On 30 September, the PRA published Consultation Paper CP14/20 (PDF 800 KB) which sets outs proposals to introduce new expectations for Internal Ratings Based (IRB) UK mortgage risk weights.
The proposals primarily aim to address the prudential risks caused by inappropriately low IRB UK mortgage risk weights. As an added benefit, they should also narrow the differentials between IRB and standardised approach (SA) UK mortgage risk weights and limit future divergence, supporting competition between firms that take different approaches.
The PRA proposes to introduce two requirements, as it considers that models delivering risk weights materially below these levels are likely to be materially deficient in risk capture:
- a risk weight of at least 7% for each individual UK residential mortgage exposure; and
- an exposure-weighted average risk weight of at least 10% for all UK residential mortgage exposures to which a firm applies the IRB approach.
Why are these changes proposed?
Incoming reforms to the IRB and SA approaches (including the “hybrid approach”) will reduce excessive variability of firms' risk weighted assets and make risk-based capital ratios more transparent and comparable. This may lead to an increase in the lowest IRB risk weights, but the extent of this is uncertain. The PRA is therefore proposing its own measures to address prudential risks associated with:
- IRB mortgage risk weights which may not fully reflect the potential losses in unlikely, but possible, tail scenarios, meaning that risk weights could be inappropriately low. UK risk weights for low loan to value (LTV) mortgages tend to show large variations and be lower, sometimes significantly, than international peers. The EU has already acted to address low risk weights from IRB models.
- Differences between standardised and IRB approaches which can result in a competitive imbalance between firms.
- Difficulties in calibrating risk weights for low LTV mortgages.
- Significant divergence from the SA for a given LTV. The final Basel 3 reforms (Basel 4) will introduce a minimum SA mortgage risk weight of 20%. Although firms' models may be able to discriminate risks well enough to support risk weights below this level, the PRA considers that that risk weights significantly below a third of the SA minimum are unlikely to be justified.
- The fall in IRB mortgage risk weights over time. The proposals aim to reduce the risk of risk weights continue to fall over the medium to long term, thereby increasing the likelihood of IRB mortgage providers being undercapitalised.
Interaction with other capital measures
The PRA has considered whether other capital measures already provide adequate mitigation and concluded that they do not for an asset class as substantial as residential mortgages:
- The Basel “output floor” may mitigate some risks. However, it was not designed to address the specificities of IRB mortgage risk weights in the UK and would not mitigate risks where inappropriately low risk weights are off-set against products with higher risk weights. In addition, under the Basel Committee's revised timeline, the floor will not be fully implemented until 2028.
- Again, the leverage ratio is a broad measure and would not mitigate the risks for firms who balance inappropriately low IRB mortgage risk weights against products with higher risk weights.
Scope and expected impacts
The CP is relevant for PRA-authorised banks, building societies and ring-fenced banks holding IRB permissions. It may also be of interest to firms considering applying for IRB permission and to other market participants.
Both proposals would apply at all levels of consolidation and cover all UK residential mortgages exposures.
The PRA does not expect the changes proposed in this CP to have a significant implementation cost for firms. However, firms whose risk weights increase as a result of the proposals, and where capital requirements are not already determined by other capital measures such as leverage, will have costs associated with the additional capital required.
The proposals are not expected to limit the overall growth of the mortgage market.
The consultation will close on 30 January 2021, with resulting policy expected to take effect from 1 January 2022, alongside other IRB reforms.