Series 8 Episode 2: Optimising the UK prudential framework: Basel 3.1 and beyond

Transcript

Tessa Norman: Hi everyone, and welcome to this episode of Risk and Regulation Rundown. The podcast where we share perspectives on the latest issues shaping financial services, risk and regulation. I’m your regular host, Tessa Norman, and today we’re talking about what feels like a quite significant moment in the evolution of the UK’s banking prudential framework. In recent months, there’s been a series of significant developments and updates, from the finalisation of the Basel 3.1 rules to the Financial Policy Committee’s capital review. And in today’s episode, we are going to be exploring how those various reforms fit together and what they mean in practice for banks. We will also be tackling some of the bigger questions that they pose, such as whether they represent a sensible optimisation of the post-crisis framework or whether we risk losing sight of some of the lessons of the past. I’m delighted to be joined by two brilliant guests, Michael Snapes and Stefanie Aspden who are a Partner and Director in PwC’s Banking Financial Risk Practice, and who are perfectly placed to help us unpack all of this and what it means.

Michael, it would be great if you could start by giving a high-level view in terms of what the PRA and the Bank of England seeking to achieve with some of these reforms and changes, and what are some of the significant policy developments that you'd highlight from the last few months.

Michael Snapes: Thank you, Tessa. It's almost 18 years to the day since the UK Government nationalised Northern Rock as the global financial crisis really began to hit in the UK. And for the vast majority of the subsequent 18 years, policymakers have been focusing on preventing a recurrence of large scale banking failures and government bailouts by introducing a plethora of new rules designed to make banks much more resilient in life, and much more self-dependent in death, so there's no more 'too big to fail', no more bailouts in the future. The final Basel 3.1 rules which you alluded to, they were published last month, and they're due to be implemented in the main from the start of next year. They arguably represent the final piece of that policy jigsaw in the UK. But more broadly in recent months we've also seen developments across a large number of regulatory acronyms - MREL, IRB, SDDT, PSM to name a few. They represent a degree of relaxation of some components of the rule book, and we'll come on to talk about them shortly and explain what some of those acronyms mean.

Tessa: Brillant, thank you. Why don't we start with Basel 3.1, and that final policy statement that we have from the PRA in January. Steph, can you talk us through what does that statement tell us, and how will that regime impact banks?

Stefanie Aspden: Sure, thanks Tessa. As Michael mentioned, firms are preparing to implement the Basel 3.1 reforms from 1st January 2027, or in the case of some smaller firms, move on to the Strong and Simple or SDDT regime. Alongside the Government regulating for growth agenda, the PRA has prioritised international consistency and alignment in their local implementation of the Basel standards. This is ultimately good for growth. It supports things like comparability of capital ratios with international peers, which matters for investor confidence and ratings. And as we've heard in the recent CityUK report as well, certainty, stability, predictable and transparent regulatory frameworks are important things for attracting foreign investment and new entrants to the market. In line with the Basel standards, we're also set to see capital benefits for some types of lower risk lending, and that's particularly good for smaller firms that don't use internal models in areas like prime, good quality residential mortgages. This is generally good for competition as well, as we're seeing convergence in capital requirements between different segments of the mortgage market, which is the largest asset type on the banking balance sheet. As larger lenders are facing higher modelled risk rates, and constraints on the benefits of using models, due to the overall output floor and smaller firms are seeing a lowering of capital requirements for lower risk lending. Now, notwithstanding what I just said about international alignment, we are seeing the PRA deviating from Basel standards in some areas, in a more nuanced way. For example, they're undertaking a data collection exercise at the moment that will allow firms to carry forward some capital benefits for SME and infrastructure lending that they enjoy today, which were inherited from the European framework, but are being removed from the formal or Pillar 1 capital framework going forward to ensure it remains internationally aligned. So we have an outcome that's trying to be the best of both worlds, but it does add some complexity. Finally, for the small UK focused banks and building societies with simple models, the SDDT provides a more tailored and proportionate financial framework.

This is a significant departure from the one size fits all kind of approach we've had to date and allows these firms to avoid some of the pain of Basel 3.1 implementation with simplified capital calculations and streamlined reporting and disclosure obligations. While firms on SDDT remain unlikely, individually and collectively, to provide effective competition to the major UK banks, they do make important contributions in local and specialist markets, and SDDT will help reduce their cost of compliance through lower frequency and intensity of regulatory compliance related activities. Smaller banks and building societies, almost all of whom are expected to opt into the SDDT regime will also benefit from more flexibility in how they manage their balance sheet following the recent withdrawal of the building societies source book.

Tessa: Thanks Steph. A really helpful overview of the finalisation of those two regimes. Let's turn now to some of those other policy changes that you referenced Michael, which are aimed at delivering on the PRA's secondary objective for competition. Can you talk us through some of the changes that the PRA has made in that space?

