CP16/22 – Implementation of the Basel 3.1 standards: Scope and levels of application

Overview

2.1 This chapter sets out the Prudential Regulation Authority’s (PRA) proposed scope and levels of application for the proposals outlined in this Consultation Paper (CP).

2.2 The proposals in this chapter would affect the scope and levels of application of the following proposed new Capital Requirements Regulation (CRR) Parts of the PRA Rulebook to implement the Basel 3.1 standards:

• Required Level of Own Funds (CRR)
• Credit Risk: General Provisions (CRR)
• Credit Risk: Standardised Approach (CRR)
• Credit Risk: Internal Ratings Based Approach (CRR)
• Credit Risk Mitigation (CRR)
• Market Risk: General Provisions (CRR)
• Market Risk: Internal Model Approach (CRR)
• Market Risk: Advanced Standardised Approach (CRR)
• Market Risk: Simplified Standardised Approach (CRR)
• Credit Valuation Adjustment Risk
• Operational Risk

2.3 The proposals in this chapter would also result in a new (CRR) Part of the PRA Rulebook to implement a Transitional Capital Regime available to firms meeting the Simpler-regime criteria:

• Simpler regime Transitional Capital Regime (see paragraphs 2.15 to 2.27)

2.4 The proposals included in this chapter are:

• replicating the CRR scope of application for the purposes of implementing the Basel 3.1 standards, except for TCR firms and TCR consolidation entities (see below);
• replicating the CRR levels of application for the purposes of implementing the Basel 3.1 standards, except for the output floor (for which different levels of application are proposed in Chapter 9 – Output floor);
• introducing a revised version of the scope criteria consulted on in CP5/22 – ‘The Strong and Simple Framework: a definition of a Simpler-regime Firm’ (taking into account the responses to CP5/22) as the basis for determining which firms would be required to implement the Basel 3.1 standards; those criteria are referred to as the Simpler-regime criteria;
• introducing a capital regime containing rules for risk-based capital requirements substantively the same as those currently applicable under the CRR (the ‘Transitional Capital Regime’) available to firms meeting the Simpler-regime criteria on 1 January 2024, during the interim period between the PRA’s proposed implementation date for the Basel 3.1 standards (1 January 2025) and the future implementation date for an intended permanent risk-based capital framework for the simpler regime;^{footnote [1]}
• setting out the PRA’s intention to offer firms that meet the Simpler-regime criteria on 1 January 2024 a modification by consent to access the Transitional Capital Regime; and
• replicating the effect of CRR provisions relating to prudential consolidation^{footnote [2]} for the purposes of implementing the Basel 3.1 standards and the Transitional Capital Regime.

2.5 The proposals set out in this chapter aim to ensure the PRA’s proposed implementation of the Basel 3.1 standards is applied to relevant firms at appropriate levels of application and to advance the PRA’s statutory objectives. The proposed Transitional Capital Regime aims to ensure small firms do not have to apply the PRA’s Basel 3.1 rules before moving onto a permanent risk-based capital framework under the simpler regime.

Scope and levels of application

Scope of application

2.6 The CRR requirements currently apply 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’). For mutuals, the CRR requirements are only applied to building societies.^{footnote [3]}

2.7 For the purposes of implementing the Basel 3.1 standards, the PRA proposes to replicate the scope of application under the CRR, except for TCR firms and TCR consolidation entities, which are addressed separately in the ‘Strong and simple framework: Approach for firms that meet the proposed Simpler-regime criteria’ section of this chapter. This aims to ensure that prudential measures continue to be applied to the relevant firms.

Levels of application

2.8 Prudential requirements may be applied at the level of an individual firm, its consolidated group, or a sub-group of which it is a member.

2.9 The CRR requirements are currently applied at the following levels:

• firms (including ring-fenced bodies (RFBs)) on an individual entity basis;^{footnote [4]}
• groups of entities containing one or more firms on a consolidated basis, as though they were a single entity;^{footnote [5]} and
• in certain circumstances, sub-groups containing one or more firms (eg RFB sub-groups) on a sub-consolidated basis.^{footnote [6]}

2.10 For the purposes of implementing the Basel 3.1 standards, the PRA proposes to make rules replicating the levels of application that currently apply to Part 3 (Capital Requirements) of the CRR, except for the output floor (for which different levels of application are proposed in Chapter 9).

