About Innovate Finance
Innovate Finance is the independent industry body that represents and advances the global FinTech community in the UK. Innovate Finance’s mission is to accelerate the UK's leading role in the financial services sector by directly supporting the next generation of technology-led innovators.

The UK FinTech sector covers businesses from seed-stage start-ups to global financial institutions who embrace digital solutions, playing a critical role in technological change across the financial services industry. FinTech has grown strongly since the Global Financial Crisis of 2007/8, which led to mistrust in traditional banks and coincided with an explosion in the use of smartphones, widespread adoption of the use of apps, the advent of blockchain technology, and significant investment in FinTech start-ups.

FinTech is synonymous with delivering transparency, innovation and inclusivity to financial services. As well as creating new businesses and new jobs, it has fundamentally improved the ways in which consumers and businesses, especially small and medium sized enterprises (SMEs), access financial services.

1. Introduction

1.1. Innovate Finance welcomes the opportunity to respond to the Prudential Regulation Authority’s (PRA) Consultation Paper (CP 16/22) entitled Implementation of the Basel 3.1 standards. In preparing this submission, we have engaged with a cross-section of our membership, including start-up and scale-up challenger banks and e-money institutions. Our response was prepared with support from Hogan Lovells' Financial Services Regulatory Consulting team.

1.2. Innovate Finance supports the aim of Basel 3.1 which is the introduction of a more risk-sensitive Standardised Approach (SA), especially for credit risk, which underpins the regulatory capital requirements for the provision of credit to small and medium-sized enterprises (SMEs) by most challenger banks.

1.3. Challenger banks make an important contribution to the UK economy by providing credit to a growing number of SME customers. Fifty-five per cent of SME lending is provided by challenger banks outside the 'big 5' high street banks (based on Bank of England (BoE) and British Business Bank data for 2022). As the UK economy faces depressed activity in 2023 and 2024, the likely impact of the new standards on the provision of credit to SMEs and the transition from the current SA require careful consideration.

1.4. Given the importance of SMEs to the economy — they constitute approximately 61% private sector employment and roughly half of UK GDP¹ — and the critical role of challenger banks in providing credit to the SME sector, our response focuses mainly on this aspect of the implementation of Basel 3.1 standards, drawing on the specialist insights of our members. We also consider implications for secured lending for SMEs and retail customers — commercial real estate, residential real estate and buy-to-let (BTL).

1.5. We provide a summary of our recommendations in relation to SME lending in the last section of this document.

1.6. We discuss the interactions between Pillar 1 and Pillar 2A capital requirements and the importance of avoiding double counting. We also consider the linkages between the Basel 3.1 changes and other regulations, notably the PRA's emerging Strong and Simple Regime, and Minimum Requirements for Own Funds and Eligible Liabilities (MREL).

1.7. Given the PRA's existing secondary objective of facilitating competition between firms and in the markets for their services, and the soon-to-be-introduced secondary objectives to promote growth and the international competitiveness of the UK, we highlight some areas of 'super equivalence' or 'gold plating', both in relation to the Basel rules and the EU’s implementation of Basel 3.1. These go against the PRA's secondary objective and could make UK firms who use the SA uncompetitive relative to UK banks that use the Internal Ratings Based approach (IRB) or firms that branch in from the EU with less onerous capital requirements.

1.8. Our members wish to see a capital regime for SME lending that is prudent and risk-aligned for non-systemic banks. The PRA has full discretion on capital requirements for domestic, non-systemic banks, and we consider it is vital that the regulator takes a holistic review of the capital regime for SME lending to ensure the approach is evidence-led, proportionate and aligned to the risks of different types of lending.

1.9. We present our comments under eight themes with signposts to relevant questions in the Consultation Paper (CP). We provide recommendations throughout and, for SME lending, an additional summary of recommendations.

a) Economic context;
b) Super equivalence;
c) SME Support Factor and unsecured lending;
d) Secured lending;
e) Credit ratings and other exposures
f) Pillar 1 and Pillar 2A;
g) Strong and simple regime;
h) Transition Capital Regime; and
i) Summary of recommendations for SME lending.

1.10. We would be happy to discuss these points with you and the role of challenger banks on a bilateral basis, and/or facilitate a roundtable with our challenger bank working group as you refine the details of the UK regime.

1.11. Given the importance and interconnectedness of the changes being proposed, we recommend that the PRA establish a standing committee to promote dialogue with challenger banks and to monitor the effectiveness of implementation. This will help the PRA identify potential unintended consequences of the UK's implementation of Basel 3.1 and provide a forum to share views on issues and solutions.

