Assessing the impact of Basel 3.1 on mid-tier banks’ ability to support the UK economy

Working with UK Finance and our members, EY LLP has examined the effects on mid-tier banks’ ability to lend to Small and Medium Enterprise (SME) and provide buy-to-let mortgages (BTL) under the PRA’s proposals for implementing Basel 3.1 in the UK.

The opinions expressed here are those of the authors. They do not necessarily reflect the views or positions of UK Finance or its members.

Many of our mid-tier members that use the Standardised Approach to calculate risk weighted asset capital requirements have for some time expressed concerns around the implementation of Basel 3.1; particularly the increase in risk weights for BTL Mortgages and SME lending, if the SME supporting factor is removed and risk weights for unconditionally cancellable commitments are brought in. Larger firms using the Internal Ratings Based (IRB) approach for capital calculation will not be subject to this increased risk weighting immediately, due to the five-year phasing of the output floor. At the opposite end of the scale, the PRA has proposed a ‘Transitional Capital Regime’ for firms meeting the Small Domestic Deposit Takers (SDDT) definition, allowing them to remain on the current Basel 3/CRR standards. Both measures effectively defer potential future capital impacts but mid-tier firms will face an immediate cliff edge for both SME and BTL lending.

This will place mid-tier firms in a difficult position. Their assets are growing and evolving, and often have specific concentrations where a risk/reward balance is found which is not currently well-catered for by larger (or smaller) lenders. Such concentrations can include BTL lending and SME financing.

In its study, using stylised examples, EY LLP has estimated that this may result in a 24 per cent reduction in mid-tier banks’ appetite for lending to SMEs or an increase in capital of about 30 per cent. These increases will result in increased SME borrowing costs of on average of 30 basis points although the impact is likely to higher in some subsectors of the market. The increase in risk weights for BTL’s will increase capital requirements by around 24 per cent, or bring about a 19 per cent reduction of lending, We expect this to impact professional BTL landlords the hardest, potentially decreasing the stock of private rented accommodation, driving more renters in to the social housing sector.

To overcome these day one impacts and to level the playing field we propose that the Transitional Capital Regime could be applied to mid-tier firms by providing the option to remain on the current CRR approaches until such time as the PRA has implemented a ‘mid-tier’ or ‘intermediate’ regime  alongside the SDDT regime.

An alternative would be for increased risk weights to be phased in over a five-year transitional period, similar to the IRB output floor. This type of grandfathering regime is not new and has been successfully implemented before in the UK to smooth significant changes in capital requirements.

We expect the PRA to release its finalised Rulebook by the end of the month and look forward to it amending the current proposed approach to ensure mid-tier firms are not unfairly disadvantaged compared to their larger and smaller competitors.