At a glance

  • The UK’s implementation of the Basel 3.1 revised bank capital standard this year will proceed very differently now that the UK has left the EU.
  • With the Financial Services Bill nearing finalisation, the task will fall to the PRA to assess the likely impact of Basel 3.1 on the UK banking sector and decide how best to calibrate the framework in its consultation that we expect later this year.
  • The PRA will have broad discretion to implement Basel 3.1 as it sees fit, but we believe that it will prioritise the timely and faithful implementation of Basel standards, creating a more proportional regime for smaller banks and taking measures to preserve the competitiveness of the UK as a centre for financial services.

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The UK’s implementation of Basel 3.1 will be an important regulatory development for banks in 2021. With the Financial Services Bill nearing finalisation in the UK Parliament the path to Basel 3.1 implementation is now becoming clearer and banks can have a better idea of the next steps that the Prudential Regulation Authority (PRA) will take to finalise the UK version of these standards.

This blog provides our latest understanding of the process through which Basel 3.1, as agreed by the Basel Committee on Banking Supervision (BCBS) in December 2017, will be implemented in the UK, its likely timing and our reflections on how the PRA is likely to calibrate the framework.  

Basel 3.1 implementation in the UK will be very different than before

With the UK now fully outside of the EU, the task falls to the UK Parliament to implement international regulatory standards in domestic law rather than simply adopt new EU Directives and Regulations. Very practically, this means that the CRD6/CRR3 bank capital proposal expected later this year from the European Commission will not apply to UK banks, and that a separate UK regulatory process will now have to take place for the first time in decades.

The UK’s Financial Services Bill is the primary legislation that gives a legal basis for UK regulators to adopt and implement Basel 3.1. When this has been passed by Parliament, the lion’s share of the work will then fall to the PRA to determine how best to implement the BCBS standards.

Importantly, however, the Financial Services Bill does not specify in detail how the PRA should implement Basel 3.1 in the UK, and instead gives the PRA broad discretion. This marks a significant departure from the process that the UK banking industry has known in Brussels, where a legislative-led and very transparent procedure sees the European Council and European Parliament debate, negotiate at length, and vote on the finer points of the rules before a final decision is made.

While this new approach the UK will take is very different from how BCBS capital standards are adopted by the EU, it is actually more similar to the regulatory-led process seen in other major BCBS jurisdictions including the US, Canada and Australia.

With these new powers, we expect the PRA to consult on the detailed UK implementation of Basel 3.1 later this year and then finalise the rules after the consultation period has closed.

The PRA will face a difficult balancing act in its Basel 3.1 consultations

A regulatory-led process for implementing Basel 3.1 versus a legislative-led one is not a purely formal difference; regulatory-led implementations of international standards tend to be more technocratic. The PRA has traditionally been a strong supporter of applying BCBS rules in a timely and faithful way. The PRA’s recently-expressed intention to reverse the benefit [1] of some of the EU’s COVID-19 related bank capital support measures, particularly on the capital treatment of software assets, show us that this preference lives on. Based on the fourth quarter results of the largest six UK banks, the software measure provided a 28 basis point average uplift to their Common Equity Tier 1 (CET1) capital and would have been welcome capital relief as banks face uncertainty in the quality of their post-COVID loan books.  

The PRA’s alignment to the BCBS standards is re-enforced by strong support among broader UK policymakers for taking a more Basel-compliant approach to bank capital standards, as emphasised by the Chancellor in the proposal of the Financial Services Bill in 2020. Indeed, during the UK’s membership of the EU, HM Treasury stood out as one of the most ardent defenders of Basel-adherence among all the participants in European Council debates.

The Financial Services Bill nevertheless creates an ‘enhanced accountability framework’ that mandates the PRA to implement Basel 3.1 not only with regards to relevant international standards but also considering its impact on the medium-to-long-term financing of economic activity, and the UK’s standing relative to other jurisdictions as a centre for financial services among internationally active banks. The PRA will be required to explain how its decisions on implementation have taken these considerations into account, but the nuance in the framework will give it wide discretion in doing so, particularly where it sees higher standards as contributing to a more sustainable financial system.

This expanded mandate might not mean much for the regulatory policymaking process in normal times, but as the UK recovers from the economic shock of COVID-19, scrutiny of any adverse impacts of the PRA’s proposed rules on banks’ ability to lend to support the economic recovery will be very high. Given that the UK has also now begun to forge its own path outside of the EU Single Market for financial services, there will also be pressure to ensure that the UK’s implementation maintains, and where possible enhances, the competitiveness of the UK financial system.  In this regard, we expect all stakeholders to take a close interest in any aspects of the PRA’s Basel 3.1 implementation which go beyond the BCBS standards [2].  For further analysis from us read our recent piece: Ruling the waves or waiving the rules? on potential pathways for the UK’s post-Brexit prudential regulatory regime.

