Basel reforms: similarities and divergences between the UK and EU

Basel reforms: similarities and divergences between the UK and EU

Wed 28 Jun 2023

Both the UK and the EU are consulting on the next wave of iterations to the Basel reforms. Whilst the focus of these consultations has been relatively broad, the rules around the computation of Pillar one Credit Risk RWAs have seen the most significant change. This article outlines some of the main differences between the respective approaches of the UK and EU on this topic, along with our thoughts on these divergences.

Standardised approach

Article 117: Exposures to multilateral development banks (MDBs)

The European Commission (EC) has proposed to retain the version of the regulation that currently exists– meaning that it would continue to recognise a set of MDBs that will attract a 0% risk weight, with the rest being treated as ‘exposure to institutions’ per Articles 120 and 121. The UK’s proposal is similar, but it reduces the risk weight for those entities that belong to credit quality step (CQS) two from 50% to 30%. Further, the UK proposals impose a blanket risk weight of 50% for unrated MDBs, thereby over-writing the current approach where such risk weights are dependent on the CQS bucket for the central bank of the country where the unrated MDB is headquartered. This will be welcomed by UK firms, as the current approach lends itself to risk weights for unrated MDBs to be as high as 150%. It should be noted that the EU Council is considering similar amendments than UK ones, which are discussed during the ongoing trialogue with EU Parliament (EP).

So far, the proposed changes mean that the UK would apply lower risk weights on MDB exposures in comparison with the EU. This would enable opportunities for UK institutions to borrow more from MDBs, which positions the UK regulatory regime as more competitive relative to the EU, if EP does not accept Council’s amendment.  

Article 121: Exposures to unrated institutions

Both the UK and the EU have proposed to change the base maturity from residual maturity to original maturity; and, both jurisdictions plan to impose higher risk weights to qualifying exposures that bear an original maturity of three months or less. The UK proposals are more risk-sensitive than the EU. This is because exposures to the least creditworthy, unrated institutions that have an original maturity of three months or less would attract a risk weight that is twice as high in the UK compared to the EC’s initial proposal (150% and 75% respectively). The  Council and the EP are consequently considering aligning to the UK’s 150% risk weight.

EU and UK firms lending to unrated institutions are therefore incentivised to prioritise longer term lending to unrated institutions. This recognises the tightening of economic circumstances and incentivises banks to allow firms to take longer to repay. However, the UK proposals go further in discouraging banks from lending to less creditworthy institutions. This should be interpreted as prudent, but the 150% capital coverage requirement that the EU may also adopt shortly could also be seen as overly conservative.

Article 122: Exposure to unrated corporates

The EC has proposed a simple approach of applying a 100% risk weight to unrated corporates, which aligns with the existing regulations. Yet, until the end of 2032, firms may assign a risk weight of 65% to unrated exposures provided that that entity estimates the PD is no higher than 0,5%. In the UK, the proposals are similar, but they are also introducing a risk-sensitive approach (permission required) where firms have the option to classify unrated corporates as either IG or non-IG which would attract risk weights of 65% and 135% respectively.

This reflects the overarching desire of the Basel reforms to increase the risk sensitivity of the standardised approach. Firms will need to apply a consistent approach to their risk weighting of corporate exposures, either following the simplified or risk sensitive methodology. This decision would depend on firms conducting an in-depth analysis of the capital efficiency and the risk management outcomes to using both methodologies.

However, the risk sensitive approach could discourage UK banks from increasing their exposures to less creditworthy corporates – which would include most start-ups – and therefore raises the risk of funding sources for such institutions narrowing. Although this approach aligns with the sentiments of the proposals to overwrite Article 121, it could still be seen as too cautious.

Article 501: SME supporting factor

The UK intends to remove the CRR SME supporting factor (which was lending to CRE firms with a turnover below $50mn) and introduce a ‘corporate SME’ exposure sub-class which will receive a risk weight of 85% (previously 100%). Retail transactor SMEs are now eligible for a range of risk weights, spanning 45 to 112.5%. This contrasts with the EC proposal which leaves the underlying SME risk weights unchanged (100% for corporate SME, 75% for retail SME and 45% for retail transactor SME) but keeps the SME supporting factor.

As a result, there is significant divergence between the PRA and ECB over Retail SME lending and Retail Transactors (this category will cover exposures such as credit facilities and commitments to SMEs) in particular. It is expected that UK firms that lend to SMEs will be at a clear disadvantage compared to their European counterparts from a cost of capital perspective. The increase to UK bank’s capital requirements is forecast to be around one third.  

IRB approach

The UK is proposing a higher input floor for residual mortgage exposures (0.10%) in comparison with the EU (0.05%). The reason for this appears sensible. It reflects the Bank of England’s growing concern that IRB UK retail residential mortgage risk weights have been falling over recent years and may not fully reflect potential losses in stress scenarios. However, this will make mortgage lending costlier for lenders and a part of this cost will eventually be borne by borrowers. There is a question whether this would push mortgage rates higher in the UK, thereby compounding rising interest rates.

The scope of the exposure to central governments and central banks (Article 147 – where the IRB method will be banned by both the UK and EU) is more limited in the UK than it is in the EU, with the latter including MDBs and international organisations. This means that UK firms can apply the F-IRB approach to MDBs and international organisations, which will be advantageous to the UK in comparison with the EU. This move also supports our aforementioned analysis, where we have concluded that the UK proposals are more conducive to UK firms’ likelihood to borrow more from MDBs., albeit this is unlikely to have a material impact on domestic UK lending.

Conclusion

The divergences present a mixed bag. It appears that the UK’s approach is more risk sensitive, but also more conservative in the most material areas of lending. We can see this being reflected in its decision to apply higher input floors for mortgages under the IRB approach and removing the ability of firms to leverage the SME support factor.

This reflects the dilemma that the UK now faces. Post-Brexit expectations were that having left the EU, the country would use its increased flexibility over prudential regulation to increase its international competitiveness by reducing requirements. Yet, deregulation comes with the associated cost of reducing resilience. This has been underscored by recent events in the United States, where retrenchment of the Dodd-Frank post crisis reforms has arguably contributed to considerable banking turmoil. Consequently, when reviewing the credit risk element of the Basel reforms, it appears the UK is taking the more cautious route for now.