1.12. Lastly, we wish to acknowledge recent market events, notably the collapse of Silicon Valley Bank (SVB), and emphasise that we are not calling for a loosening of prudential requirements for smaller, non-systemic banks. The PRA broadly applies the Basel framework in the regulation of all UK deposit-taking banks (including liquidity measures such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio) and has embedded liquidity and interest rate risk in the banking book (IRRBB) into ongoing stress testing. In contrast, we understand that SVB (and other non-systemic banks) in the US was subject neither to Basel liquidity requirements nor IRRBB controls. Further, with respect to SVB, there are also wider questions in relation to its risk management and governance, including Board oversight.

2. Economic context

2.1. Growth is a key objective for the Government. However, the UK economy is likely to be subdued over the next couple of years. In March 2023, the Office for Budget Responsibility (OBR) expects weak economic growth of 0.2% in GDP in 2023. Thereafter, the OBR expects the economy to grow slowly.

2.2. Inflation is expected to fall but declines in real wages mean consumer confidence is low. Businesses face supply-side challenges with a reduced workforce and skill shortages. The war in Ukraine continues and there remains risks to growth from energy prices and interest rates.

2.3. The OBR forecast differs from the BoE's more pessimistic, 'flatlining' view published in February. Commentators note that the divergence is greater than normal, which underlines the uncertainty that the UK faces.

2.4. The next few years will be a challenging period for retail customers and SMEs with fragile consumer confidence and reduced activity.

2.5. The Government's Spring Budget on 15 March 2023 had a major focus on investment and associated tax incentives. Credit from challenger banks is likely to play a key role in financing that investment and it will be critical that the supply of credit is not interrupted by regulatory change.

2.6. The majority of the PRA's proposals are set to apply to both existing and new loans from 1 January 2025. In our view, this is too soon for SA firms given the likely large impacts on their capital and the subdued and uncertain economic climate. With this in mind, we recommend that existing SME loans that see an increase in capital requirements under the final implementation should be ‘grandfathered’ — i.e. retain their existing capital treatment — to avoid a cliff-edge effect on lending.

2.7. The PRA expects "very small increases" in capital requirements for small and medium-sized SA firms. However, based on our members' input, we predict SME lending is likely to see a jump of over 30% in SA regulatory capital requirements. This will put at risk the sector's contribution to the provision of credit to support economic growth. There will also be a knock-on effect from the SA to IRB banks as a result of the output floor in Basel 3.1. This viewpoint is supported by Oxera’s economic analysis², which concludes that the PRA’s proposals (if implemented in their current form) could result in a £44bn (£21 billion for SA banks and £23 billion for IRB banks) drop in lending to UK SME based on the reduction required to keep the capital backing SME exposures at its current level.

2.8. This significant increase in regulatory capital requirements will either reduce the supply of credit or raise its price. To illustrate the scale of impact, one challenger bank's well-established pricing model indicates the increase in capital requirements will result in a 100 basis point (bp) to 160bp increase in its lending margin over base rate (the average margin is currently 350-400bp). Other members have indicated that their lending margins over base rates will also have to increase as a result of these changes.

2.9. The corresponding increase in IRB risk weights for SME lending means that the IRB banks are likely to be unable to fill any lending shortfall from challenger banks.

2.10. If there is no ‘grandfathering’ of capital treatment on existing loans, firms will anticipate regulatory changes and adopt new rules ahead of deadlines (such as they did with the higher Common Equity Tier 1 ratios in Basel 3 or to price multi-year loans). Care therefore needs to be applied to the implementation of any rule change that increases credit-risk capital requirements, particularly in a time of economic difficulty.

2.11. This risk is increased by related regulatory uncertainties such as the absence, until later in 2023 or mid-2024, of a methodology to deal with the interaction between Pillar 1 and Pillar 2 capital requirements, or a definitive ‘strong and simple’ regime. Regulatory uncertainties like these make it difficult for firms to plan their capital needs, which reduces their capacity for growth.

2.12. The British Business Bank noted in its 2022 annual report that capital raising has already become harder for challenger banks. This increase in regulatory capital requirements and general uncertainty is likely to make capital raising harder still, hindering competition from challenger banks.

2.13. There are also risks to competitiveness for challenger banks from PRA gold-plating of the Basel rules, misalignment of SA with the IRB approaches, over-conservatism compared to the EU’s implementation and uncertainties surrounding unfinished UK regulatory changes (notably the strong and simple regime).

2.14. Given the importance of the PRA's goal of maintaining the competitiveness of the UK financial sector and HM Treasury's (HMT) goal of maintaining the supply of credit, we urge the PRA to address the points we outline below prior to implementing Basel 3.1.

