BASEL II EU Capital Requirements Directive: The UK Approach

1
BASEL II / EU Capital Requirements Directive
The UK Approach

• Michael Ainley
• Head of Wholesale Banks
• Investment Firms Department
• Financial Services Authority

2

• Agenda
• Overview
• Pillar 1
• Pillars 2 and 3

3
Basel II

• What is the Basel II agreement?
• Closer alignment of regulatory capital and
  economic risks
• Incentives to improve risk management
• Maintenance of overall level of capital in the
  system.

4
The Three Pillars
Pillar 1
Pillar 3
Pillar 2

• Ensure adequate capitalisation of firms
• Encourage the development and usage of better
  risk management techniques

• Minimum capital requirements

• Market discipline

5
CRD

• Basel 2
• Basel agreements and related publications do not
  have the force of law and they are of limited
  application to G10 Internationally active banks

• Across the EU the Basel II agreement is given
  legal life by the Capital Requirements
  Directive
• Scope 27 EU Member States
• Legal Basis EC Directive
• Coverage Credit institutions and investment
  firms i.e. potentially very broad e.g. banks,
  mutually-owned deposit takers, investment banks,
  asset managers

6
CRD

• The Capital Requirements Directive is already in
  force
• The EC legislative process ran broadly in tandem
  with the Basel Committees deliberations over
  Basel II
• Came into force at 1 January 2007 (though some
  elements subject to transitional arrangements
  until 1 January 2008)
• Basel II has therefore already been adopted
  across the EU.

7
CRD to FSA Handbook

• Member States should take steps to implement CRD
• National discretions allow tailoring of policy
  to suit local circumstances and
• CRD establishes only minimum capital standards
• Our overall policy-making approach was no
  super-equivalence, instead, copying-out the
  CRD text into our handbook with minimal extra
  guidance
• Handbook changes came into effect at 1 January
  2007. Except where transitional provisions
  apply, firms must now comply with the new
  prudential module of our handbook.

8
CEBS Guidance

• The EU established a Committee of European
  Banking Supervisors (CEBS)
• CEBS has produced guidance documents for firms
  and for supervisors on both Pillars 1 and 2
• CEBS guidance aims to ensure that consistent
  practices are adopted throughout Europe on
  technical issues
• We have tried to ensure that our rulebook and
  supervisory approach are fully consistent with
  CEBS guidance

9
Pillar 1 Waiver application process

• Firms must apply for a formal waiver of our
  rules to allow use of the advanced approaches
• The application should be detailed enough to
  allow us, in conjunction with on-site review
  work, to form a complete view on a firms
  compliance with our standards
• A strict timetable governs the process, telling
  firms when they should apply and, when we will
  reach a decision
• Key deadline we will process any application for
  a CRD advanced approach received by 31/12/2006 in
  time for first-use at 1/1/2008
• For firms that apply during 2007 we offer no such
  service standard.
• At end-2006 we had received around 30
  applications, we expect several further
  applications for IRB in the coming weeks.

10
Pillar 1 Waiver application process

• Our internal process gives supervisors a key role
  throughout
• On-site review work, assisted by risk
  specialists
• Liaising with other regulators
• Scrutinising firms application packs
• Presenting to the decision making body.
• There are 4 possible outcomes for firms
• Accept unconditionally
• Accept with conditions
• Minded to grant reasonable compliance but
  uncertainty over ability close gaps
• Reject
• Most decisions are likely to be conditional
  acceptance or minded to grant.

11
Risk-based approach

• FSA has conducted risk-based supervision for
  many years via ARROW but Basel II poses even
  greater challenges to supervisors
• This is particularly so for the supervision of
  internationally diversified groups
• FSA is Home regulator to a number of UK-parent
  firms with complex overseas operations e.g. HSBC,
  Standard Chartered and
• FSA is Host regulator to many subsidiaries of
  complex foreign-parent groups e.g. Citigroup,
  Goldman Sachs.

12
Risk-based approach

• We have responded to this challenge in a number
  of ways, for example
• Not publishing rules that unnecessarily differ
  from the minimum standards of the CRD
• Conducting proportionate reviews of applications
  for Pillar 1 advanced approaches for example,
  limiting our on-site review work where we can
  rely on the work of a foreign subsidiarys parent
  company supervisor.

