broad outcome intended by the Basel 3.1 standards. The proposal should help mitigate potential procyclicality in RWAs due to valuation changes, thereby enhancing the ability of firms to continue lending, and supporting growth of the economy in the long run throughout the economic cycle.
• The proposed risk weight treatment for commercial real estate in the SA would not be materially different from the existing SA for UK firms, and, therefore, should not negatively impact sustainable growth. Significantly lower risk weights for commercial real estate could potentially result in undercapitalisation of risk, and, therefore, have negative financial stability implications, which would undermine sustainable growth.
• The PRA acknowledges that the proposed approach to real estate exposures could lead to further sustainable growth in lower LTV lending, while growth in higher LTV lending may be impacted.
• Overall, the PRA considers that the proposed treatment of real estate exposures helps ensure that firms are adequately capitalised for the risks that they are facing. This should help enhance: (i) the ability of firms to provide finance to households in the long run throughout the economic cycle; and (ii) the aim that firms can be successfully resolved if necessary without significant disruption to the wider economy.

Capital instruments, defaulted exposures, and high-risk items

3.196 This section sets out the PRA’s proposals for the SA to credit risk for: (i) equities, subordinated debt and other capital instruments; (ii) defaulted exposures; and (iii) high-risk items. The changes in the Basel 3.1 standards in these areas seek to enhance the risk-sensitivity and robustness of the risk-weighted treatment for these exposures. The PRA supports these changes as they would result in the SA framework better reflecting the relative risk of different types of exposures, and this improved risk-sensitivity would contribute to the safety and soundness of firms.

Equities, subordinated debt and other capital instruments

Equity exposures

3.197 As set out in Chapter 4, the PRA proposes to remove the use of IRB modelling to calculate RWAs for ‘equity’ exposures. That means all equity exposures would be subject to the proposed SA treatment set out in this section.

3.198 The PRA considers that the CRR definition of equity exposures^{footnote [51]} lacks clarity, particularly concerning the other instruments that structurally and economically behave like equity and should be treated as equity exposures. To provide enhanced clarity and to help ensure that firms assign exposures to the correct classes, the PRA proposes to clarify the definition of equity exposures.^{footnote [52]} The PRA also proposes changes to the risk-weighting of equity exposures, in line with the Basel 3.1 standards.

3.199 The CRR requires SA risk weights of 100% or 150% for equities, and a 150% risk weight applies to items identified as ‘high risk’. This compares with risk weights of 190%, 290%, or 370% under the ‘simple risk weight’ approach for IRB, which is the IRB approach to equity exposures most commonly used by UK firms. The PRA’s proposes to risk weight equity exposures at 250%, or at 400% if classified as ‘speculative unlisted equity exposures’. This aligns with the Basel 3.1 standards.

3.200 The Basel 3.1 standards define ‘speculative unlisted equity’ as equity investments in unlisted companies that are invested for short-term resale purposes, or are considered venture capital or similar investments which are subject to price volatility and are acquired in anticipation of significant future capital gains.

3.201 The PRA proposes that the speculative unlisted equity category would only include venture capital exposures. These exposures would be assigned a 400% risk weight and all other exposures meeting the definition of equity exposures would receive a 250% risk weight. The PRA proposes to define venture capital as:

‘‘unlisted’ equity investments held with the objective of providing funding to newly established enterprises, including to the development of a new product and related research for the enterprise in order to bring this product to the market, to the build-up of the production capacity of the enterprise or to the expansion of the business of the enterprise’.

3.202 The PRA proposes that the new SA equity risk weights should be phased-in over a five-year period under the SA approach as set out in Table 6. The PRA also proposes to introduce an IRB equity transitional approach that would only apply to firms with IRB permissions, and which should be considered in combination with the changes described in this section (see Chapter 4 for further detail). Overall, the PRA approach aims to allow firms to smoothly adjust to the new SA risk weights, avoiding risk weight volatility during the transition period.

Table 6: Equity exposure risk weights over the five-year phase in period

Subordinated debt and other capital instruments^{footnote [54]}

3.203 To better reflect the risk profile of subordinated debt and other capital instruments that are not equity exposures, ie a higher risk of loss compared to holding a senior loan to the same entity, the PRA proposes to increase risk weights for subordinated debt and other capital instruments to 150% from the existing 100% under the CRR. The PRA considers its proposal would increase the risk-sensitivity of the SA. This would be in line with the Basel 3.1 standards.