3. Super equivalence

3.1. The Basel standards apply to large internationally-active banks but not to domestic, simpler banks. However, in its approach to Basel 3.1, the PRA has chosen to apply Basel standards to all UK banks, regardless of size and complexity. This may be a legacy inherited from the EU's universal adoption of the Capital Requirements Regulation (CRR) for all banks, but the PRA’s approach would put UK challenger banks at a disadvantage in their domestic market.

3.2. The PRA's strong and simple framework for non-systemic banks and building societies may well, in due course, address some of these concerns but it is not yet fully finalised or published (see below), and indeed the PRA has suggested that its Basel 3.1 SA capital regime would be the basis for ‘strong and simple’. The CP includes some refinements to the framework, notably an increased balance-sheet threshold of £20 billion.

3.3. Ironically, the PRA's strict interpretation of the Basel standards means that the UK proposes to be super-equivalent to the EU's approach to Basel 3.1. We agree with the PRA's argument that the EU is non-compliant with Basel 3.1 in certain areas, particularly for IRB banks. However, the PRA's 'one-size-fits-all' approach and failure to use several permitted national discretions feels like a missed opportunity to ensure UK capital requirements are sensitive to the risk profile of smaller UK banks and their exposures. As a result, for SME lending, the PRA is likely to go against one of the Basel Committee's overarching goals for Basel 3.1, namely to enhance the robustness and the risk sensitivity of the SA approach. In our view, the PRA's proposed approach does not align SA risk weights to the risk of SME lending, and thereby hands a competitive advantage to EU banks who branch into the UK (the US rules are not yet published).

3.4. In addition, the PRA's proposed SA risk-weighting for secured business loans and commercial real estate exposures deviates materially and exceeds the Basel 3.1 standards (see below).

3.5. We recommend that in any areas where the PRA proposes increases to risk weights, these should be supported by quantitative evidence to justify the increases. There are several points in the CP where increases are proposed but no evidence is provided — notably in relation to the secured business loan risk weight floor and removal of the SME Support Factor (SF).

4. SME support factor and unsecured lending

Question 11: Do you have any comments on the PRA’s proposed removal of the small and medium- sized enterprise (SME) support factor? Do you have any evidence – quantitative or qualitative – to support your comments?

4.1. The PRA proposes to remove the SME SF, but does not provide any empirical evidence to justify the decision. Based on our members' assessments, its removal will markedly increase capital requirements for exposures to SMEs which in turn may inhibit lending. Indeed, we firmly believe that the potential capital impacts will be more severe for SME lending firms using the SA than the PRA envisages.

4.2. The SME SF was introduced in 2014 in the CRR (Article 501) to maintain the flow of credit to SMEs during the initial Basel 3 reforms following the global financial crisis of 2007/8. It currently reduces SME exposures up to EUR 2.5 million by applying a factor of 0.7619, and reduces exposures over EUR 2.5 million by applying a factor of 0.85. The effective risk weights for qualifying retail SME exposures are therefore 57% rather than 75% (see Table 1 below).

4.3. The PRA cites the European Banking Authority's (EBA) 2016 report on SMEs and the SF as justification for removing the SME SF. However, the report was inconclusive as to whether the SF stimulated lending to SMEs, and said that it was too early to tell. However, the EBA found evidence that resultant risk weights reduced by the SF were appropriate for SA firms. The EBA report recommended further monitoring.

4.4. Since then, the Deutsche Bundesbank (2016), Banco de España (2017) and Banque de France (2020), have all separately published empirical quantitative research into the SF. They concluded unanimously that SF-adjusted SA risk weights fairly reflect the risk of exposures to SMEs and that use of the SF has stimulated additional lending to SMEs. Understandably, the EU has decided to maintain the SME SF in its implementation of Basel 3.1.

4.5. As Figure 1 shows, the introduction of the SME SF in 2014 was strongly correlated with growth of challenger bank SME lending in the UK, which has more than doubled since then, and is now 55% of new SME lending (data from British Business Bank and BoE).

Figure 1: Gross new SME lending per annum

4.6. When risk weights increase, average changes can be misleading indicators of the impact on bank behaviour and lending decisions. It is important to recognise that an increase in an individual risk weight may trigger binary lend/no lend decisions which may result in shutting off the supply of credit to particular customers or the withdrawal of certain products.

4.7. The PRA's CP includes a new 85% risk weight for unsecured SME corporate exposures that do not qualify for the retail class (i.e. loans >£880k, previously >EUR 1 million). Such exposures currently have a risk weighting of 100% and benefit from a SME SF of between 0.7619 for exposures up to £2.2m and then 0.85 for the portion of exposures above £2.2m. So, the 85% risk weight proposed by the PRA is actually higher than the current corporate SME capital requirement which ranges from 76% (£1m loan) up to 81% (£5m loan).