PRA objectives analysis

2.11 The PRA has assessed the proposals in this section and consider the proposed approach on scope and levels of application would best advance its primary and secondary objectives. The analysis presented for this section excludes consideration of the proposed levels of application for the output floor (see Chapter 9) and the application of the Basel 3.1 standards to firms that meet the Simpler-regime criteria (see ‘Strong and simple framework: Approach for firms that meet the proposed Simpler-regime criteria’ section of this chapter). As such, ‘firms’ here refers to firms within the PRA’s proposed scope of application for the Basel 3.1 standards.

2.12 The PRA considers the proposals in this section would advance the safety and soundness of firms by ensuring that firms within the scope of application of the Basel 3.1 standards (and their wider groups, where applicable) are adequately capitalised at the consolidation level as well as at the sub-consolidation and individual entity levels. This would help ensure that capital is allocated where risks arise, safeguarding the financial resilience of firms, their groups, and sub-groups against adverse shocks and stresses. Adequately capitalised firms and groups would also facilitate more orderly resolvability, where necessary.

2.13 The PRA considers the proposals in this section advance its secondary competition objective. The PRA considers that having the scope and levels of application provisions within the PRA’s rules would improve their clarity and accessibility for firms given the rules would be located in the PRA Rulebook alongside other rules within the same policy area. The PRA considers this approach would reduce the complexity of own funds requirements which in turn reduces barriers to entry for new firms.

‘Have regards’ analysis

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

• By ensuring that the Basel 3.1 standards are applied to relevant firms at the appropriate levels, the PRA considers the proposals in this section would preserve the UK’s reputation for having a robust regulatory environment for doing financial services business, ensuring it remains an attractive domicile for internationally active financial institutions.

2. Finance for the real economy (FSMA CRR rules) and sustainable growth (FSMA regulatory principles and HMT recommendation letters):

• The PRA considers the proposals in this section would help ensure that firms are adequately capitalised at appropriate levels, strengthening their financial resilience and ability to provide financial services to the real economy through the economic cycle to support sustainable growth. In particular, the application of the Basel 3.1 standards at the sub-consolidation level would protect UK retail banking, a source of key financial services the real economy relies on, from shocks originating elsewhere in the group and from global financial markets. Adequate capitalisation of firms would also facilitate their resolvability, if necessary, avoiding significant disruption to the wider economy. The proposals in this section would thus promote greater financial stability and support the sustainable growth of the wider UK economy.

3. Relevant international standards (FSMA CRR rules):

• The PRA considers the proposals in this section are aligned with the Basel 3.1 standards.

Strong and simple framework: Approach for firms that meet the proposed Simpler-regime criteria

2.15 In CP5/22 – ‘The Strong and Simple Framework: a definition of a Simpler-regime Firm’, the PRA set out its intention to consider whether and how firms meeting the proposed scope criteria for the simpler regime should be included in the scope of application of the PRA’s implementation of the Basel 3.1 standards.

2.16 The PRA has started its analysis of the appropriate capital framework for the simpler regime (covering Pillar 1 and Pillar 2 minimum capital requirements and capital buffers requirements) but has not concluded its considerations at this stage; see paragraphs 1.55 to 1.56 of Chapter 1 – Overview.

2.17 This CP proposes a Transitional Capital Regime so that small firms do not need to apply the Basel 3.1 standards before the future implementation date for a permanent risk-based capital framework for the simpler regime, and so that they remain subject to a regime based on the existing CRR provisions until that time. In CP5/22, the PRA proposed draft scope criteria for the simpler regime that it is developing. Box A explains how the draft scope criteria have been revised to reflect responses to CP5/22. In this CP, the PRA proposes to use those revised criteria to determine the firms that would be able to choose to be subject to the Transitional Capital Regime.

