Capital framework

2023 will be the year the frameworks for banking and insurance capital requirements once again come into focus, as policymakers in the UK and EU look to finalise major packages of reform.

Given the macroeconomic context will likely have micro (and macro) prudential implications, particularly in terms of credit losses and diminished business opportunities, the remaining policy negotiations are likely to be buffeted by debates around the impact of revised rules on economic growth. Senior leaders in both sectors will need to invest time to ensure that they understand the strategic implications of changes to the relevant rules.

The PRA also proposed to implement the Output Floor without the majority of the EU’s extended deferrals, and also not to include the preferential approach for unrated specialised lending facilities that exists in the EU framework. Firms with subsidiaries in both the EU and the UK will have to ensure their systems can calculate solo risk weighted assets (RWA) figures for rules in the UK and EU, while calculating Group RWA figures appropriately.

In the EU, the European Council’s general approach to Capital Requirements Directive 6/Capital Requirements Regulation 3, also reached in November 2022, set out a position that eases requirements for third-country branches (compared to those that the European Commission originally proposed), proposes that the Output Floor be applied at all levels of consolidation – albeit with a member state discretion, affirms support for changes to the fit and proper person elements of the package, provides for existing COVID-era public guarantees to be recognised under the new banking package, and supports enhanced environmental, social and governance reporting. Further deviations from the Basel framework remain a possibility as negotiators continue their work to reach agreement in trilogues, expected before end-2023.

The inevitable reality is that Basel 3.1 adoption will mean more divergence in the rulebook for bank capital requirements between the EU and the UK than has existed before. This will place a greater operational burden on cross-border banking groups, but it will also give them an opportunity to assess how a more divergent rulebook might affect their pricing and their optimal product offering in different markets, for example by undertaking UK-based lending that benefits from preferential treatments under EU rules out of EU subsidiaries.

The finalisation of the EU and the UK Solvency II frameworks will be particularly important for the life insurance industry, although some of the proposed reforms (including proportionality and reporting) will also be relevant to non-life firms. In the EU, we expect the final outcome of the reforms to look similar to the European Commission's original proposals for amendment. In the UK, the PRA will engage with insurers on the technical details of the Solvency II reforms during 2023 before issuing a formal consultation.

The ongoing EU and UK reviews of their respective Solvency II framework aim to achieve similar objectives - mainly to channel funds into green and sustainable investments. However, the mechanisms applied to achieve this in the two jurisdictions differ quite significantly.

While both the EU and the UK propose changes to the risk margin, UK reforms remain centred around amending the matching adjustment (MA) criteria, although the UK Government is leaving the fundamental spread calibration within the MA untouched as per its recent consultation response. The European Commission, meanwhile, is seeking to adjust the volatility adjustment (VA) and long-term equity (LTE) criteria. While different in substance, these sets of reforms provide both EU and UK insurers with an opportunity to review and adjust their overall investment strategies as well as MA/VA portfolios, in line with the new rules and, importantly, according to their own climate strategy.

Looking ahead, we expect the reforms to prompt insurers to review their product offerings and strategy, especially in light of the current macroeconomic environment. For life insurers, high interest rates coupled with capital reforms could prove to be a catalyst for re-designing existing products or exploring new product features.

Banks:

• Enhance capabilities that will support Basel 3.1 implementation, focusing on:
  
  
  • Understanding the strategic and operational challenges and opportunities arising from differences in UK and EU implementations of Basel 3.1.
  • The accuracy of RWA calculations (including Standardised RWA calculation for modelled portfolios in internal ratings based banks).
  • Developing new data management and reporting capabilities.
• Smaller banks: assess the PRA's proposals and form a view on whether their growth plans mean they should opt into the full Basel 3.1 framework at the same time as other firms on 1 January 2025, or whether they want to opt in to the Simpler Regime. This option must be exercised by 1 January 2024.

Insurers:

• Undertake a planning and prioritisation exercise to prepare for the implementation of specific Solvency II reforms, focusing on areas of reform that are unlikely to change over the coming months. These include changes to MA eligibility criteria in the UK and in the EU, the specific reforms to the VA and the reduction in the risk margin for both EU and UK. For example, insurers should consider their reinsurance programmes if they currently reinsure longevity risk abroad, since a lower risk margin will make these arrangements less commercially attractive.
• Where insurers make use of the MA or VA, they should explore whether the specific reforms warrant any changes to their investment and/or asset and liability management strategies. Where they do not, they should explore whether they could benefit from applying for the VA (in the EU) or the MA (in the UK) under the new rules.
• Review and, where relevant, adjust their overall investment strategies as well as MA/VA portfolios not only in light of the reforms but also in view of their own internal climate and net zero strategies.