Michael: Sure. I'll start by focusing on competition within the UK market, which I think is fair to say has been encouraged by regulators since shortly after the global financial crisis, both to offer more choice to customers, and over time to reduce the concentration of the provision of banking services away from the main high street bank incumbents. But whilst that's fine in principle, in practice, some of the early adopters have encountered structural challenges to achieving the extent of growth that would have facilitated that effective competition with the big banks, due to the Bank of England and the PRA's policy on MREL and IRB respectively. And more recent new bank applicants have been frustrated at the seemingly slow pace and unresponsiveness of the regulators when they're trying to enter the market. But to be fair to the BoE and the PRA, they have responded on all of these topics over the last year or so, so taking them in turn, they've allowed challenger banks that have been constrained by MREL thresholds to almost double in size before being hit with the additional funding costs of issuing MREL eligible debt, which is expensive. They're taking a more pragmatic approach, the approval of IRB models, so many of these firms, by definition, didn't exist in 1990 and therefore don't have credit loss information that dates back to 1990, so they're now rather demanding that, which is somewhat an impossible barrier to meet, they're coming up with a more pragmatic approach to allow them to use alternative data to be able to support their model calibration, notwithstanding the point that Steph made around, the benefit of being on IRB is being narrowed compared to the standardised banks, but that still helps with regards to competition. And then finally, with regards to authorisations, adopting a more flexible and consultative approach to new bank license applications. These are all welcome updates that should support that objective of achieving effective competition within the UK markets whilst balancing against the risk that firms will need to take on in order to be able to do so.

Tessa: Brilliant, I think all of those changes, as you say, are broadly positive for the sector, and I think as well as that focus on UK competition, we are also seeing growing focus on international competitiveness and growth and think that is where that balancing act becomes increasingly challenging for the PRA. What are your thoughts on the extent to which the PRA is getting that balance right at the moment and or are we hearing some concerns from certain parts of the market that we might be at risk of forgetting some of the lessons of the crisis?

Michael: I completely agree. That's where the biggest judgment around balance is required. This secondary objective around international competitiveness has only been in existence for about three years for the PRA and the FCA. And I'm old enough to remember the FSA having a similar objective of sorts in the run-up to the Global Financial Crisis, and that's often cited as one of the reasons why the crisis occurred and impacted the UK so hard. Achieving an appropriate equilibrium between the secondary objective as it exists today and the PRA's primary objective of safety and soundness is a delicate balance. The FPC's one percentage point reduction in the target system-wide level of capital to a 13% tier 1 capital ratio arguably represents the first movement, the first momentum shift, towards that secondary objective and slightly away from the primary objective. And the FPC have committed to future reviews of the leverage ratio to ensure it's an effective backstop rather than an overbearing front stop, and of capital buffers to make sure that these operate as they're intended to do to absorb losses in a stress, rather than just being another capital requirement. Those things have the potential to further accelerate that momentum. But if I take a step back and compare where we are today in terms of system-level capital compared to where we were before the financial crisis, that 13% tier 1 capital ratio is more than double the equivalent 6% before the crisis. One unit of capital is a lot better than it was before the crisis due to various technical reasons about how it's defined. Similarly, one unit of RWA is more than it was before the crisis, because risk is better captured within the RWA calculation. So just mathematically, when you look at the capital ratios, it's a lot stronger, but there's also all the policy work that's been done by the Bank of England and resolution authorities around the world to help remove barriers to failure for the largest banks. It's largely untested, admittedly still at this point, but banks themselves, and the resolution authorities, have spent a lot of time and money investing in making themselves a lot more resolvable. The cost side of that cost benefit equation is quite different going forward. And just coming back to the point on the leverage ratio and the FPC's ongoing review around that, quite an interesting observation I saw in the CityUK report that Steph referenced, which was prepared in association with PwC, I should mention that, called 'No Time to Lose', amidst a range of recommendations in that report for maintaining and growing the UK financial services industry, there's a statistic showing that the average risk weight density of banks in the UK has reduced from 34 percentage points to 26 percentage points, over the past decade or so, while it's risen slightly in other financial jurisdictions. There are any number of reasons why that might have been the case, and I haven't done all the desktop analysis to conclude what that might be, but things such as the ring fencing rules in the UK encouraging more mortgage lending in the absence of other things that banks could potentially lend against. Increasing lending from non-banks, with a focus particularly on the areas that is unattractive for banks to lend in because of the higher risk weights that lending incurs. And increasing use of securitisations, guarantees, other mechanisms of transferring risk off bank balance sheets into other parts of the financial system. Whatever the rationale, it does raise the question of whether risk has truly been reduced in the UK banking system such that proportionally less capital is required, and therefore you might relax the leverage ratio. Or, whether there's been a shift to private credit markets, other areas of the UK financial system, and therefore consistent with that point you might be able to relax the leverage ratio. Or is the risk still in the banking system, in which case you should retain the leverage ratio where it is. It's there to do what it should be doing, and it shouldn't be kind of lobbied down from where it is. So clearly, an interesting data exercise, and that's no doubt what the FPC will be doing, in order to be able to review that.

