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Basel 1: pro’s & con’s

A regulatory perspective: assessing ‘best practice’ risk systems Michael Ainley Head of Wholesale Banks Department Financial Services Authority, UK 18 May 2004. Basel 1: pro’s & con’s. How well has Basel 1 served risk management?

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Basel 1: pro’s & con’s

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  1. A regulatory perspective:assessing ‘best practice’ risk systemsMichael AinleyHead of Wholesale Banks DepartmentFinancial Services Authority, UK18 May 2004

  2. Basel 1: pro’s & con’s • How well has Basel 1 served risk management? • It introduced a widely accepted standard for measuring capital adequacy • Despite its success, a number of weaknesses are now apparent, e.g. - the simplistic view of credit risk weights - the lack of CRM incentives - the treatment of securitisation - the bundling of operational and credit risk capital

  3. From 1988 to 2006 • Basel 2: a need for a new international ‘best practice’ standard • Objectives: - more risk-sensitive regulatory capital requirement - incentives for better risk management - closer alignment of regulatory and economic capital - greater consistency in international supervisory practice • A valuable start - but not the alchemist’s stone

  4. Basel 2: core elements • Pillar 1: minimum capital requirements - the risk menu e.g. external or internal ratings? whose LGD? the maturity dimension - breaking out Operational Risk ‘quantum of data’ approaches

  5. Basel 2: core elements • Pillar 2: four key principles of capital adequacy - the bank’s self-assessment process - supervisory review - a capital buffer in excess of the minimum requirement - early supervisory intervention where necessary • Pillar 3: ‘risk in public’ - quantitative and qualitative disclosures • The overall effect – hard to predict

  6. Moving towards best practice • The consultation process: international and regional/national efforts • The value of Quantitative Impact Studies • ‘Group therapy’: the work of - the Accord Implementation Group, and - the Core Principles Liaison Group (for non-G10 input) • Re-defining capital: looking ahead to Basel 3?

  7. Moving towards best practice • Capturing all the risks • Disclosure: how will this look? • The FSA’s role: - publish which firms have adopted advanced approaches - indicate (anonymously) how firms have met our requirements - comment on trends in both credit and operational risk

  8. The FSA approach to implementing best practice • National practices will vary • Implementing an EU Directive: is there a mismatch? - timetable and coverage • ‘No compulsion, no prohibition’ • Setting demanding standards • Alignment with the FSA’s risk-based regulation • Parallel running

  9. The FSA approach to implementing best practice • The FSA’s internal structure - Prudential Sourcebook (’the Rules’) - Firm-Specific Implementation (the practice) • Talking to our firms: who wants what? • Industry fora • Cross-border considerations: - the AIG - the Groupe de Contact - supervisory ‘colleges’

  10. The current timetable Phase 1 RBCD issuesCP189 Prudential Source Book PSB Devise FSA policy Phase 2 Final text CP (Jan) IRB & AMA applications Preparation for IRB/AMA approvals Interlinked Phase 3 Waivers Discuss individual capital Supervisory review: policy development 2003 2004 2005 2006 2007

  11. The main challenges for banks - 1 • Senior management responsibility & oversight - the FSA will not be prescriptive • The ‘use test’ - for real • Including the ‘too difficult’ risks • Skillsets in internal control functions: - risk management - audit • Independent challenge

  12. The main challenges for banks - 2 • IT systems • Data adequacy: capture and storage - by 1.1.2005 • Data integrity: - stressing credit risk data from a benign economic climate - operational risk data, and the use of insurance products: the end result? • Methodology:rating systems and models • Model validation: inputs and outputs • Roll out plans

  13. The main challenges for banks - 3 • Risk: culture and governance • Risk appetite: quantitative and qualitative • ‘Joined up’ risk management • ‘Does it smell right? v. LTCM: no contest? • Taking care of business (as usual) • Dealing with wider implications

  14. The main challenges for regulators - 1 • Resources, resources, resources • Using internal and external expertise • Training: - ‘Superusers’ as champions • Model validation • Talking to the firms: - how well do we know them? - what can we take on trust?

  15. The main challenges for regulators - 2 • Consistency with flexibility: - the use of national discretions - the home/host dialogue - involving the non-G10 • The EU’s application to investment firms • Pillar 2: - not a Pillar 1 mirror - individual capital requirements - will come more easily to some than others

  16. The main challenges for regulators - 3 • A risk-based approach to handling applications • Specific fees for advanced approaches… • …but no ‘free’ consultancy! • Integrating Basel 2 with the supervisory model: - data needs - regulatory reporting - ARROW • Assuming the right resources, of course

  17. Costs & benefits • The jury is out • For firms – cannot yet measure the cost • For regulators – cannot yet measure improved risk management • Many questions – only pragmatic solutions

  18. Michael AinleyHead of Wholesale Banks DepartmentFinancial Services Authority, UK18 May 2004 Conclusion

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