What are the Basel 3.1 reforms?

The 2008 global financial crisis triggered a major review of the Basel 2 framework for bank capital. The 'Basel 3' standards agreed between 2010 and 2017 required banks to hold significantly more, higher quality capital (the numerator of bank capital ratios), in particular common equity, and included new or revised standards on risk coverage, leverage, liquidity, large exposures and disclosure.

The package of additional reforms agreed in 2017 and 2019 and known as 'Basel 3.1' (or sometimes 'Basel 3.5' or 'Basel 4') focused on improving the measurement of risk - the denominator of capital ratios - in particular because of concerns that the Basel 2 approach of allowing banks to use internal models to calculate risk weighted assets (RWAs) for credit, market and other risks had led to excessive differences between banks’ RWAs.

To address this, the new standards revise the standardised approach for calculating RWAs for credit risk, significantly limit the extent to which banks can use the internal-ratings based approach for credit risk and change the rules on the use of credit risk mitigation techniques. The reforms include a fundamental review of the trading book (FRTB), overhauling the way in which capital is calculated for market risk, and also end the use of the internal models for calculating operational risk and credit valuation adjustment (CVA) risk. They also impose an ‘output floor’ to ensure total RWAs for banks using internal models cannot fall below 72.5% of RWAs derived under standardised approaches - phased in over five years.

For many banks, the reforms will significantly increase required levels of required capital, involve significant implementation costs (particularly to implement the FRTB) and impact their market behaviour. In particular, differences in the way different jurisdictions implement the reforms may affect banks’ competitive position against other banks and against non-bank financial intermediaries.

What is the timing of the reforms?

The Basel 3.1 reforms were originally scheduled to be implemented from 1 January 2022 but implementation was delayed to 1 January 2023 because of Covid-19. Some G-10 jurisdictions (Canada, Japan) have completed their implementation but the EU, Switzerland, the UK and the US have not.

In the EU, implementing legislation has been adopted and largely applies from 1 January 2025, while the US authorities have consulted on ‘Basel endgame’ rules with a target implementation date of 1 July 2025. However, the US proposals have been mired in controversy and may be reproposed (at least in part), leading the European Commission to propose a one-year delay in the EU implementation of the FRTB to address concerns about the competitive implications for EU banks.

The PRA had proposed a UK implementation date of 1 July 2025 to align with the US. It is not yet clear whether the PRA will change its timetable as a result of delays to implementation in the US and the EU.

How are the EU and UK implementing the reforms?

The European Commission proposed its banking package in October 2021 and the legislation was finally adopted and published in the Official Journal in June 2024. The package consists of a regulation (CRR3) amending the capital requirements regulation and a directive (CRD6) amending the capital requirements directive.

In line with the existing legislation, the changes implementing Basel 3.1 will apply to all EU banks, not just the internationally active banks covered by the Basel framework. Partly because of this, there are a number of ‘EU specificities’ in the EU implementation that reduce the impact on EU banks, including additional transitional provisions and phase-ins.

The package also includes additional measures going beyond the Basel 3.1 reforms, including an interim capital regime for crypto-asset exposures, new governance and risk management rules for environmental, social and governance (ESG) risks and a new supervisory regime for EU branches of non-EU banks. In addition, CRD6 includes new restrictions on cross-border banking business into the EU, a new approval regime for bank M&A and reorganisations and new rules for bank senior management and governance. While the interim regime for crypto-assets applies now, many of these other changes are to apply from January 2026, although most of the new rules for third-country firms are deferred to January 2027.

In the UK, the post-Brexit ‘future regulatory framework’ reforms aim to move prudential rules from the 'onshored' EU capital requirements regulation (CRR) and related technical standards into PRA rules. HM Treasury will use its powers under the Financial Services Act 2021 to revoke relevant provisions of onshored CRR to ‘clear the way’ for the PRA to adopt rewritten replacement rules which (at the same time) implement Basel 3.1. The PRA has consulted on its proposals and the final policy statement is expected after the summer break. The PRA proposals were closely based on Basel 3.1 with some more stringent requirements, but they exempted a class of ‘small domestic deposit-takers’ for which the PRA is creating a new ‘strong and simple’ regime differentiated from the rules for larger banks. 

What are the changes to the treatment of credit risk?

The Basel 3.1 reforms will have significant impacts on the calculation of capital requirements for market risk, operational risk and CVA risk. But the extensive changes to the capital rules for credit risk are also at the centre of the reforms. For example:

• Banks will no longer be able to use models to estimate loss given default and exposure at default for ‘low default portfolios’ under the internal ratings based approach, including for exposures to large corporates (with a consolidated turnover exceeding €500m in the EU or £440m in the UK), likely increasing capital charges for these exposures.
• There will be new capital charges for overdrafts and other ‘unconditionally cancellable facilities’ that currently benefit from a 0% 'credit conversion factor' and the capital charges for undrawn short-term facilities will also rise.
• There will be a significant recalibration of risk weights for unrated exposures and specialised lending in the standardised approach and for commercial real estate lending in all approaches.
• New higher risk weights will apply to subordinated and equity exposures, with new definitions capturing some loans with equity conversion features.
• There will be numerous changes to the eligibility rules for collateral, guarantees and other risk mitigation techniques.
• As the output floor is phased in, banks using internal ratings based approaches will increasingly also need to manage the impact of the standardised approaches on the calculation of RWAs.
• It will be more difficult to move assets from the banking book to the trading book (eg to take advantage of offsetting short positions).