13
Pillar 2 process

• Pillar 2 operates on a separate, though related,
  timescale to Pillar 1
• A firm must have its individual capital adequacy
  assessment (ICAAP) in place at the time it begins
  to use any of the Pillar 1 approaches, and no
  later than 1/1/2008
• We will review the ICAAP, and issue Individual
  Capital Guidance, as soon as possible once it is
  ready
• Some firms have chosen to submit a draft ICAAP at
  the same time as their application for a Pillar 1
  advanced approach.

14
Other transparency and governance

• Emphasising senior management responsibility is a
  fundamental axiom of FSAs approach to
  supervision
• E.g. the requirement for the Board and Senior
  Management to have, respectively, general and
  good understanding of AMA and IRB models.
• Governance is a key area of focus in CRD model
  review work and more generally for standardised
  approach firms
• Pillar 3 disclosures help to enhance transparency
  and promote market discipline. FSA approach in
  line with CRD details for firms to decide.

15
Other organising supervisors for delivery

• Training technical and practical training
  rolled out to supervisors and DMC members
• Central Project Team established to coordinate
  implementation
• Basel Implementation Project Teams established
  in all supervisory divisions to coordinate
  implementation
• Risk Review Specialist teams to lead on-site
  review work for advanced approaches.

16
Other CRD for smaller banks

• Our approach to smaller banks is embedded within
  our Pillar 1 approvals process and ARROW, which
  give us the flexibility to be proportionate
• Most smaller banks in the UK are adopting the
  standardised approaches to risks under CRD
• But we are not compelling smaller banks to adopt
  a particular approach - some intend to progress
  to IRB soon.
• Special circumstances apply to EU-parent banks -
  the CRD assumes that all EU supervisors are
  equivalent
• For subsidiaries adopting the Pillar 1 advanced
  approaches there is only one application, to the
  EU-parent Member State.

17
Key Home-Host Considerations

• Different implementation timetables
• U.S. delay
• Different approaches to implementation
• National discretions
• E.g. Different definitions of default and
  implications for consolidation
• Different interpretations of Basel 2
• Pillar 2, stress tests, Basel 1A
• Allocation from Group models
• Pillar 2, AMA

18
Example 1 Standard Chartered and HSBC

• UK Home Supervisor
• IRB approach being rolled out
• Over 50 (SC) and 80 (HSBC) host supervisors,
  mostly non-EEA
• Close cooperation and information sharing key.
• Colleges hosted in UK since 2005

19
Example 2 UK Subs of U.S. Groups

• US Delay should not be a barrier to UK subs of US
  groups applying for advanced approaches in the UK
  to the CRD timetable.
• Close cooperation and information sharing with US
  home regulators has been key and has included
  joint visits by FSA staff with Fed/ OCC
  colleagues at the head offices of US groups in
  New York.

20
Concluding remarks

• Basel II challenges supervisors as well as firms,
  particularly in the context of internationally
  active groups
• Supervisors can respond to this challenge by
  adopting a proportionate, risk based approach.
  For example, in the UK we have
• Copied out our rules from the CRD text
• Been clear and consistent about how we handle
  Pillar 1 advanced approach applications
• Embedded Pillar 2 in our ARROW II risk based
  approach to supervision
• Equipped our supervisory staff with the necessary
  resources for delivery.

21

• Pillar 1

22
Credit risk under Basel II

• A critical innovation under Basel II is the use
  of credit ratings to differentiate the credit
  quality of assets held by banks
• In measuring the amount of capital to allocate
  against credit risk, Basel II permits banks to
  use either
• External ratings from credit rating agencies (the
  standardised approach) or
• Banks own internal ratings and associated loss
  estimates (the internal ratings based approach)

23
Credit risk standardised approach

• Standardised approach is intended for banks with
  less complex operations
• Exposures with better external credit ratings
  generally receive lower capital charges
• Most UK banks will adopt the standardised
  approach at 1/1/08
• We currently regulate around 350 banking
  subsidiaries (not including building societies
  and securities firms) but we have only received
  around 25 applications for IRB

24
Credit risk Internal Ratings Based approach
(IRB)

• IRB is intended for banks with more complex books
• It allows substitution of banks own internal
  ratings for the rating agency assessments of
  credit risk
• Two types of IRB approach permitted
• Foundation (F-IRB)
• Advanced (A-IRB)
• IRB models estimate some or all of the elements
  in the risk weighting calculation
• Risk Weight comprises Probability of Default
  (PD) Loss Given default (LGD) Exposure at
  Default (EAD) and Effective Maturity (M)