2.18 The PRA proposes that firms meeting the Simpler-regime criteria on 1 January 2024 can choose between being subject to the Basel 3.1 standards on the same timetable as other firms to which the new rules apply (see Chapter 1, ‘Implementation’ section), or being subject to the Transitional Capital Regime that would be in place until the implementation date of a permanent risk-based capital framework for the simpler regime. As discussed in CP5/22, this would help ensure that small firms do not have to experience more than one change to the applicable risk-based capital framework, as well as enabling small firms to apply the Basel 3.1 standards at the earliest opportunity in the cases where firms considered it appropriate given the nature and scale of their activities. See Appendix 9 for the draft rules for the Transitional Capital Regime.

2.19 A firm that is part of a group based in the UK that meets the Simpler-regime criteria as of 1 January 2024 would be invited to consent to a modification to be subject to the Transitional Capital Regime if it chooses to (provided that any other bank or building society in its consolidation group is also willing to consent to the modification at the same time). In the draft rules, any firm that consents to this modification is a ‘TCR firm’. If all PRA-authorised firms in a consolidation group are TCR firms, the CRR consolidation entity is a ‘TCR consolidation entity’, which would also be subject to the Transitional Capital Regime. A firm that meets the Simpler-regime criteria on 1 January 2024 that does not consent to the modification would implement the Basel 3.1 standards on the PRA’s proposed implementation date of 1 January 2025.

2.20 A firm that is part of a group based outside of the UK – be that a subsidiary of a foreign headquartered banking group or a firm with a foreign holding company – cannot meet the Simpler-regime criteria but could apply for a modification of the criteria that would enable it to be subject to the Transitional Capital Regime. The draft Statement of Policy included in Appendix 10 sets out circumstances in which the PRA considers that it is likely to be possible (subject to the statutory conditions being met) to grant a modification to the Simpler-regime criteria that would enable a firm that is part of a group based outside of the UK to consent to the modification for application of the Transitional Capital Regime.

2.21 The PRA intends to publish the draft modification directions and the terms on which the directions would be offered in due course.

2.22 If a firm that has a modification direction to be subject to the Transitional Capital Regime ceases to meet the scope criteria between 1 January 2024 and the implementation date of the permanent risk-based capital framework for the simpler regime, it would be required to notify the PRA. In many cases, such firms should have been able to prepare for ceasing to meet the Simpler-regime criteria and should; therefore, be able to comply with the Basel 3.1 standards almost immediately. In some circumstances, a firm might reasonably need some limited further time to prepare for complying with the Basel 3.1 standards. The PRA would consider this when deciding when to revoke the firm’s modification, at which point any incidental matters such as the treatment of existing permissions will be considered and addressed. In the event that a firm ceases to meet the scope criteria because it receives a permission to use an internal ratings based (IRB) approach model, the PRA would engage with the firm in the period before the IRB permission approval was made to help ensure the firm is ready to move from the Transitional Capital Regime to the Basel 3.1 standards.

2.23 For the proposed Transitional Capital Regime, the PRA intends to make CRR rules to replace the CRR articles and technical standards that HM Treasury (HMT) intends to revoke, in order to preserve their effect as appropriate for firms meeting the Simpler-regime criteria. In some cases, this would entail a simple reinstatement by reference of the CRR articles or technical standards being revoked. In other cases, the CRR articles and technical standards include a provision which cannot simply be reinstated. For example, some of the CRR articles and technical standards include obligations on HMT to make regulations and, more generally, obligations on the PRA, which PRA rules cannot appropriately impose.

2.24 In order to help ensure that the existing requirements in the relevant CRR articles and technical standards would be legally operable as rules, the PRA would need to make certain amendments.^{footnote [7]} These are set out in the proposed modifications in the draft Simpler Regime (Transitional Capital Regime) Instrument in Appendix 9. The PRA considers that these changes would not be substantial, and would only entail what is needed for the continuation of the existing requirements during the interim period, pending the development of a full proposal for capital rules for the simpler regime. The PRA also intends, in due course, to publish more details of its approach, including the powers on which it intends to rely, in order to achieve the same or similar results as the CRR articles and technical standards that HMT intends to revoke.