Tessa: Fascinating, if we come back from the macro level, to take it back down to some of the more micro priorities that firms are thinking about, another interesting development that we saw at the start of this year was the PRA's banking supervisory priorities letter that they published in January and as well as that setting out the areas that the PRA intends to focus on it also signals some changes in terms of supervisory approach and cycle. Steph, could you tell us more about that and what it’s going to mean for banks?

Stefanie: As you said Tessa, the PRA published its 2026 priorities letter last month, and it really signalled continuity in its priorities, but a clear shift in how it supervises firms. The headline change is in the periodic summary meeting, or PSM cycle. Historically, most firms have had an annual PSM which serves as kind of a checkpoint where the PRA sets out its views of a firm's key risks and supervisory priorities and communicates the outcomes of its capital and liquidity assessments. From 2026, the PRA is moving to a two-year PSM cycle starting with the larger firms and then rolling this out more broadly. So why the change? The PRA says risk doesn't move neatly on a one-year horizon, which makes sense. Most of the biggest prudential risks that firms face, things like credit deterioration, operational resilience, or data and model weaknesses come to bear over longer horizons. Annual PSMs were becoming process heavy without always adding proportional benefits and insights and moving to a two-year cycle is meant to support more strategic, forward-looking supervision, and focus on the risks that matter, while reducing the burden on firms, and also on the PRA themselves. For firms it's generally a positive development, as it obviously reduces a level of box ticking, and can enable some cost savings, as there'll be fewer formal checkpoints. But although the PRA retains the flexibility to set capital and liquidity requirements on an ongoing basis between PSMs, the change does also potentially limit a firm's ability to obtain lower requirements, or remove scalers where they have made improvements in risk management and governance in practice, particularly where it comes to lowering of requirements as they may have to wait for the next meeting in the two-year cycle. It does also put more onus on firms to manage risks proactively within their own governance, and for some smaller firms that are perhaps used to the formality of an annual PSM, and looking for regulatory guidance in certain areas, it might feel like a bit of a gap. The change isn't intended to signal lighter overall supervision though, and the PRA has clearly stated that they'll continue ongoing engagement and intervention where required, we might see more activity in terms of thematic or targeted reviews in areas of concern, for instance. Really they're just trying to supervise smarter.

Tessa: I think that is a really interesting example as some of the broader changes we are seeing from both the FCA and PRA, I think that smarter supervision was a key tenet of the FCA’s recent strategy, and as you say, its more about greater flexibility but really emphasising that the standards very much remain high. If we just look a bit broader than those supervisory implications, what opportunities do you see from this broader pipeline of change that we’ve talked about, particularly thinking about this from a financial and business model perspective?

Stefanie: Yes, it's really interesting. One of the big opportunities here is for firms to reassess and reset their balance sheets. With Basel 3.1 reducing the benefit of models as we've touched on a number of times. Obviously, the output floor is set to bind for at least a few of the more monoline firms. And at the same time, leverage ratio and MREL thresholds being revised upwards. Firms are being pushed to reprice and rebalance portfolios based on true risk-adjusted returns. That means doubling down on assets that are genuinely capital efficient, or where the firm can enjoy a structural advantage. In some cases, it might mean diversifying the balance sheet and bringing in more risk, and in other cases maybe even exiting or running off marginal businesses that perhaps only ever worked because of specific factors like model benefits. It'd be interesting to see how these market dynamics play out practically over the coming period, and I hope we can sit here in a few years' time and say we're looking at a simpler, more transparent, and ultimately more resilient banking balance sheet, and we have more competition in the market.

Tessa: So for listeners who are looking a bit further ahead, hopefully to a brighter future and are keen to take advantage of some of those opportunities. What's the key message that you would encourage them to take away from our conversation today?

Stefanie: I think we're at a really interesting inflection point in UK financial regulation. 18 years after the crisis that the Basel reforms were ultimately, or originally designed in response to, we have a renewed push on UK competitiveness, and the tide is starting to turn in the other direction. There's an opportunity for banks to stop managing regulation defensively and start using it as a platform for growth and even for innovation. We're already starting to see the first examples of this last week, with initiatives like the scale-up that was announced with the first six firms coming into that.

Tessa: Michael, what would you add to that?

Michael: Similar to Steph, the PRA are genuinely trying to identify and implement tangible changes in support of growth and competition, while not overstepping, given its primary safety and soundness objective. I would absolutely encourage banks to embrace this change, take advantage of these new opportunities for growth, but also ensure that they step up in areas where the regulator is stepping back.

Tessa: Thank you both very much for an insightful conversation. Thank you very much to our listeners for tuning in and if you would like to find out more about any of the topics that we talked about please don’t hesitate to get in touch. If you enjoyed this episode, please do subscribe to the series and please consider leaving a rating or a review as it helps other listeners to find us and I look forward to speaking to you again next month.