25
Credit risk foundation IRB

• The Foundation IRB approach allows firms to
  estimate some, but not all, of the risk weighting
  factors principally PD
• F-IRB also only applies to a limited range of
  exposures - corporate / sovereign / institutional
  exposures
• F-IRB is therefore proving attractive to
  securities firms and commercial banks with
  wholesale-only exposures
• Of the 9 IRB applications currently being
  considered within the FSA Wholesale Firms
  Division, 5 are for F-IRB

26
Credit risk advanced IRB

• Advanced IRB (A-IRB) approach allows all of the
  factors to be estimated
• PD, LGD, EAD and M
• A-IRB applies to all asset classes, including
  retail exposures
• It is therefore proving particularly attractive
  to the large UK retail banks
• A-IRB requires substantial technical / modelling
  capability because of its increased complexity

27
Credit risk applications experience

• A number of areas are causing difficulties, for
  example
• Low default portfolios how to estimate PD for
  exposures that have never defaulted e.g.
  sovereigns, corporates
• Immaterial exposures large numbers of small
  exposures to a particular type of counterparty
  e.g. hedge funds
• Our approach to these issues is to be flexible
  where possible to allow firms to develop their
  own cost-effective solutions
• We have also given guidance to firms via our
  Industry Standing Groups e.g. on stress testing

28
Credit risk lines in the sand

• We have also indicated to industry several areas
  of IRB policy where we will not tolerate
  imperfect compliance, which we call the lines in
  the sand
• Documentation
• Validation
• Stress testing
• Senior management understanding
• Use test

29
Credit risk lines in the sand

• Documentation
• IRB models and processes need to be well
  documented both from the user and the development
  perspectives
• There should be enough information for an
  independent reviewer to understand how a final
  rating was arrived at for a specific borrower.

30
Credit risk lines in the sand

• Validation
• IRB models need to be validated independently of
  the model development unit
• Validation aims to assess the performance of
  internal systems consistently and meaningfully
• Supervisors need to have regard to a number of
  issues, including the involvement of senior
  management and, that firms have a regular
  ongoing cycle of model validation

31
Credit risk lines in the sand

• Stress testing
• It is essential that firms are able to understand
  how the ratings system performs and what happens
  to the risk portfolio under stressed conditions
• What happens in a mild, relatively frequent,
  recession?
• What happens in a severe recession say, a 125
  year event?
• Stress testing procedures for credit risk are
  proving to be less well developed than for market
  risk

32
Credit risk lines in the sand

• Senior management should have a reasonable
  understanding of what the IRB model is telling
  them
• This mitigates black box risk where the risk
  management approach is only understood by the
  risk managers
• For IRB we ask for a board member to demonstrate
  a general understanding
• Senior individuals within the risk management
  function need to have a good understanding
• Supported by appropriate management information
  and reporting.

33
Credit risk lines in the sand

• Use test
• make effective and non-marginal use of internal
  ratings, for example in
• Credit approval
• Management of risk e.g. setting limits
• Internal capital allocation
• Loan pricing
• Provisioning

34
Market risk

• The market risk (trading book) rules were
  impacted by Basel II
• The Trading Book Review looked at the definition
  of the trading book
• The scope of the trading book is possibly broader
  than in the past
• e.g. includes traded loans and hedge fund
  positions for the first time
• Use of the trading book is governed by a policy
  statement
• Firms are required to value trading positions
  prudently, which may be different to accounting
  fair valuations

35
Operational risk

• Basel II for the first time introduced a Pillar 1
  capital charge relating to
• the risk of losses resulting from inadequate or
  failed internal processes, people and systems, or
  external events
• It is expected that it will account for around
  12 of Pillar 1 capital in the financial system
• There are 3 permitted approaches to operational
  risk capital

36
Operational risk Basic Indicator Approach (BIA)

• Average gross income for whole business over
  three years
• Capital charge is 15 of the result
• Encouraged to comply with Statement of Sound
  Practices

Operational risk The Standardised Approach (TSA)

• Gross income for eight business types considered
  separately
• Capital charges range from 12 to 18
• Qualitative entry criteria including Policies for
  managing operational risk, a framework for
  managing operational risk, processes and systems
  for monitoring operational risk / losses,
  internal and external reporting