2.25 One area where the proposed rules do differ from the relevant CRR articles and technical standards is their scope of application. The Transitional Capital Regime would apply to the cohort of the TCR firms and TCR consolidation entities, rather than all CRR firms as is currently the case under the CRR.

2.26 HMT intends to use its powers under Section 3(5) of the Financial Services Act 2021 to make savings provisions in relation to the relevant CRR permissions that are replicated in PRA rules so that TCR firms do not need to apply for a new permission to retain their existing capital treatment.

2.27 In CP5/22, the PRA proposed that firms that wish to develop IRB models and submit an IRB application would be able to do so while continuing to meet the Simpler-regime Firm definition.^{footnote [8]} To enable a firm to submit an IRB application while it is a TCR firm, the scope of the proposed Basel 3.1 rules governing the IRB permission approval process would include TCR firms and TCR consolidation entities for the purpose of any such applications.

Cost benefit analysis

2.28 The Transitional Capital Regime may result in modest benefits and costs. The benefits to firms that meet the Simpler-regime criteria derive primarily from the avoidance of operational compliance costs necessary to understand and operationalise the Basel 3.1 standards. Appendix 7 (see section C) estimates these to be in the order of £45 million for the banks and building societies that the PRA estimates would meet the proposed criteria in CP5/22 if those criteria were in place now.^{footnote [9]} The Transitional Capital Regime may produce additional benefits to the extent that, by providing certainty about capital requirements during the interim period between the proposed implementation date of the Basel 3.1 standards and the future implementation date for an intended permanent risk-based capital framework for the simpler regime, it helps firms avoid costs of adjusting business models and balance sheets under two different capital regimes (ie first under the Basel 3.1 standards and then under the subsequent simpler regime). During the interim period, it is possible that TCR firms incur opportunity costs to the extent that capital requirements are higher under the Transitional Capital Regime compared with the Basel 3.1 standards. These costs however, would depend on the degree to which TCR firms’ assets have lower SA risk weights under the Basel 3.1 standards. Since firms meeting the Simpler-regime criteria would have the option of applying the Basel 3.1 standards, such costs would be expected to be minimal.

PRA objectives analysis

2.29 The PRA considers that the proposals in this section advance its primary objective. The use of the Transitional Capital Regime allows the PRA to maintain the safety and soundness of TCR firms while developing a regime appropriate for small firms.

2.30 The PRA considers that the proposed Transitional Capital Regime would advance its secondary competition objective as the PRA considers that by introducing the Transitional Capital Regime, small firms could avoid the unnecessary regulatory burden of having to go through two changes to the risk-based capital framework. The PRA considers this approach would support TCR firms’ ability to compete effectively. Further, firms in the Transitional Capital Regime that benefit from the refinements to Pillar 2A,^{footnote [10]} which reduce the differences between risk weights in the standardised approach to credit risk (SA) and risk weights in the IRB approach, would continue to do so.

‘Have regards’ analysis

2.31 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. Proportionality (FSMA regulatory principles):

• The PRA considers the proposed Transitional Capital Regime is a proportionate approach to manage the interim period between the proposed implementation date for the Basel 3.1 standards and the future implementation date of the risk-based capital framework for the simpler regime. The proposed approach would allow firms meeting the Simpler-regime criteria to remain subject to a capital framework which currently applies to them. The PRA also considers the Transitional Capital Regime avoids placing unnecessary burden and costs on these firms, which could reduce their safety and soundness, by requiring them to incur the costs of two changes to the applicable risk-based capital framework.

2. Finance for the real economy (FSMA CRR rules) and sustainable growth (FSMA regulatory principles and HMT recommendation letters):

• The PRA considers a Transitional Capital Regime would avoid placing an unnecessary regulatory burden on firms meeting the Simpler-regime criteria because a firm would not have to incur the costs of moving onto the Basel 3.1 standards before incurring the costs of moving onto the risk-based capital framework designed for small firms that the PRA intends to develop. The PRA considers that the proposed approach would avoid disruption to these firms and therefore support their continued provision of finance to the real economy and allows these firms to continue supporting sustainable economic growth.

