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Derivatives and securities finance industry associations have published responses to the Prudential Regulation Authority (PRA) consultation on Basel 3.1 implementation.
The International Swaps and Derivatives Association (ISDA) and the Association for Financial Markets in Europe (AFME) issued a joint response to the PRA consultation paper 16/22 on 31 March.
The associations indicate that the Basel 3.1 capital framework is a necessary element of protecting financial stability but they warn against “disproportionate capital requirements” that may impact a bank’s ability to provide key financing, liquidity, hedging services and a wider range of products to end users.
According to aggregated cost benefit analysis conducted by the PRA, the PRA’s proposed rules outlined in CP 16/22 would require banks to raise an additional 3.1 per cent in Common Equity Tier 1 (CET1), equivalent to £14.2 billion across all firms falling into scope, compared with a baseline where the provisions detailed in the consultation paper are not implemented.
The PRA’s cost estimates predict that total capital, including CET1, Additional Tier 1 capital and Tier 2 capital will rise by 3.1 per cent, or £19.7 billion, across all firms falling into scope.
Additionally, total operational compliance costs associated with these changes will be close to £4.9 billion, the largest share resulting from changes to the market risk framework, at £3.8 billion. These costs, the associations indicate, will be borne mainly by the large banks.
In responding to the PRA consultation, ISDA and AFME put forward recommendations which they intend should maintain global connectedness by supporting the role of the UK as an international financial hub.
This should also encourage appropriate risk-calibration under the Basel framework which aligns with international standards, but which permits adaptations to reflect “regional specificities”. They note that, post-Brexit, the UK has the ability to write its own rules independently in line with the provisions of the Financial Services and Markets Act of 2000 and the Financial Services Act 2021.
In a separate response to PRA CP 16/22, the International Securities Lending Association (ISLA) focuses on Question 8 in the CP relating to the proposed approach for unrated corporates.
ISLA indicates that it supports the introduction of a move to a more risk-sensitive approach to unrated institutions, but raises concerns that a significant increase in capital costs under the new output floor may “inevitably cause the activity of securities financing to become uneconomical”, potentially resulting in a decline in this activity and a reduction in liquidity across the capital market.
“This effect will be most noticeable in the case of low risk, financially sound but unrated institutions which is where a majority of the supply for SFTs in Europe derives from.” This, the Association believes, will drive up costs for low-risk entities such as pension funds and mutual funds.
The PRA’s proposed approach will allow exposures for firms rated as Investment Grade to be risk-weighted at 65 per cent, but for firms classified as Non-Investment Grade to be risk-weighted at 135 per cent.
Drawing on data from ratings specialists S&P Global and Credit Benchmark, ISLA indicates that the average credit quality of funds that lend securities in Europe are mostly “of the highest credit quality”.
Given that ratings are typically used by issuers of securities to raise capital, many mutual funds and pension funds may be unrated because they do not raise capital through issuing securities and have little requirement for an external credit rating.
However, ISLA fears that the proposed changes may unduly punish securities loan trades where these entities are the lender — potentially resulting in a rise in risk weight for these types of counterpart from 12.5 per cent to 65 per cent.
This may result in borrowers — predominantly banks and broker-dealers — reducing their borrowing from these ‘unrated counterparties’. Alternatively, borrowers may seek to pass this increase in the aggregate cost of trading through to the counterparty, which may render securities lending activity increasingly “uneconomic” for many pension fund and mutual fund lenders.