37
Review of BIA/ TSA approaches

• No approval required for BIA/ TSA
• Scale, nature and complexity of the firm are key
  determinants of what we expect in risk management
  
• Review through
• Thematic work
• Included in standardised visits/ meetings

38
Operational risk Advanced Measurement Approach

• Qualitative criteria apply, building on those for
  TSA
• Independent operational risk management function
• Three years historical internal loss data
• Modelling based on combination of inputs
• External verification

39
Operational risk key issues for AMA

• AMA allows diversification benefits to be
  recognised
• Key difference is between branches and
  subsidiaries
• OK if capital is freely transferable to support
  risks
• Not OK if there are restrictions on capital
  mobility
• Not just an operational risk issue

40
Operational risk our experience

• AMA is proving to be a big challenge for firms
• Many firms that had earlier indicated an
  intention to apply for AMA have delayed
• We are currently considering only 4 applications
  for AMA
• Though more firms may apply later this year

41
Investment Firms and Basel II

• CRD applies Basel II to investment firms as well
  as banks in Europe
• Many of these investment firms are small we
  want to be easy for them to do business with
• So we have written to over 2000 affected firms
  since summer 2006 clarifying the impact of CRD
• E.g. some types of firm need to calculate the
  operational risk charge, others do not
• Another new EU Directive MiFID will bring
  further investment firms into the CRDs scope
  later in 2007

42
Pillar 2
43
Pillar 2 What is it?

• An assessment of risks and mitigation
• Risk based
• Proportionate
• Not a model
• A dialogue with the firm
• A review of firms assessment

44
Pillar 2 What is it?
 
Firms assessment
Supervisory assessment
Dialogue
Identify and assess material risks Identify
mitigating controls
Review and evaluate risk and control factors
Identify amount of capital in relation to
business plan, strategies, and profile
and
Review and assess the firms risk assessment
Produce capital number and assessment
challenge
Supervisory conclusion
45
Principles for an ICAAP

• 1 A firm must have an ICAAP
• 2 Is the responsibility of the Firm
• 3 Management body to take responsibility
• 4 Should be
• An integral part of the management process
• Reviewed regularly
• Risk based
• Comprehensive
• Forward looking
• Based on adequate measurement and assessment
  process

CEBS guidance
46
Consolidation UK Group with Overseas
Subsidiaries
UK consolidation group
UK Firm e.g. Standard Chartered
UK non reg
UK Firm
DE sub
US sub

• ICAAP should be at the level of the UK
  consolidation group and should be capable of
  allocating the group capital number to individual
  firms
• It also covers the business of the groups
  overseas operations.

47
Consolidation UK Sub-group of an EEA or Non-EEA
Group
EEA/non EEA parent e.g. Habib
UK consolidation group
UK Firm
Firm
Firm

• The ICAAP
• is at the level of the UK consolidation group
• covers the business of the UK consolidation
  group
• must be capable of allocating the group capital
  number to the individual firms.

48
Consolidation UK Sub-group of an EEA or Non-EEA
Group

• This does not mean the UK consolidation group
  must have its own set of processes, strategies
  and systems.

EEA/non EEA parent
Systems

• the global group can have a single set of
  processes, strategies and systems which are used
  by the UK group

UK consolidation group
Firm
Processes
Firm
Firm

• Must be capable of
• explaining the risks within the UK consolidation
  group
• determining a capital number for the UK
  consolidation group and each firm.

49
FSAs approach to the SREP
50
FSA Pillar 2 Timeline

• Starting point is the result of the firms ICAAP
  or the capital resources requirement (CRR)
• Steps are iterative
• Interwoven with Pillar 1 Waiver Process Arrow

51
Risks under each element
Element 1 Pillar 1 risks

• Operational risk

• Market risk

• Credit risk

Element 2 Risk not fully covered under Pillar 1

• Residual risk

• Securitisation risk

Element 3 Risks not covered by Pillar 1

• Settlement risk
• Reputation risk
• Underwriting risk

• Pension risk
• Transfer risk
• Underestimation of credit risk using standard
  approach

• Interest rate risk in the banking book
• Concentration risk
• Liquidity risk
• Business risk (earnings and costs)