What are the differences between the EU and UK implementation?

Both the EU implementation and the UK proposals closely track Basel 3.1 but they differ in many respects (and not just in relation to timing and scope of application). For example:

• CRR3 includes several additional transitional provisions and phase-ins beyond those proposed by the PRA, eg, in relation to the impact of the new 10% credit conversion factor for unconditionally cancellable commitments and the ending of the eligibility of bank ratings that rely on implicit parental support.
• The EU is applying the output floor to individual banks and at consolidated and sub-consolidated levels, whereas the PRA proposes to exempt UK subsidiaries of non-UK parents from the floor if the non-UK parent applies the floor on a consolidated basis.
• The EU is applying a flat 100% risk weight to unrated corporate exposures in the standardised approach. The PRA proposes to allow banks to use a more risk sensitive alternative approach with a 65% risk weight for investment grade exposures offset by a 135% risk weight for other exposures.
• The EU is continuing to apply support factors to reduce risk weights for lending to small and medium-sized enterprises (SMEs) and infrastructure lending. The PRA proposes to end the use of these support factors but to apply an 85% risk weight for exposures to SMEs not included in the retail class.
• The PRA proposes additional multipliers and risk weight floors for the calculation of risk weights for commercial real estate lending. It is also proposing an extra capital add-on when items are reclassified between the banking and trading books.
• The EU is retaining exemptions from the CVA risk charges for transactions with some corporates, pension funds and sovereigns (and is adopting a different approach to intragroup transactions).
• The EU is introducing immediate new capital rules for crypto-asset exposures and wide-ranging governance and risk management rules for ESG risks (although it is not proposing a ‘green support factor’ at this stage).

Additional differences between the EU and UK requirements may arise as a result of the PRA’s rewriting of those rules moving from the onshored CRR into the PRA rulebook and the EU's adoption of technical standards and guidelines to supplement CRR3 and CRD6.

What's next in the Basel Committee?

The US reference to the ‘Basel endgame’ might suggest that there are no plans for future policy work in the Basel Committee, which has now closed the book on its post-crisis reforms. However, the Committee still has an active work programme focusing on emerging risks and horizon scanning, digitalisation of finance, climate-related financial risks, monitoring and review of existing standards and guidance, and monitoring and evaluating implementation of those standards.

In July, the Committee published the final disclosure framework for banks' cryptoasset exposures and targeted amendments to its cryptoasset standard – both of which are to be implemented by 1 January 2026.

The Committee also published a recalibration of the interest rate shocks to be used by banks when measuring interest rate risk in the banking book and is consulting on the disclosure framework for climate-related financial risks and on the principles for the sound risk management of the risks from critical third party IT suppliers, also being addressed by recent EU and UK legislation.

In addition, the Committee may yet take further steps to respond to the March 2023 banking turmoil and the failure of Silicon Valley Bank and other US banks and the crisis at Credit Suisse, looking at the treatment of liquidity, banking book interest rate risk, the role of 'Additional Tier 1' capital instruments and how the Basel framework applies to smaller banks with some international operations. However, no definite proposals have yet been published.

There may also be further action in relation to the treatment of non-bank financial intermediaries as regulators continue to voice concern about the possible systemic risks posed by funds and other non-bank intermediaries, and the banking sector’s exposure to them.

What's the future prudential agenda in the EU and UK?

Both the EU and the UK are committed to wide-ranging future work on bank prudential policy.

In the EU, implementation of CRR3/CRD6 is a huge task with more than 50 mandates for ‘Level 2’ acts and over 30 mandates for EBA guidelines. The upcoming implementation of the legislation on markets in crypto-assets and digital operational resilience also has implication for bank prudential policy.

In addition, CRR3 tasks the EBA and the Commission to carry out a dozen reviews in the period to 2030, including a review this year of the treatment of insurance as credit risk mitigation, which may lead to further legislative proposals. Moreover, the EU crisis management and deposit insurance package is likely to be finalised this year, which will have implications for bank recovery and resolution, and there is ongoing consultation on revising the prudential treatment of investment firms.

In the UK, the PRA will continue to work with HM Treasury towards replacing the remaining provisions of onshored CRR with PRA rules. The PRA has said that it will consult in 2024/25 on proposed rules to replace, with modifications where appropriate, the relevant firm-facing provisions in Part Two of the onshored CRR (definition of own funds and eligible liabilities). However, the pace of this will depend on the prioritisation given to it by the new Labour Government. On top of this, the PRA is developing its ‘strong and simple’ framework for small domestic deposit-takers as well as working on other specific initiatives, such as the treatment of branches and subsidiaries of non-UK banks and their booking models.

Authors: Marc Benzler, Caroline Meinertz, Chris Bates