The PRA will need to assess the likely impact of Basel 3.1 on UK banks

The latest assessment by the European Banking Authority (EBA) of the capital impact of implementing Basel 3.1 in the EU is an increase of 18.5% in minimum required capital with the impact for some national banking sectors forecast to be much higher [3].  However, there has not yet been a published impact assessment of the likely capital increase that Basel 3.1 implementation could mean for UK banks. Neither the EBA’s 2019 nor 2020 impact assessments included the UK banking sector due to the UK’s imminent departure from the EU.

The PRA is required to undertake a cost/benefit assessment of the likely impact of all the rules it produces and industry representatives have called for the results of this exercise for Basel 3.1 to be released at the consultation stage to allow for informed debate about the rules before they are finalised [4].  The PRA will face the challenge of assessing how a capital increase from Basel 3.1 implementation could coincide with downward pressure on bank capital levels driven by the financial consequences of COVID-19, in the same way as the EBA had to do in the December 2020 update to its impact assessment.

Some priorities for the PRA in Basel 3.1 implementation can be anticipated today:

While the PRA will have to consider its new Basel 3.1 mandate in the Financial Services Bill and the challenging environment the UK banking sector will face from 2021 onwards, we believe it is likely to prioritise several items in its upcoming consultation:

Timing of implementation: the UK government and the PRA have always maintained their commitment to implementing Basel 3.1 on time, by 1 January 2023. They have re-stated this commitment as recently as late-2020 in the context of the proposal of the Financial Services Bill. We have said before that the EU is likely to miss this target [see our earlier blog] due to the substantial political negotiations that will have to take place. In the UK, however, the PRA’s simpler, regulatory-led process for implementation could proceed in a shorter timeframe. This does not mean that the UK will accelerate every deadline, as its December 2020 decision to delay the implementation of certain components of the CRR2 by a full year demonstrates. Generally, however, we believe that the PRA’s ability to move more quickly with its policymaking process will be paired with a greater desire to meet internationally agreed timelines provided it is practical to do so.

Proportionality for smaller banks: the PRA has been signalling that it would like to develop a simpler – but equally stringent – prudential regime for smaller banks than currently exists under the EU’s CRD/CRR rules. Sam Woods, Chief Executive of the PRA, recently noted that, in the PRA’s view, many BCBS capital metrics are more effective for large banks, whereas for smaller banks it is more important to have strong supervision of their governance [5] . This approach may feature first as a separate initiative or Discussion Paper instead of being a part of the Basel 3.1 CP. The design of the regime, particularly the thresholds for proportionality that are established and the extent to which capital, reporting, Pillar 2 or other requirements are simplified under a new approach, will be critical.

The competitiveness of the UK financial sector: finally, we expect the PRA to consider how it can use its implementation of the Basel 3.1 framework to help enhance the standing of the UK financial sector as a place for all banks to do business – in line with its new mandate under the Financial Services Bill accountability framework. While the PRA has made clear that it is likely to adhere to BCBS minimum standards, it will have a freer hand to determine how it will meet those standards than it did under the CRD/CRR. There may be cases where the PRA feels it is appropriate to propose simpler prudential rules that may be less operationally burdensome on banks (large or small), but which still achieve the aims of Basel 3.1. In some areas, the PRA may feel that a principles-based approach, accompanied by strong supervision of banks’ risk management and governance may be equally as effective as the more prescriptive, rules-based approach set out in the CRD/CRR framework.  

As we noted at the beginning of this year in our Financial Markets Regulatory Outlook for 2021, we believe that EU-UK regulatory divergence will be an important regulatory theme going forward. The proposals to implement Basel 3.1 that we will see later this year from the European Commission and the PRA may include some substantial indications of where this divergence is first likely to arise and how significant it is likely to be. Until we see those proposals, however, it is important to understand just how different the Basel adoption process will be this time around, given the UK’s departure from the EU, and what that different process might mean for the kind of rules that we are likely to see adopted.

[1] Prudential Regulation Authority, Statement on the EU requirement on prudential treatment of software assets, 30 December 2020: https://www.bankofengland.co.uk/prudential-regulation/publication/2020/statement-prudential-treatment-software-assets

[2] The Basel III standard is expressly defined by the BCBS as a minimum standard only and the BCBS has said that jurisdictions are free to implement more conservative requirements and/or accelerated transitional arrangements and still be considered compliant with the Basel framework (Para 8): https://www.bis.org/bcbs/publ/d424.pdf

[3] European Banking Authority, Base III reforms: Updated impact study https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Reports/2020/961423/Basel%20III%20reforms%20-%202019Q4%20update%20and%20Covid%20impact.pdf

[4] UK Parliament, Financial Services Bill (Second Sitting), 17 November 2020, testimony by Adam Farkas and Constance Usherwood, Association for Financial Markets in Europe: https://hansard.parliament.uk/commons/2020-11-17/debates/0ade4d23-7c36-4a01-9a53-d019186d2c14/FinancialServicesBill(SecondSitting)

[5] Prudential Regulation Authority, Strong and Simple, Speech by Sam Woods, 12 November 2020: https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/strong-and-simple-speech-by-sam-woods.pdf