Defaulted exposures

3.204 The PRA proposes to clarify the criteria that are used under the SA to determine whether exposures are treated as retail exposures for the purpose of applying the definition of default (see Chapter 4 for further proposed changes relating to the definition of default). Additionally, the PRA proposes to introduce the following SA risk weights for defaulted exposures:^{footnote [55]}

• 150% where specific provisions are less than 20% of the outstanding loan amount;
• 100% where specific provisions are equal to or greater than 20% of the outstanding loan amount; and
• a preferential flat risk weight of 100% for residential real estate exposures where repayments do not materially depend on cash flows generated by the property.

3.205 The PRA’s proposals would change the existing treatment of defaulted exposures as follows:

• The PRA proposes that specific provisions should be compared against the outstanding loan amount (gross of specific provisions) to determine whether the 150% or 100% risk weight applies. This differs to the CRR which compares specific provisions to the unsecured part of the exposure value (gross of specific provisions). The PRA considers its proposal to be a more prudent treatment and to align with the Basel 3.1 standards.
• The preferential flat 100% risk weight treatment would be restricted to exposures secured on residential real estate where repayments do not materially depend on cash flows generated by the property. This differs to the CRR where the treatment is available for all exposures secured on residential and commercial property, provided they are ‘fully and completely secured’. The PRA considers its proposal to better reflect the riskiness of defaulted assets.

High-risk items

3.206 CRR Article 128 relating to items associated with particular high risk has already been brought into PRA rules. Parts of the article would become redundant following the implementation of the proposals set out in this CP; however, the PRA considers it prudent to retain some elements of it as set out below.

Speculative immovable property financing

3.207 ‘Speculative immovable property financing’ under PRA Rulebook Article 128(2)(c)^{footnote [56]} is currently defined in the CRR Article 4(79) as ‘loans for the purposes of the acquisition of or development or construction on land in relation to immovable property, or of and in relation to such property, with the intention of reselling for profit’.

3.208 Under PRA Rulebook Article 128(2)(c), speculative immovable property financing would be treated as exposures associated with particularly high risk and should be assigned a 150% risk weight. The application of this treatment ultimately hinges on a borrower’s intention to resell the property for a profit, regardless of whether it is to construct, develop or acquire the property. This means it potentially covers a very broad range of circumstances and borrowers, ie from individuals ‘flipping’ a single property, to real estate construction firms building large scale new developments.

3.209 The PRA proposes to remove PRA Rulebook Article 128(2)(c) and to instead introduce an explicit treatment for ADC as set out in the ‘Residential and commercial mortgages’ section. The proposals would capture loans to companies or special purpose vehicles financing ADC of any residential or commercial property. A 150% risk weight would apply to these exposures unless specific criteria are met.

3.210 The PRA considers that ADC captures the type of activities with the most risk that currently fall under PRA Rulebook Article 128(2)(c), but exposures to individuals whose intention is to resell for profit would not be captured.

3.211 The PRA proposes that a real estate exposure to an individual (out of scope of ADC) in respect of any land acquired for development and construction purposes, or for the purposes of financing development and construction of any residential or commercial real estate, would be treated as an ‘other real estate exposure’ (as set out in the ‘Residential and commercial mortgages’ section).

Items associated with particularly high risk

3.212 Under PRA Rulebook Articles 128(1) and 128(3),^{footnote [57]} a 150% risk weight would be assigned to exposures that are associated with particularly high risk. When assessing whether an exposure is associated with particularly high risk, firms should consider: (i) whether there is a high risk of loss as a result of a default of the obligor; and (ii) whether it is possible to adequately assess whether the exposure falls under point (i).

3.213 The PRA proposes to retain PRA Rulebook Articles 128(1) and 128(3), particularly for exposures where there is evidence of a higher risk of loss given default (or where it is not possible to adequately assess the risk), but they are not in default. The PRA considers this to preserve existing risk-sensitivity in the framework.

3.214 The PRA proposes to remove Article 128(2) in light of the proposals on speculative immovable property financing (see above) and on the treatment of equity exposures (as set out in the ‘Equity exposures’ part of this section above).

Question 15: Do you have comments on the PRA’s proposals on capital instruments, defaulted exposures, and high-risk items?