4.8. As part of the move to greater risk sensitivity, some other retail SME exposures may qualify for a new lower risk weighting of 45% if they meet the criteria for the new 'transactor retail exposure' (a reduction of 21% compared to current Pillar 1 requirements, with the SME SF, or 40% without). Transactor retail exposures relate to customers with credit-card or charge-card facilities who repay in full each month. These exposures are only a small percentage of the overall market.

4.9. Clearly the net impact of these changes will vary by firm depending on the risk profile of its unsecured SME exposures, but the impacts are likely to be material for many. Oxera estimates that the weighted average impact of the changes would be an increase in Pillar 1 SA credit risk capital requirements for unsecured SME exposures of 20% to 30%.

Table 1: Risk weights for SME exposures

Table 1: Risk weights for SME exposures

Exposure to SME	Current SA risk weight (with SF)	CP16/22 proposed risk weight	Increase in capital requirement for whole exposure
Unsecured term loan, equipment term finance, invoice finance	<EUR 1.0 m – 57% (75% x 0.7619)	75%	+31%
	EUR 1.0m to 2.5 m – 76% (100% x 0.7619)	85%	+31% to 18% depending on loan size – declining as loan size increases
	>EUR 2.5m: from >76% to 85% depending on loan size (100% x 0.85 for portion >EUR2.5m)	85%	18% at just above EUR 2.5 million, declining as loan size increases (for example, 4% at EUR 10 million)
Transactor retail	57% to 75%	45%	-21% to -40%

4.10. We strongly recommend that the UK maintain the SME SF and existing risk weightings until there is conclusive empirical evidence for the UK that justifies its change or removal. Given the risks to the supply of SME lending, we recommend that the PRA and HMT conduct a detailed empirical study into the riskiness and competitiveness of SME lending by challenger banks and the effects of the proposed changes to the SA before implementing them.

4.11. It is important to recognise that ‘Unsecured’ currently captures all SME lending that is not secured on property. 'Unsecured' captures other secured SME lending such as equipment finance (e.g. secured on trucks, cranes, etc) and invoice finance (secured against debtors). These forms of secured lending have lower risk than unsecured lending as shown by the PRA's own data. Figure 2 below compares the costs of risk of unsecured and secured SME lending for non-systemic banks (Category 2-4) presented at the February 2023 PRA CEO conference.

Figure 2: Cost of risk - provisions divided by loan balance (September 2022)

4.12 We recommend that the PRA improve risk sensitivity of the SA by considering equipment and invoice secured SME lending as a separate type of lending (‘asset-based lending’) with a lower risk weight than unsecured lending. We recommend setting the risk weight for asset-based lending at 69%, which we arrive at by two methods:

a) The current Pillar 2A upper IRB average benchmark for SME lending used by the PRA in their published guidance (“The PRA’s methodologies for setting Pillar 2 capital, January 2020”).

b) The average of the range of current risk weights including the SME support factor that are being used today – where Retail SME is 57% (75% * 0.7619) ranging up to 81% for a £5m loan to a Corporate SME (100% * 0.81).

4.13 If, based on evidence, the PRA decides to withdraw the SF and make no adjustments to other risk weights (such as removing the risk weight floor on secured business loans, and introducing a lower risk weight for asset-based lending), we would recommend that the relevant new SA risk weights are not applied to existing SME loans. For new loans, we would recommend an extended transition period from 1 January 2025 to 2030, to phase in the changes and to try to avoid a cliff edge effect that would restrict the supply of SME finance to the real economy, particularly in 2024 to 2026.

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

4.14. In addition, the PRA is proposing a one-size-fits-all change to the treatment of committed facilities. The PRA proposes a 10% credit conversion factor for all Unconditionally Cancellable Commitments (UCC). However, the Basel Committee allows national discretion to exempt certain low-risk arrangements relating to commitments to corporate and SME borrowers. For example, the EU exempts certain contractual arrangements relating to corporate and SME borrowers, thereby allowing a 0% risk weight to be maintained.

4.15. The proposed increase in UCCs from 0% to 10% will have a significant impact on members with a material credit card book, and introduce a large ‘cliff-edge’ risk-weighted assets (RWA) movement on 1 January 2025.

4.16. To provide greater risk sensitivity, we recommend that the PRA exercise its national discretion and introduce comparable exemptions (zero risk weightings) for specified contractual arrangements with SMEs.

4.17. We also recommend that the PRA allows firms to continue to apply a 0% credit conversion factor for UCC until 2029, followed by a graduated transition period until 31 December 2032, after which the 10% credit conversion factor applies where required.