3. Different business models (FSMA regulatory principles):

• The proposals in this section recognise differences in the nature of firms’ business models. The proposed Simpler-regime criteria include firms’ size, trading activities, and domestic exposures. Further, the proposed Transitional Capital Regime, which firms would be familiar with, avoids placing a potentially unnecessary regulatory burden on small firms of having to adapt to a new capital framework and any associated costs which could reduce their safety and soundness.

4. Relevant international standards (FSMA CRR rules):

• The PRA considers the proposals in this section conform with the Basel 3.1 standards as the option to be subject to the Transitional Capital Regime, rather than the Basel 3.1 standards, only applies to firms the PRA considers to be domestically focused.

5. Mutuals (FSMA obligation):

• The PRA has an obligation to give an opinion on the impact of its proposals on mutual societies (s138K FSMA), (‘mutuals’). The PRA expects building societies (the only group of mutuals within the scope of the proposals) to be among the firms eligible to enter the Transitional Capital Regime.

Question 1: Do you have any comments on the PRA’s proposals for the Transitional Capital Regime?

Table 1: Proposed revisions to the scope criteria in CP5/22

Question 2: Do you have any comments on the PRA’s proposed Simpler-regime criteria?

Approach for CRR provisions relating to prudential consolidation

Individual consolidation

2.32 Under the CRR, the PRA may permit firms to meet certain requirements on the basis of their consolidated situation with their subsidiaries, rather than on an individual basis. This is referred to as ‘individual consolidation’.^{footnote [12]}

2.33 Where a firm currently has the PRA’s permission to meet CRR requirements on an individual consolidation basis, the PRA proposes to make rules that automatically extend the existing determination and thereby preserve the effect of the existing permission for the purposes of implementing the Basel 3.1 standards and the Transitional Capital Regime.

Methods of prudential consolidation

2.34 The CRR grants powers to the PRA to determine methods of prudential consolidation.^{footnote [13]}

2.35 Where the PRA has previously made a determination on the method of prudential consolidation for a firm for the purposes of CRR requirements, the PRA proposes to make rules that automatically extend the existing permission and thereby preserve the effect of the existing determination for the purposes of implementing the Basel 3.1 standards and the Transitional Capital Regime.

Organisational structure and control mechanisms

2.36 The CRR requires firms to meet appropriate organisational structure and control mechanism requirements in order to meet requirements on a consolidated basis.^{footnote [14]}

2.37 The PRA proposes to make rules applying the same requirements to implement the Basel 3.1 standards.

PRA objectives analysis

2.38 The PRA considers the proposals in this section advance the primary objective of promoting the safety and soundness of firms by maintaining consistency with the existing CRR requirements. In doing so, the proposals in this section would prevent gaps in the level of prudential coverage for firms within the scope of the requirements set out in this CP, and facilitate an orderly transition to the new capital regime.

2.39 The PRA considers the proposals in this section would support the PRA’s secondary objective by facilitating a smooth transition for firms moving to the new capital regime. The PRA considers the proposals in this section to be neutral on the compliance burden on firms, for example, if firms would not have to reapply for PRA permissions, and that this would avoid undue impact on smaller firms that do not have the advantage of economies of scale of larger firms. The PRA considers that the proposal to preserve CRR requirements on organisational structure and control mechanisms would be neutral on competition, helping to ensure firms continue to appropriately meet PRA requirements that are applied at the consolidation level.

‘Have regards’ analysis

2.40 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 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. Proportionality and efficient use of PRA resources (FSMA regulatory principles):

• The PRA considers the proposals in this section are proportionate, as firms would otherwise be required to reapply for a permission that the PRA had previously granted, in the absence of material change in the conditions for granting these consolidation permissions. Likewise, the proposals in this section would support the efficient and economic use of the PRA’s supervisory resources as this would avoid the PRA having to review and grant these permissions again.