Following the global financial crisis of 2007 to 2009, the Basel Committee on Banking Supervision (BCBS) has rolled out Basel 3 as part of a continuing effort to improve the global financial banking regulatory framework. The aims? Simple, to enhance banks’ resilience to reduce the system-wide shocks and prevent economic meltdowns by increasing capital requirements.​

Fast forward to November 2022, the Prudential Regulation Authority (PRA) has issued a consultation paper for the Basel 3.1 implementation. ​

The objective of the Basel 3.1 framework is to:

• reduce the unwanted variability in risk weighted assets (RWAs) through the removal of internal models in certain areas,
• introduce constraints on the use of credit risk internal models,
• improve the risk sensitivity of standardised approaches for various risk areas (i.e. credit risk, market risk, etc), and​
• Introduce an output floor to provide a standardised approach backstop to limit the benefit of internal models.

Find out more about Basel III

The EU Commission published a review of the EU banking rules in the 2021 Banking Package on 27 October including the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD). The new rules will help EU banks become more resilient to potential future economic shocks, contribute to EU’s recovery from the COVID-19 pandemic and transition smoothly to climate neutrality.

The scope of the CRR III and CRD VI includes the following:

The standardised approach to credit risk

The standardised approach will become more risk sensitive where more tiers, categories and requirements are added.

The IRB approach to credit risk

Changes to the IRB approach include the input of floors with the aim of establishing minimum levels of probability of default, loss given default and exposure at default within the framework.

The Calculation Of CVA

The European Commission incorporates changes to Credit Valuation Adjustment to remove the use of internal modeled approaches and proceed with a standardised or basic approach.

The Operational Risk Framework

Changes to the operational risk framework require the removal of the advanced measurement approach (AMA) and replace it with a non-modeled standardised approach.

The Output Floor Limiting Capital Benefits

The output floor limits the capital benefit arising from the use of risk models across all risk types by establishing minimum risk weighted assets (RWAs) at 72.5% of the standardised level.

The Fundamental Review of the Trading Book (FRTB) comprises a comprehensive framework of capital regulations established by the Basel Committee on Banking Supervision (BCBS). These regulations are designed to apply to a bank’s wholesale trading operations.​

Being a globally recognised standard, FRTB outlines guidelines for determining the amount of capital that banks are required to maintain to cover their market risk exposures. Consequently, these regulations have a significant impact on a bank’s choices regarding trading activities, pricing strategies, and, ultimately, its overall financial performance.​

Internal Model Approach (IMA) To Market Risk

• Permits banks to utilise their proprietary internal models for capital requirement calculations, subject to approval by regulatory authorities.
• This approach enables banks to employ models that align with their unique risk profiles.
• Requires the establishment of advanced and intricate risk management systems.
• Demands a higher degree of expertise in modeling and validation processes.

Standardised Approach (SA) To Market Risk

• Straightforward method employing predetermined risk weights and formulas for capital requirement calculations.
• Does not account for a bank’s unique risk profile, making it less flexible in its application.
• Simpler and less intricate making it suitable for smaller or less complex banks.

Internal Model Approach (IMA)

• Default Risk Charge (DRC).
• Risk factor eligibility test (RFET).
• Non-modellable risk factors (NMRF).
• P&L attribution test (PLAT) and back-testing.