4.18. In addition, we recommend that the PRA provides greater clarity on the interaction between Pillar 1 and Pillar 2A requirements for undrawn commitments. This is because Pillar 2A may already identify capital requirements for undrawn commitments that could lead to drawdown and loss during stress. This particularly applies to SA firms that use a proxy IRB calculation to calibrate their Pillar 2A add-on. Our members would welcome clarity as to how any interim uplift in RWAs (between the implementation of Basel 3.1 and the PRA’s next Capital Supervisory Review and Evaluation Process (C-SREP) and resultant Total Capital Requirement) would be mitigated to avoid double-counting of commitment risk.

5. Secured lending

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

5.1 Secured business loans and commercial real estate lending:

a) The PRA's proposals are likely to create significant increases in capital requirements for SME secured lending and result in reduced risk sensitivity. Our members are extremely concerned about the effects these changes will have on the supply and pricing of SME finance. Oxera’s report estimates that the PRA's current proposals would increase SA risk-weights for secured SME lending by 40% to 50%.

b) Secured lending both to general SMEs secured on their trading premises (‘secured business loans’) and income-producing commercial real estate (’investment lending’) is a central part of challenger banks' provision of finance to SMEs.

c) The PRA proposes a risk weight floor of 100% for regulatory commercial real estate, for exposures secured both on income-producing real estate and on SME trading premises. This approach would be a material deviation from the Basel 3.1 standards and is contrary to the goal of creating greater risk sensitivity.

d) For exposures to income-producing commercial real estate (IPCRE), we recommend SA firms should apply the Slotting approach that is mandated by the PRA under the IRB approach. This will improve risk sensitivity and better reflect the specific risks involved. The PRA already requires SA firms to use Slotting for IPCRE in their Internal Capital Adequacy Assessment Process (ICAAP) and the PRA’s setting of the Pillar 2A credit risk add-on for capital. Using Slotting to determine the Pillar 1 SA risk weight would be more simple and transparent compared to a Pillar 2A add-on, and would align SA and IRB firms to the same capital regime.

e) For exposures secured on trading premises, the proposed 100% risk weighting is insensitive to the risk of these loans. It is also illogical. The proposed approach replaces the risk sensitivity of the Basel approach, which links risk weighting to loan to value (LTV) utilising a conservative prudent valuation. The typical Basel 3.1 SA risk weight would be 60-65% which means that a UK move to 100% represents a dramatic increase. The PRA's proposed approach also creates the illogical position that an unsecured exposure to a SME for £500k would attract a 75% risk weighting, while a secured loan to the same SME for £500k would attract a 100% risk weight.

f) Secured business loans are one of the least risky forms of SME lending, as the PRA's own data demonstrates. Figure 3 shows data that the PRA presented on the cost of risk for non-systemic banks (Category 2-4) at the PRA CEO conference in February 2023.

Figure 3: Cost of risk - provisions divided by loan balance

g) Additionally, our analysis of Pillar 3 disclosures for IRB UK banks in 2019 indicates an average risk weight of around 50% for SME loans secured on trading premises. This shows that the relevant Basel 3.1 risk weights for SA are in line with, or indeed slightly above, existing IRB risk weights in the UK (before applying the SME SF).

h) For both secured business loans and IPCRE, Basel 3.1 introduces a ‘prudent valuation’ basis for collateral. We recommend adoption of Vacant Possession (VP) as the basis of ‘prudent valuations’ for SME commercial property collateral.

i) VP (also known as the ‘Bricks and Mortar’ value, ‘Closed Value’ or ‘MV3’), is readily available from any Royal Institution of Chartered Surveyors valuer and is already used by most firms in their underwriting. The value differs to Market Value (MV), as if the company defaults or becomes insolvent, then the property will become vacant and so the property drops to the VP valuation. VP values are typically prepared with several core Special Assumptions such as the property being stripped of fixtures, fittings and equipment and subject to a restricted sale period. One firm’s data shows VP is on average 10-15% lower than MV, but with a significant range from no difference to 90% lower, reflecting the idiosyncratic differences of commercial property which should be reflected in a ‘prudent valuation’ method.

j) In terms of the Basel 3.1 text on ‘prudent valuation’, we believe VP aligns well to the Basel text which the PRA have adopted — fulfilling the requirements that the value of the property:

i) Must not depend materially on the performance of the borrower;
ii)Has been adjusted to take into account the potential for the current market value to be significantly above the value that would be sustainable over the life of the loan; and
iii) Should not be higher than the market value, where a market value can be determined.

k) One of our members has conducted detailed modelling on secured business loans, simulating the conditions of the global financial crash. This modelling replicates the high loss rate on commercial property reported by the BoE. It also uses the higher LTVs (average 75%) and MV valuations in place at the global financial crisis. By simulating the same fall in current commercial property prices, but with current LTVs (average 60%) as in Basel 3.1, and a VP valuation, losses are 60% less than those seen in the global financial crisis, and are readily absorbable by current loan pricing and capital resources.

l) We recommend that the Basel 3.1 standards should be adopted for secured business loans and the risk weight floor of 100% be removed.