PRA objectives analysis

3.215 The PRA considers that its proposals set out in this section would enhance its safety and soundness objective:

• The PRA’s proposals on equity exposures, subordinated debt, and other capital instruments should improve the risk-sensitivity and consistency of application of SA risk weights. The PRA considers that its proposals would help ensure that firms’ RWAs better reflect the risks associated with equity and other capital instruments. For example, applying higher risk weights for equity exposures than subordinated debt reflects that equity exposures are riskier given their position in the creditor hierarchy. This would help ensure that firms are able to continue lending throughout the economic cycle, and that they can be successfully resolved if necessary, without significant disruption to the wider economy.
• The proposal to compare specific provisions against the outstanding loan amount for defaulted exposures (instead of against the unsecured part of the exposure value under the CRR) better reflects the risk and the PRA considers it to achieve an appropriate level of conservatism.
• While the PRA proposes to address high-risk variants of different types of exposures more specifically within each exposure class, the proposal to retain some provisions relating to high-risk items (PRA Rulebook Articles 128(1) and 128(3)) helps ensure that existing risk-sensitivity in the framework is maintained.

3.216 The PRA considers that its proposals set out in this section would enhance or maintain its secondary competition objective:

• The PRA acknowledges its proposals on equity exposures would increase RWAs for SA firms but may decrease RWAs for some firms using the IRB approach that would have to use the SA equity risk weights under the PRA’s proposals (depending on the IRB equity approach they are currently using to risk-weight equity exposures). However, while there may be some impact on the cost of financing for these exposures, the proposal should also enhance competition between different types of firms as the treatment of equity exposures at the end of the equity phase-in period would be the same for SA and IRB firms, given the modelling of equity exposures under IRB would be prohibited and all exposures would be risk-weighted under SA. The narrowing of the gap between the SA and IRB approaches should facilitate competition.

‘Have regards’ analysis

3.217 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Sustainable growth (FSMA regulatory principles) and growth (HMT recommendation letters):

• The PRA considers the proposals set out in this section would increase RWAs for some subordinated debt exposures and equity exposures from the existing treatment, but it considers this to be prudentially justified as it reflects the relative degree of risk associated with the exposures, ie the higher risk of equity exposures compared to subordinated debt and of both compared to holding a senior loan to the same entity. The proposed approach would help ensure that firms calculate RWAs that adequately reflect the risks on their balance sheets. This helps ensure that firms are able to continue lending throughout the economic cycle, and that they can be successfully resolved, if necessary, without significant disruption to the wider economy.

2. Proportionality (FSMA regulatory principles):

• The PRA considers its proposed changes to the treatment of equity exposures to be proportionate. Allocating equity exposures to the different categories would result in some moderate initial costs for firms, but they should not be disproportionate to the expected prudential benefits. The PRA considers its proposed approach for venture capital exposures to be proportionate as it should help ensure the riskiest exposures would be subject to the higher 400% risk weight while less risky exposures would be subject to the lower 250% risk weight.

3. Relevant international standards (FSMA CRR rules):

• The PRA considers that its proposals align with the Basel 3.1 standards:
  • The Basel 3.1 standards include a category of speculative unlisted equity and the PRA considers the intended scope of this to be open to interpretation. The PRA’s proposal for speculative unlisted equity achieves what the PRA considers to be a faithful and proportionate implementation of the Basel 3.1 standards that seeks to achieve an appropriate balance between prudence and risk-sensitivity. The PRA considers its proposal aligned with the treatment for capital instruments set out in the Basel 3.1 standards.
  • The PRA considers its proposals on defaulted items and items associated with particularly high risk to support its international standards have regard as they align with the Basel 3.1 standards.

4. Relative standing of the UK as a place to operate (FSMA CRR rules):

• The PRA considers that the proposals set out in this section would not materially impact the relative standing of the UK:
  • For equity exposures, the PRA is aware that regulators and policymakers in some other jurisdictions,^{footnote [58]} for example, the European Commission, propose a more limited scope of exposures that would be assigned a 400% risk weight, ie excluding equity exposures that are long-term equity investments from the 400% risk weight category. Such a treatment would result in lower risk weights being applied to these exposures. However, the PRA considers its approach to strike an appropriate balance between risk-sensitivity, prudence, and operational simplicity. The PRA does not expect its proposals to have a material impact on the relative standing of the UK as these exposures only account for a relatively immaterial proportion of UK firms’ credit RWAs.
  • For the treatment of defaulted exposures, the PRA is aware that some other countries^{footnote [59]} may not fully align with the Basel 3.1 standards and apply approaches the PRA considers to be less prudentially sound than the Basel 3.1 standards. Therefore, the proposed faithful implementation of the Basel 3.1 standards could impact the UK’s relative standing; although the PRA does not expect the impact of this to be material.
  • For treatment of exposures associated with particularly high risk, the PRA considers its proposals to maintain the relative standing of the UK. For example, other regulators have also proposed to remove the category of speculative immovable property financing.