Basel 3.1 – The PRA consults on the Internal Model Approach
The Prudential Regulation Authority (PRA) is consulting on a package of adjustments to the Basel 3.1 internal model approach (IMA) for market risk (CP9/26), proposing changes that are intended to make the framework more proportionate and operationally workable while maintaining its prudential standards and keeping it aligned with the IMA proposals of other major jurisdictions.
The proposals follow the PRA's finalisation of the Basel 3.1 rules published in PS1/26 and also respond to evidence that surprisingly few firms had been planning to adopt internal models under the framework as it was drafted.
Sam Woods, Deputy Governor for Prudential Regulation and Chief Executive Officer of the PRA, said the rules are the last part of the post-financial-crisis reform programme agreed between the UK and other major jurisdictions. He said that the added time allows the regulator to reflect implementation elsewhere while ensuring trading activity in the UK remains appropriately capitalised.
The CP has put forward seven proposals which can be summarised as follows:
Proposal 1: Extend the monitoring period for the profit and loss attribution test (PLAT) from one year to three years. During this period, the PLAT test will not be binding.
Proposal 2: Adjust the risk factor eligibility test (RFET) by:
reducing the number of required verifiable prices to pass the quantitative RFET from 24 to 16 for risk factors with a liquidity horizon of greater than 20 days; and
introducing a proportionate RFET requirement for new issuances.
Proposal 3: Introduce targeted adjustments and operational simplifications to the non-modellable risk factors (NMRF) framework by:
introducing a new category of NMRFs that satisfy qualitative data standards, but do not meet the quantitative verifiable price requirements (Type 1). Type 1 NMRFs would be included within the expected shortfall (ES) model. Reflecting that these risk factors do not have a sufficient number of verifiable prices, they would also be subject to an NMRF capital add-on, with an assumption of zero correlation between the risk factors. Risk factors that fail both the quantitative and qualitative requirements (Type 2) would continue to be capitalised as set out in PS1/26.
making a number of operational simplifications, including aligning the NMRF stress period with the stress period used for the expected shortfall (ES) model, reducing the calculation frequency for Type 2 NMRFs to monthly, and removing the distinction between idiosyncratic and non-idiosyncratic NMRFs.
Proposal 4: Reduce barriers to the gradual nature of IMA approval for any given firm by:
recognising diversification between Advanced Standardised Approach (ASA) and IMA portfolios through a marginal ASA adjustment; and
replacing the existing partial caps on IMA capital with a permission-based cap on IMA capital at the full ASA level.
In addition to the changes set out above, the PRA also proposes a number of adjustments to clarify and ease the operational burden of the IMA framework:
Proposal 5: Adjust the treatment of collective investment undertakings (CIUs) by introducing a 90% de minimis look-through threshold for IMA inclusion and extending the ASA treatment of index-tracking funds to IMA.
Proposal 6: Make a number of minor operational adjustments and clarifications to the IMA framework, including:
clarifying the process for determining the own funds requirements for general interest rate risk internal hedges desks;
providing IMA firms with the option to use alternative tests to assess the reduced set of risk factors, subject to notifying their respective PRA supervisors; and
clarifying the treatment of listed closed-ended investment funds that also meet the definition of a CIU within the trading book boundary.
Proposal 7: Update reporting and disclosure obligations to align with the above proposals.
The consultation is open until 18th September 2026 while the proposed implementation date remains unchanged. In CP17/25 the PRA proposed to implement all aspects of the FRTB alongside the rest of the Basel 3.1 rules on 1 January 2027, except for implementation of the IMA which is delayed until 1 January 2028 to allow time for international coordination, given that IMA is predominantly used by major trading firms including international groups engaged in cross-border trading activity.
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FMCR is a network of senior practitioners, former COOs, global business heads, traders and risk leaders from Tier 1 global banks, providing advisory services to Markets and Banking leadership teams across risk management and performance. The FMCR team includes highly qualified and experienced mathematicians and modellers and would be pleased to discuss technical aspects of the proposals. To discuss how FMCR can help your firm, please contact us at contact@fmcr.com.
ABOUT THE AUTHOR
Written by Peter Manning, a Senior Advisor at FMCR with over 40 years of experience in the City in senior management, risk, compliance and regulation.