5.2. Buy to Let

a) The new PRA rules will require banks to use a 'whole loan' approach for BTL exposures, which means that small changes in LTV may lead to step changes in risk weights. This contrasts with the current approach which uses 'loan splitting' to smooth changes in risk weight as LTV changes. The PRA proposal differs from the EU approach for Basel 3.1 which maintains loan splitting for all lending secured on residential real estate.

b) The UK treatment is based on the size of the portfolio and the number of properties is limited to three. Our members fear that this will cause issues. In practical terms, it will be difficult to establish how many properties an investor holds throughout the life of a mortgage, and will create cliff edge effects when an investor moves from having three properties to four properties. We recommend that the PRA reduce risk weights for BTL exposures to more accurately reflect their risk. In addition, we recommend that the PRA continue with loan splitting for BTL lending to smooth changes in risk weight.

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?

5.3. Residential Real Estate

a) We support the revised risk weights linked to buckets as this approach improves risk sensitivity.

b) However, the CP proposes that the value of the property at origination should be used to assess LTV for the purposes of calculating Pillar 1 RWA over the life of a mortgage. This is in line with the Basel rules, but it removes the ability to index security against house price changes (unless a property is remortgaged), which is the PRA's current approach. We consider that this reduces risk sensitivity and will increase capital requirements unnecessarily. It also creates a new difference between the SA with the IRB approach, which allows indexation. It is unfortunate that the PRA provides no justification for making this change.

c) Under Pillar 2B, house price indexation is used for stress testing to set the relevant component of the planning buffer. The effect of the proposed rule change, if prices are rising, will be to reduce Pillar 2B and increase Pillar 1 compared to the current rules. If house prices are falling (as they are currently), the effect will be to increase Pillar 2B rather than Pillar 1 (unless supervisors require firms to reduce their property values).

d) We recommend that PRA revises its approach to property valuation to allow indexation to give greater risk sensitivity to Pillar 1 as this would be more in line with the goals of the Basel Committee for the SA. It will also remove a difference with the IRB approach and reduce the need for supervisory intervention on house prices. Protection against excessive cyclicality should be picked up in Pillar 2B through stress testing.

6. Credit ratings and other exposures

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?

6.1. For rated corporates, the PRA expects firms to undertake their own due diligence of counterparty credit quality, and if necessary apply a higher risk weight to the exposure. However, the CP provides no guidance on what might constitute proportionate due diligence. This is important because firms cannot rely solely on the judgments of nominated external credit assessment institutions (ECAIs). For vanilla investments in bonds, gilts and other unsecured investments, it is unlikely that smaller firms will have any more recent and/or relevant financial and other information concerning their counterparties compared to the data held by their nominated ECAIs. Indeed, smaller banks tend to have limited resources.

6.2. We recommend that the PRA clarifies supervisory expectations for due diligence and provides practical guidance.

6.3. Our members agree that excluding central government, central bank, regional government, regional authority, and public sector entities is sensible and proportionate. We also recommend that the PRA considers excluding named multilateral development bank exposures that benefit from a 0% risk weighting, from the due diligence requirements. The draft PRA rulebook includes a short-list of these names.

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, public sector entities, and multilateral development banks?

6.4. The UK onshored equivalence listings largely recognise equivalence between the UK and EU treatment of exposures to government, central bank and public entities. While the UK has never recognised any UK Public Sector Entities (PSEs) as eligible to be treated as exposures to regional governments, local authorities, or central government, the EBA (and EU CRR) still recognises a number of EU PSEs as eligible to be treated as exposures to their relevant central government under CRR Article 116 (4).

6.5. With this in mind, we would welcome clarification as to whether relevant EU PSEs (where recognised on the EBA listing) may be treated as exposures to their relevant central government. To not do so would put UK firms at a disadvantage compared to EU firms. In essence, this would mean retaining a version of CRR Article 116 (4) that applies to non-EU PSEs subject to an equivalent supervisory regime.

Question 7: Do you have any comments on the PRA’s proposed changes to the external credit rating approach, the proposed introduction of the standardised credit risk assessment approach, for exposures to unrated institutions, and the proposed treatment of covered bonds?

6.6. We note that the PRA is not proposing to amend the mapping of the external credit ratings to the credit quality steps (CQS) set out in the Commission Implementing Regulation (EU) 2016/1799 of 7 October 2016, but the CP flags that this will be kept under review.

6.7. The UK version of this regulation (as amended by EU Exit Instrument No. 4) is no longer aligned with the EU version, which was last updated on 7 December 2021 to include counterparty amendments. The UK version also notes, “there are outstanding changes not yet made to Commission Implementing Regulation (EU) 2016/1799”.

