Basel 3.1 – What do the new capital requirements rules mean for building societies?
The Basel Committee on Banking Supervision is an international body with long-standing responsibility for setting prudential rules via the Basel accords (although jurisdictions have discretion regarding how the accords are reflected in domestic prudential regulation.)
Basel III ushered in stringent capital and liquidity reform requirements and was introduced in response to the collapse of Lehman Brothers, and the subsequent financial crisis. The central aim of Basel III was and is to ensure that banks hold sufficient regulatory capital against assets and investments, with a view to preventing irresponsible lending or institutional failure.
Risk management is an evolving practice, and Basel 3.1 – otherwise known as ‘Basel III Endgame’ - represents the final phase of this ongoing regulatory project (although its implementation will be keeping risk management professionals busy for years to come.)
Last month the UK’s Prudential Regulatory Authority (the PRA) set out its response to Basel 3.1 in PS9/24, a new and near-final suite of capital requirement rules. The implementation date has been postponed to 1st January 2026, followed by a four-year transitional period.
Industry responses in the UK and abroad
Responses to jurisdictions’ interpretations of Basel 3.1 have been mixed. The EU Commission’s stated ambition of ‘regulating without suffocating’ has been met with a relatively muted response. The US Federal Reserve’s initial proposals exceeded the standards set out by the Basel Commission, and were met with ferocious opposition; the rules have since been revised.
In the UK there hasn’t been a particularly strong response to PS9/24, potentially because the PRA have ‘made changes where the evidence suggested too much conservatism in our original proposals’, including the removal of proposals that could have proved ‘costly’ or ‘difficult’ to implement. The proposed final reforms include lower capital requirements with respect to SME lending and infrastructure projects, output floor calculation reforms, and a simplified approach to mortgage lending. The PRA also propose the implementation of a simpler parallel regime for smaller firms.
We’d like to take the opportunity to set out how and why the reforms may have a bigger impact for lenders that focus heavily on lending against ‘regulatory real estate’, and what this means for building societies specifically.
A minimum of 75% of building societies’ lending must be secured against residential property, leaving building societies uniquely exposed to regulatory reform and market changes in this area. Consequently, building societies and other lenders with high exposure to regulatory real estate-linked lending should give due consideration to the implementation of these proposed reforms, and the extent to which these reforms may have a disproportionately large impact on these lenders.
Traditional mortgage lending – a simplified valuation system:
On balance, the new rules are less onerous than those mooted in the Regulator’s initial consultation, CP 16/22.
- When assessing the risk profile, lenders must still use the value of the property at origination (VAO) (i.e. when the mortgage was made.) However, lenders will now be required to reevaluate the value of the loan every five years
- There are two exceptions to this rule, in which case the lender must or may reevaluate every three years: where the value of the loan exceeds £2.6m or >5% of the firm’s funds, or where the valuation was obtained due to a broader depreciation in market prices.
- The PRA will still require firms to monitor the market value of properties, increasing the level of monitoring during times of market turbulence. Firms will only be required to undertake a fresh valuation where it is estimated that the property has fallen by >10% of the recorded value.
- The PRA has removed the draft requirement that a valuation be adjusted to reflect a sustainable property value over the life of the loan, on the grounds of operational complexity and potentially inconsistent results.
- Lenders may use automated valuation models, ‘where prudent to do so’.
Risk-weighting of ‘real estate sub-classes’
Basel 3.1’s definition of ‘regulatory real estate’ includes both residential and commercial real estate. Much of the PRA’s new draft rules determine exposure risk with reference to whether repayments are ‘materially dependent on the cash flow generated by the property’ (‘materially dependent’), alongside property type and loan-to-value ratio. This is with a view to introducing more risk-sensitive weights, depending on the real estate sub-type and risk profile.
Where the exposure is not designated as materially dependent, the risk weight treatment will conform to the ‘loan splitting approach’ set out in the Basel 3.1 standards:
- Assigning a 20% risk weight to the part of the exposure value up to 55% of the property value and the risk weight of the counterparty;
- Plus the risk weight of the counterparty (e.g. 75% for individuals; minimum of 75% for social housing exposures) to any residual part of the exposure.
What sort of lending will be in or out of scope
The PRA’s classification system with respect to what will or won’t render an exposure materially dependent will designate owner-occupiers – and likely many small landlords, and housing associations – as not materially dependent, which could be positive if this results in a lower risk weighting in respect to the exposure. This is because the PRA has determined that the exposure will be classified as materially dependent unless the loan is:
Secured by a single property that is the obligor’s primary residence– i.e. traditional residential lending;
- To an individual or special purpose entity where an individual is a guarantor and doesn’t exceed the ‘three-property limit’ - i.e. many forms of ‘buy-to-let’ lending;
- To a public housing company or not-for-profit association regulated in the UK that exists to serve social purposes and offer long-term housing - i.e. a housing association;
- To an association or a cooperative of individuals that exist with the sole purpose of granting its members use of a primary residence – i.e. a community land trust.
What this means for specialist lending
- Houses in multiple occupation (“HMO”) will no longer be explicitly designated as materially dependent, meaning that firms will be required to assess HMOs as they do other residential real estate exposures.
- Self-build mortgages will not be will not be classified as ‘other residential real estate’ (and so subject to higher risk weights);[1] they may be designated as ‘regulatory real estate exposures’. When determining and risk-weighting the exposure of such a property, firms must use the higher of the following: the most recent valuation with a 20% haircut applied, or the land value. This is positive news for the many building societies offering specialist products focused on self-build.
For further information contact Jeremy Ladyman and Eve Willis
