ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Over the coming years, the final parts of the Basel III framework will be implemented around the world, completing an important phase of the post-crisis financial regulatory reforms. At the end of last month, we got a sense of how the UK intends to implement the rules when the Prudential Regulation Authority (PRA) published legislative proposals, just over a year after the European Commission (EC) came out with its own proposals in October 2021. The PRA has opted to stay fairly close to the Basel standards, but it has proposed some targeted changes that it says would better capture risk and support the competitiveness of the UK.

Notably, the PRA has opted not to follow the EU in providing an exemption for credit valuation adjustment (CVA) capital requirements for trades with non-financial counterparties. It has made changes in other areas, though. For example, it proposes to reduce the alpha factor under the standardized approach for counterparty credit risk for pension funds and corporates, and has also added more granularity to CVA risk weights with the introduction of a separate risk weight for pension funds. Greater granularity in the CVA framework has long been an ISDA recommendation, as it would bring improved accuracy and risk sensitivity.

In its interpretation of the Basel III market risk capital framework – the Fundamental Review of the Trading Book (FRTB) – the PRA is broadly faithful to the Basel standards, with some deliberate deviations. These include the addition of a new standardized approach for the capitalization of equity investments in funds (EIIFs), known as the external party approach. ISDA has previously raised concerns that existing approaches to the capitalization of EIIFs are either too computationally intensive or too conservative, and a simpler approach that could allow banks to continue to use internal models would be a positive step.

Other potentially positive recommendations include allowing non-modellable risk factors to be used for backtesting purposes under the internal models approach, with certain constraints. This is a pragmatic modification that recognizes backtesting exceptions could be due to the exclusion of these risk factors rather than poor model performance.

The PRA has also introduced a new bucket for carbon trading under the FRTB. ISDA has conducted detailed analysis on stressed volatilities of carbon certificates and found that the appropriate risk weight for carbon credits should be 37%, rather than the 60% set under the FRTB standardized approach. While the EC proposal would reduce the risk weight to 40%, the UK PRA has maintained the risk weight at 60%.

Like the EU, the UK proposes that this important package of reforms should be implemented from January 1, 2025, with certain transitional arrangements. The UK also proposes to allow an additional year for implementation of the FRTB profit-and-loss attribution test – an approach that aligns with the Basel standards and would enable a smooth transition to the new requirements. We would urge other jurisdictions to align their own timelines with the EU and the UK, because differences in timing can make implementation much more challenging for international banks.

In the meantime, the PRA consultation is open until March 31, giving banks the time needed to gather and submit relevant data and information before finalization of the rules. We will work closely with our members in the months ahead to test the proposals and determine the full impact of the package. We look forward to sharing our findings with the PRA next year.

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