6.8. As a result, our members have flagged that this makes the regulation cumbersome and arduous to navigate; it also makes it less definitive than it should be as a single source of ECAI mapping information.

6.9. We recommend that the PRA amends its mapping to provide a definitive single source.

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

6.10. We also note that the PRA proposes to apply a minimum risk weight of 250% for investments in equity that may capture subsidiary investments currently held at a 100% weighting. Banks will have detailed information to support the valuation of subsidiary share capital based on subsidiary balance sheets and other management information.

6.11. Therefore, our members consider that applying a 250% minimum risk weight (in place of the previous 100%) for investment in subsidiary capital is likely to be overly punitive.

6.12. We recommend that a 100% risk weighting is maintained for subsidiary investments where detailed information is available to support the valuation.

7. Pillar 1 and Pillar 2A

7.1. The CP only describes the interactions of the changes to Pillar 1 with the PRA's Pillar 2 framework at a high level. Firms need more detail to be able to assess the combined impacts of the PRA's implementation of Basel 3.1 on capital requirements.

7.2. Where Pillar 1 credit risk RWA increases due to better measurement, the PRA states that it will reduce any corresponding Pillar 2A requirement for poorly-measured credit risk. The aim is to avoid double counting. Perversely, the net effect is likely to be that firms will undertake significant work to implement Basel 3.1 only to end up holding the same amount of capital for credit risk across both Pillars. Logically, we would expect a net reduction from greater precision.

7.3. While we welcome this approach, it is important to recognise that, as most challenger banks are subject to a triennial Supervisory Review and Evaluation Process (SREP) cycle, they run the risk of being locked into a minimum total capital ratio for Pillar 2A that is out of sync with changes in methodology for calculating Pillar 1 RWA under Basel 3.1.

7.4. There will also be challenges (discussed above) with the treatment of certain off-balance sheet commitments and undrawn lending that are risk weighted for the first time under Basel 3.1.

7.5. We recommend that the PRA's proposals be amended to specify how and when the corresponding Pillar 2A requirements should change, independent of the SREP cycle. This will remove inconsistency and provide certainty. Greater methodological certainty will allow banks to plan their capital requirements with confidence over a three- to five-year horizon.

7.6. We note that the PRA intends to consider capital requirements — Pillar 1, Pillar 2 and buffer requirements — in Phase 2 of its strong and simple project, and expects to publish its final framework during 2024.

7.7. This creates regulatory uncertainty, which may discourage investment in new and growing banks. The British Business Bank already noted in its 2022 annual report that capital raising has become harder for challenger banks. This increase in regulatory capital requirements and general uncertainty is likely to make capital raising harder still, hindering competition. To provide greater clarity, we recommend that the PRA brings forward relevant elements of the strong and simple capital framework to its final proposals on the implementation of the Basel 3.1 standards.

7.8. Pillar 1 RWA drives the calculation of MREL requirements, but the CP is silent on this matter in its assessment of costs and benefits. Nevertheless, there will be a multiplier effect that should be considered. The cost of servicing any additional MREL that results from additional RWA will impact bank profitability and is likely to impede challenger banks' ability to lend or grow, if they are approaching or are within the MREL threshold. We recommend that the PRA undertakes further impact assessment before finalising its changes to Pillar 1 RWA.

8. Strong and simple regime

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

8.1. As the strong and simple framework has not been completed, it is not yet possible to compare it with the Basel 3.1 proposals or the current CRR regime. This creates regulatory uncertainty for challenger banks, most of whom are likely to be eligible for the strong and simple regime. Regulatory uncertainty usually discourages investment, which is a particular risk for challenger banks whose growth often depends on investor support.

8.2. Qualifying firms on 1 January 2024 may decide to adopt the Transitional Capital Regime (TCR) and remain subject substantially to existing CRR provisions. However, a firm that does not opt for the TCR on or before this date, will be subject to Basel 3.1 from 1 January 2025.

8.3. Given that firms typically have a capital planning horizon of three to five years, this makes it difficult to plan future requirements under the new regime. It also means firms will have a narrow window of less than a year in which to implement any required operational changes.

8.4. To reduce uncertainty, we recommend that the strong and simple framework be made available in 2023. This will reduce regulatory uncertainty, facilitate capital planning, and thereby support investment in the sector. If this is not possible, we recommend bringing forward at least the elements of the regime which are most important for determining regulatory capital requirements for SA firms.

9. Transitional capital regime (TCR)

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

9.1. For SA firms adopting Basel 3.1, there is effectively no transition period as 1 January 2025 will arrive very soon, and the PRA's proposal is to apply the changes to all existing loans at this point. Firms are also unclear how Basel 3.1 dovetails with other policy shifts which the PRA has not finalised.

