Basel 3.1 – fuel to further accelerate the growth of private credit?

12 September 2024

Basel 3.1 (also referred to as Basel IV and the Basel Endgame) will make significant changes to the methods for measuring risk-weighted assets (RWAs)[1] which are used to determine the minimum level of regulatory capital that a bank is required to maintain to absorb unexpected losses.  

The changes will require some banks to increase their regulatory capital reserves or force them to sell their positions in loans which are no longer capital efficient and/or enter into arrangements to reduce their regulatory capital requirements. This will present opportunities for non-bank lenders.

Background

The global financial crisis (GFC) revealed significant shortcomings in the calculation of RWAs and capital ratios[2] which led the Basel Committee on Banking Supervision (the BCBS) to agree a series of reforms to its standards to, among other things, improve the accuracy of risk measurement by banks (the reforms being the Basel 3.1 standards). A number of the Basel 3.1 standards have already been implemented in the UK through EU legislation that was onshored post-Brexit and the second near-final policy statement on the implementation of the Basel 3.1 standards which the Prudential Regulation Authority (the PRA) published earlier today confirms that the balance of the reforms, including the changes to the methods for measuring RWAs, are to be implemented in the UK on 1 January 2026.[3]

Under the current regime, UK banks measure RWAs using either:

  • the “standardised approach”, which assigns risk weights to different types of assets, off-balance sheet exposures, and counterparty credit risks predominantly using external credit assessments from recognised credit rating agencies; or 
  • the “internal ratings-based” approach (the IRB approach) which is more complex and enables banks to use their own internal models to calculate risk which may generate a more favourable risk-weighting than using the standardised approach.[4] 

The BCBS identified a “worrying degree of variability” in the calculation of RWAs at the peak of the GFC and the Basel 3.1 standards propose to make changes to: 

  • the standardised approach, to introduce more risk-sensitive weights for certain asset classes and to reduce the reliance on external ratings; and
  • the IRB approach, to prevent the IRB approach from being used to measure RWAs for certain assets classes, restrict the use of the IRB approach for other assets classes, including large corporates and, most notably, introduce a floor to the measurement of RWAs such that it can be no less than a fixed percentage[5] of the RWAs if measured using the standardised approach (referred to as the “output floor”). 

The changes to the calculation of the RWAs is likely to materially affect the RWAs for certain asset classes, including large corporates that lack an external credit rating and certain types of real estate which may present the following opportunities for non-bank lenders.

Opportunities for private credit

Bridging the funding gap

As bank regulatory capital requirements in respect of certain assets classes increase, including the capital requirements in respect of loans to large corporates and certain types of real estate financing, non-bank lenders will be well-placed to offer those loans on more competitive terms which is likely to result in an increase in the volume of those loans provided by non-bank lenders.

Purchase of loan portfolios and forward flow financing

Banks that are negatively affected by the Basel 3.1 standards may need to sell portfolios of loans to comply with the capital ratios under the revised regulatory capital regime and non-bank lenders, who are not subject to the same requirements, may be appropriately positioned to purchase those portfolios. If a bank needs to sell a portfolio of loans, but would like to maintain long-standing client relationships and/or market share then a practical solution could be to enter into a forward flow financing arrangement with a non-bank lender, which would involve the bank transferring the portfolio to a non-bank lender, but retaining the client-facing servicing role.

Significant risk transfer transactions (SRTs)

Banks that are negatively affected by the Basel 3.1 standards may also look to enter into an SRT which can reduce a bank’s regulatory capital charge on a portfolio of loans by transferring some of the credit-risk associated with those loans to the investors in the SRT. There has been exponential growth in the SRT market over the past few years with many credit managers raising dedicated SRT funds and it is expected that the implementation of the Basel 3.1 standards will fuel further growth because a number of banks will turn to SRTs to reduce their regulatory capital requirements.

 

Macfarlanes LLP has a market leading structured and speciality finance practice in London. If you would like to discuss the Basel 3.1 standards or any of the financing arrangements referred to above in more detail, please do not hesitate to get in touch.

 

[1] “Risk-weighted assets” which refers to the estimate of the risk of unexpected losses being incurred in respect of the relevant assets.

[2] the ratio of capital held by banks to RWAs.

[3] the Basel 3.1 standards will be implemented once HM Treasury (HMT) has revoked the relevant parts of the CRR (Regulation (EU) No 575/2013 of the European Parliament and of the Council) by way of statutory instrument. The PRA has confirmed that it intends to make all the final policy materials, rules, and technical standards in a single, final policy statement, once the statutory instrument has been made.

[4] Banks require permission from the PRA to use the IRB approach.

[5] This percentage shall start at 55% on 1 January 2026 and rise annually in 5% increments to 70% on 1 January 2029 and then to its end-state of 72.5% on 1 January 2030.