Basel 3.1: The Clock is Ticking for Finance Companies

While we await the outcome of the PRA’s recent consultation period, the clock is ticking on the implementation of Basel 3.1 which will dictate the regulatory capital requirements for banks from January 2025.

Implications will ripple disruptively through commercial finance markets, impacting the profitability of not just bank-owned lenders but also intermediary lenders who access wholesale lending. 

This article focuses on issues created by one proposed change, the removal of the “SME Support Factor”.   

Outside the large retail banks, most banks in the UK use the “Standardised Approach” to define their regulatory capital, calculated by multiplying their risk-weighted assets by 8% to derive Pillar I Minimum Capital Requirements. Since 2014 the risk weighting for SME lending has benefitted from the “SME Support Factor”, which reduced the risk weighting from 75% to 57.14%. As things stand, from January 2025 the SME Support Factor will be removed.

Impact on Funding Supply and Demand

For SME lenders using the Standardised Approach this represents a 31% increase in regulatory capital for credit risk. There is, of course, complexity in the proposed new rules and the impact will be different for each bank, including as a result of their individual cost of debt and equity. There are also different ways to look at the same situation, for example from a blended cost of funds perspective or in terms of the margin requirement to achieve an acceptable return on regulatory capital. 

Based on our rudimentary analysis it appears that in most cases the impact will be in the 10-30BPs range. As a result, while uncomfortable, it appears that on its own, the customer impact could be managed, being not dissimilar to a quarter-point rises in interest rates that have been experienced regularly since early 2022 (potentially leading to some new business volume reduction). Moreover, given the ample current levels of market liquidity, we do not envisage emerging supply difficulties for creditworthy SME customers, at least not in the asset or invoice finance markets.

That said, we have had anecdotal reports from lenders who have indicated that the impact could be considerably higher. We will be interested to hear from lessors and invoice finance providers who have modelled the impact on their own business, to add some real-world context to both financial and market assessments. 

Recapitalisation of Existing Portfolios

As things stand, bank SME portfolios operating on the Standardised Approach will need to be recapitalised on 1/1/25. In asset finance, for example, that means recapitalising transactions that were potentially written several years earlier and ones that are being written today; with the result of a negative Return on Capital impact on the existing book.

Notably, the consultation response from UK Finance lobbied for SME Support Factor to be maintained on existing portfolios – when the final rules are released we will see if this suggestion has been adopted.

Role of Credit Insurance for Return on Capital Enhancement

Taking credit insurance with a highly-rated provider can mitigate some of the impact of Basel 3.1, as the counterparty risk rating shifts from the SME (75% risk weighting) to the credit insurer. For example, at Finativ we have started working with Allianz Trade, an AA-rated corporate (20% risk weighting). Our initial estimate is this can generate a cost of funding improvement of around 40BPs, reducing capital requirement and strengthening Return on Capital significantly. Please contact us if you would like to know more.

Trickle-Down Impact Though Wholesale Lending

Banks providing wholesale funding (including block discounting) will inevitably have to consider how Basel 3.1 requirements translate into downstream funding arrangements. Pricing can be expected to rise, but how the wholesale lender sees its counterparty RWA is to be determined (including whether there is a see-through to the ultimate SME borrower).

Beyond that, the impact will be opaque. From experience, a CEO of a non-bank lender I spoke to was unconvinced that positive benefits of government intervention had been passed down in the past, and that the impact of any changes in wholesale cost of funds based on Basel 3.1 would be fairly hidden to the intermediary lender. 

Competitiveness and Timing

The Basel 3.1 implementation date of January 2025 raises some interesting challenges for lessors. When should new business pricing change to reflect future recapitalisation? Are wholesale arrangements impacted and when should they be re-priced, given the term of the facility? When and how much can additional costs or yield expectations be passed on to customers? With recent cost of fund changes, we have seen how holding price has driven significant new business volumes for some lenders, at the expense of competitors. Finance companies who manage Basel 3.1. timing issues well have the potential for short-term competitive advantage. 

Ratchet Impacts, Stress Testing and Potential Exits

In itself, Basel 3.1 won’t make a lending business unviable. However, given the potential ratchet effects caused by current economic weaknesses, a call on investors for increased capital and higher yield requirements may come at a time when bad debts are rising, fraud is up, wage inflation remains high, interest rates are volatile (including some difficulties in passing on funding cost increases) and demand is suppressed. In those circumstances, pushing further capital into an SME lending business may be viewed as less attractive versus other investment options.

As a result, we recommend funders consider financial scenario planning to stress test their position, competitiveness and both exit and acquisition options. 

Buying portfolios is already difficult due to the change in funding costs between when the business was written and now. There are scenarios where that could become more difficult still, driving either an early sale decision or a future run-down scenario.

Other Key Features of Basel 3.1

Removal of the SME Support Factor is only one of a number of elements of Basel 3.1 that has the potential to disrupt commercial finance markets. Notable other features include:

• Commercial mortgages (loan secured on commercial property) to be weighted at 100%. As this is higher than unsecured lending (75% RWA), there is logic to this being reworked in the final rules. However, as things stand there are significant implications for banks providing commercial mortgages, leading to a potential retrenchment in that asset category. Banks may also need to consider the implications if there are other circumstances where commercial property is used as collateral, such as via a guarantee.
• There will be an “Output Floor” for those banks using Internal Ratings Based (IRB) capital calculations (fundamentally, the large retail banks). The Output Floor means that at an aggregate level, an IRB bank will need to hold capital either equivalent to 72.5% of the calculated Standardised Approach RWAs or per their IRB models, whichever is higher. Where the 72.5% rule applied, this clearly remains considerably below what smaller banks would hold under the Standardised Approach. Moreover, as the Output Floor applies at a consolidated level, one implication of this is that individual business units may be unaffected by the Output Floor ruling if the capital requirement of the bank is sufficiently high overall. The PRA has proposed a five year transitionary period on the Output Floor, gradually rising to 72.5%, which will presumably reduce its immediate impact.
• Changed capital weighting for unrated corporates. The UK will introduce an RWA of 85% for unrated corporate SMEs (defined as exposures where the consolidated group annual sales are €50m or less). Unrated corporates will be assessed as Investment Grade (IG) with an RWA of 65% or non-IG with an RWA of 135%. With the historic approach being a 100% RWA and reports suggesting that 70% of EU corporate exposure fits into the non-IG category⁽¹⁾, this potentially increases the cost of borrowing for small corporates
• EU bank differences – these include retention of the SME Support Factor, no application of the Output Floor on their UK entities and transitional arrangements in lending to unrated corporates. The transferability (or otherwise) of any advantages to these banks’ UK operations - and the materiality of these benefits - should be assessed in due course. 
• Requirement to improve capital reporting – as noted in a recent report⁽²⁾, “the PRA expects banks to elevate regulatory reporting to the same standards of control and expertise applied to financial reporting. This will require significant improvements to UK banks’ data systems and infrastructure, potentially including strategic systems upgrades to facilitate the transition to new reporting requirements.”

For banks, making all the practical changes that are required by the start of 2025 seems like a challenge and will become more difficult given the final rules from the PRA are not yet available. In parallel, failure to consider the strategic and commercial implications of the new regulatory capital regime may result in significant disadvantage.

There is little time to waste.

For more information contact:

Peter Hunt, Chief Operating Officer, Finativ

e-mail: peter.hunt@finativ.co.uk

 (1) The unrated corporate exposure conundrum: Basel 3.1, capital and pricing, Deloitte.com, 16/10/2022

(2) The UK implementation of Basel 3.1 – a difficult balancing act for the PRA, Deloitte.com, 11/10/2022