9.2. We recommend that the PRA grandfathers capital requirements for existing SME loans for SA firms, and introduces a transition period for SA firms over five years (in line with the transition period for IRB banks) for any loan types where there is a material increase in capital requirements under the final Basel 3.1 implementation to align the transition with the finalisation of other policy changes.

9.3. The option available to SA banks of continuing to follow CRR until the strong and simple regime is finalised is welcome for challenger banks, but we are concerned that it could end up continuing for several years. This would then become another source of misalignment with EU-based competitors. To avoid this potential problem, sunset provisions should be specified in the TCR.

10. Summary of Recommendations for SME Lending

10.1. We summarise below the key recommendations for non-systemic SA banks’ credit risk capital requirements for SME lending (with the detail above in Sections 4 and 5). We consider that our recommendations would result in a set of credit risk capital requirements for non-systemic SA banks’ SME lending that would:

a) Align risk weights to the riskiness of the loan types unlike either the current SA regime or the proposals in CP16/22;

b) Align the non-systemic banks’ risk weights much better with the IRB banks, narrowing the competitive gap; and

c) Avoid a material rise in the risk weights, and a jump in capital requirements of over 30%, so avoiding a risk of disrupting the supply of SME lending.

10.2. We estimate that our recommendations would result in a rise in Pillar 1 capital requirements for SME lending of around 8% compared to 30%+ increase under the current CP16/22 proposals. Table 2 compares our recommended risk weights with the CP, current SA risk weights and corresponding IRB risk weights for major UK banks.

10.3. Our recommendations are as follows:

a) The UK should maintain the SME SF and existing risk weightings until there is conclusive empirical evidence that justifies its change or removal.

b) The PRA and HMT should conduct a detailed empirical study into the riskiness and competitiveness of SME lending by challenger banks and the effects of the proposed changes to the SA before implementing them.

c) Secured Business Loans: For lending secured on property, adopt international Basel 3.1 standards, where risk weight is 60% up to 55% loan to value (LTV), and the counterparty risk weight (e.g. Retail SME at 75%, Corporate SME at 85%) for any portion of the loan above 55% LTV on a prudent Vacant Possession valuation basis;

d) Introduce a new exposure category of secured lending: Asset-based SME lending (e.g. equipment or invoice finance) with a 69% risk weight provided there is tangible collateral with a value greater than the value of the loan;

e) Unsecured SME lending: For any lending where there is no tangible collateral, the collateral does not cover the value of the loan, utilising the counterparty risk weight of 75% Retail SME or 85% Corporate SME;

f) Use Slotting to determine Pillar 1 risk weights for Income Producing Commercial Real Estate: Create a risk-sensitive risk weight, simplify capital calculations and remove slotting from Pillar 2.

g) There should also be carve outs at 0% to mirror the approach for ‘low-risk’ items such as certain UCC that the EU is following; and

h) Adopt a ‘phased in approach’ in line with other jurisdictions (notably the EU), to avoid cliff-edge effects that would reduce the availability of credit to the SME sector, particularly in 2024 – 2026.

Table 2: Key recommendations for non-systemic SA banks’ capital requirements for SME lending*

Risk weights by SME loan type	Output of Innovate Finance recommendations for smaller banks	CP16/22 proposed standardised risk weight	Current applicable standardised risk weight	Estimated typical IRB RW for major UK banks (ex SF)
Business Loan Secured on Trading Premises (with prudent valuation & affordability criteria)	60-65%	100%	57-81%	50-55%
Equipment Finance / Asset- Based Lending (where collateral fully covers loan & meeting affordability criteria)	69%	75-85%	57-81%	55-70%
Unsecured / Partially Secured Loans (i.e. not meeting the criteria above)	75-85%	75-85%	57-81%	70-100%

*Notes:

(i) Ranges shown for Current Standardised represents Retail SME and Corporate SME exposures and SME SF up to £5m maximum loan; for Recommended lower end range is Retail SME / 50% LTV, upper end range is Corporate SME / 70% LTV;

(ii) Unsecured does not include any government guarantees (e.g. BBL/CBIL); and

(iii) Current IRB ranges are based on 2015-19 Pillar 3 disclosures for NatWest, Lloyds Banking Group and HSBC - we appreciate that the PRA will have more detailed data on these which may change the ranges shown.

[ENDS]

1 https://www.oxera.com/wp-content/uploads/2023/03/Impact-of-the-PRA-proposals-for-Basel-Standards-in-UK_FINAL_edit.pdf
2 https://www.oxera.com/wp-content/uploads/2023/03/Impact-of-the-PRA-proposals-for-Basel-Standards-in-UK_FINAL_edit.pdf