Element 4 Capital planning

• Economic and regulatory environment risk

• Strategic risk
• Access to capital

52
Outputs from the SREP
Supervisory Decision
Individual Capital Guidance (ICG)
Individual liquidity guidance
RMPs
Other measures
53
Pillar 2 is part of
 
54
Overview of Panel Process

• Purpose
• ensure consistency of approach
• provide effective review and challenge
• Risk Focused
• Planning validation panel
• H impact firms required
• MH / ML impact firms discretion of the RM
• L impact firms optional
• Final validation panel all firms

55
Overview of Panel Process

• Timing
• Alignment with ARROW if concurrent
• Planning panel takes place before further
  questions of the firm
• Final panel takes place after firm discussions
• Methods
• Panel or independent manager review
• Conclusions must be documented

56
Example HSBC Pillar 2 Process

• Current Status
• Pillar 2 Team
• Ongoing discussions with HSBC
• Joined up with Supervisors Pillar 1 Team
• HSBC
• Developing/Refining ICAAP
• Currently Top Down Capital Assessment
• ECM Tools in Various Centres
• Building out ECM for Group
• Developing Stress Tests

57
HSBC Pillar 2 Process

• 7 Areas of Interest follow the Pillar 1 lines
  in the sand with 2 extras
• Senior Management Understanding
• Use Test
• Stress Testing
• Independent Validation
• Documentation Quality
• Downturn LGD
• Data Quality

58
ICG letter

• Key points to note
• Letter addressed to authorised firms
• Appendices including RMP
• Restrictions on disclosure
• Substantive content
• ICG (Individual Capital Guidance)
• IG on liquidity
• Clear identification of link between Capital and
  RMP actions
• Explanation of adjustments in broad and
  quantified terms

59
Home/Host Considerations

• CRD does not specify the form or the content of
  ICAAP
• FSA is committed to being flexible and
  proportionate
• We are prepared in principle to accept ICAAPs
  based on
• Allocation from a Group economic capital models
  (but this will require the understanding how the
  ECM is constructed)
• A Pillar 1 plus approach, whereby the local
  ICAAP uses Pillar 1 as the starting point and
  then bolts on Pillar 2 risks
• Hybrid Pillar 1 plus and part ECM allocation
• These questions will be addressed in the context
  of coordination between home and host supervisors

60
Home/Host Considerations

• Coordination between home and host supervisors
  will be important
• This entails the consolidated supervisor taking a
  leading role to
• Synchronise Pillar 2 work across borders
• Communicate home and hosts Pillar 2 assessments
• Exchange information both at the pre- and post
  visit stages
• Distribute tasks if possible
• Collate conclusions
• Challenges
• Little direct experience will gather pace in
  2007
• Legitimate variations in national approaches
• Timing differences
• UK will time P2 assessments to overlap with
  Pillar 1 model approval work (partner supervisors
  may be working to different timetables)

61
Our Experience to Date

• 59 RRD supported full scope SREPs planned for
  2007
• 2 Final validation panels held to date
• 1st firm a high impact building society -
  add-ons applied for concentration risk and stress
  testing
• 2nd firm a low impact investment firm no
  capital add-ons ICG set at 100 of CRR
• In Wholesale Firms Division, approximately 50
  streamlined (desk-based) SREPs planned for 2007

62
Final Word

• We will be proportionate focus on significant
  risks
• The ICAAP includes capital planning and robust
  stress testing is embedded in the firms risk
  management framework
• It is NOT just about capital but assessing risks
  and implementing appropriate mitigation
• Need to coordinate, cooperate communicate

63
Pillar 3
64
Objectives of Pillar 3 - Disclosure

• Promote market discipline
• Provide information about the banks risk
  profiles and levels of capitalisation and
• Enable market participants to make informed
  decisions based on the key information.

65
Risk-based approach to disclosure

• A firm
• needs to disclose material information and
• may omit disclosure of information which is
  regarded as proprietary or confidential.
• Senior management must determine the material
  information and also whether information falls
  into either the proprietary or confidential
  category.

66
What needs to be disclosed?
Firms need to disclose on annual basis
qualitative and quantitative information relating
to

• Risk management objectives policies
• Scope of application
• Capital resources
• Credit and dilution risk and credit risk
  mitigation
• Market risk
• Operational risk
• Securitization and
• Non-trading book exposure to Interest Rate Risk
  and Equities.