Implementation of Basel 3.1 and the potential implications for RICS Members – May 2023

The Basel Committee for Banking Supervision (BCBS) included revised criteria for the “prudently conservative valuation” of commercial and residential real estate collateral in the update of the Basel Accords commonly known as “Basel 3.1”. Regulators in the EU are close to finalising amendments to their banking regulations to reflect these changes with a proposed effective date of 1 January 2025. In the UK, the Prudential Regulation Authority has also recently consulted on proposals to reflect Basel 3.1 in possible changes to its Capital Requirement Regulations (CRR).

RICS is engaging with UK and EU decision makers to clarify the meaning and impact of these criteria for markets, valuers and banks.

Until a framework for valuation for commercial and residential lending is agreed and implemented in the jurisdiction in which you work, RICS members are advised to inform clients (who may be requesting “Prudent Value” in instructing valuations) of the ongoing situation (detailed in the remainder of this note) and to continue to provide Market Value to their banking/lending clients.

The BCBS is the primary global standard setter for prudential regulation of banks and provides a forum for cooperation on banking supervision. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. The BCBS currently has 45 members from 28 jurisdictions around the world, central banks and organisations with direct banking supervising authority. Members are committed to implement and apply BCBS standards in their national jurisdictions.

RICS has had an ongoing involvement in the implementation of Basel 3.1 Accord (“Basel 3.1”) through its longstanding membership of an independent European research forum focusing on approaches for prudent property across Europe, along with its ongoing discussions with the European Central Bank and the Bank of England.

Basel 3.1 is intended to enhance the resilience of banks throughout the economic cycle. Real estate lending was identified as a major contributing factor to the Global Financial Crisis, and in turn, valuation was identified as a major part of the loan origination and monitoring process.

Leading institutions and industry bodies within the real estate sector, and leading academics, broadly agree with the need for the provision of counter-cyclical advice to investors and lenders to avert any repeat of the excessive lending during 2005-07, with the concept of prudent valuation playing an important component part.

In the UK, the Prudential Regulation Authority (PRA) has recently held a consultation on possible changes to its Capital Requirement Regulations (CRR) to reflect Basel 3.1, including the implementation of the revised prudently conservative valuation criteria.

RICS’ discussions with financial market regulators indicate that many no longer believe that Market Value in isolation is sufficient for secure lending purposes as it is a point in time value, is pro-cyclical (rather than counter-cyclical), and as a valuation basis, is considered to encourage over-lending in boom periods and restricted lending in the period following a downturn. 

Before the finalisation of the Basel 3.1 framework in late 2017, RICS worked closely with a number of leading UK commercial real estate sector bodies, with participation of the Financial Stability section of the Bank of England, to understand the role that valuation could play in helping lenders better manage risks associated with the property cycle.

Subsequent research led to the publication of industry and academic reports on how that might best be done - see Long-term Value Methodologies and Real Estate Lending and IPF Long-term Value Methodologies in Commercial Real Estate Lending (July 2010) Full Report. This research remains ongoing – See the IPF and PRT March 2023 funded research report, however the findings so far across all past and current research are guiding the RICS in its approach.

The RICS response submitted to the PRA consultation in the UK at the end of March 2023, which is summarised in the final part of this briefing note. We also hosted a prudent value roundtable with key stakeholders from the UK property sector at RICS HQ on 7^th March 2023, produced an industry factsheet on this issue, and held a webinar for briefing members and industry stakeholders on 15^th March 2023.

As part of the EU’s implementation of the Basel 3.1, it is in the process of updating the Capital Requirements Regulations (CRR). Subject to final approval between the EU institutions, with discussions in trialogue negotiations between Council, Parliament and Commission, it is proposing to include the new Basel 3.1 criteria for the prudently conservative valuation of real estate collateral in the revised regulations, including:

• The value to exclude expectations on price increases.
• The value is adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.
• The value is not higher than a market value for the immovable property where such market value can be determined.

At this point it is not known whether the European Commission or European Banking Authority will provide further guidance, or whether the interpretation of the above requirements will be up to the industry and national authorities.

RICS has set up an EU working group who will follow the developments closely and, in cooperation with the RICS Public Affairs and Standards teams, will provide the regulators with feedback and our members with further information and guidance.  It should be noted that the research undertaken so far on prudent value identified above addressed specifically the implementation of prudently conservative valuation criteria across the whole of Europe.

If you are a member or interested party in other jurisdictions that fall under the BCBS and you have information on the implementation of prudential conservative valuation criteria in your market, please get in touch with us and we will work together with you towards a consistent and feasible implementation of the criteria.

Our current view is that the optimum approach for implementing prudent valuation criteria would be to adopt a single, consistent, market-wide measure of cycle risk rather than seeking to alter the way individual property assets are valued. RICS recommends a process for assessing the market adjustment factor should be defined and required to be applied, in consultation with RICS and other relevant actors in the valuation and banking sectors.

The approach could produce regular periodic market value adjustment rates according to an agreed frequency (e.g. quarterly), working with relevant data providers at an appropriate level of disaggregation across property type and locality. The relevant adjustment could then be applied consistently.

We believe that this approach would deliver an optimum balance of cost effectiveness and ease of implementation while ensuring transparency and consistency of approach, thus upholding the public advantage. This approach would deliver the same policy objective while avoiding risks attached to the implementation of an entirely new valuation concept into the industry. Issues already identified by the research include inconsistency of approach and lack of evidence which would create significant variation in the outcomes being reported. There are also significant professional indemnity issues raised if individual property prudent valuations are provided based on undefined or arbitrary adjustments to Market Value.

We will continue to monitor the political developments, discuss the issue with our member working groups and collaborate with relevant stakeholders in the valuation and banking sectors to ensure an effective and consistent implementation, and to provide our members with information and advice.

Following the Basel 3.1 updates, it is expected that jurisdictions will have implemented these requirements by 1 January 2025, upon which a valuation based on prudently conservative valuation criteria will be required at each individual loan origination (and any subsequent monitoring valuations) across the implementing jurisdictions.

Ben Elder, Head of Valuation & Investment Advisory Standards, RICS