How the FSA is implementing Basel II

1. How the FSA is implementing Basel II Michael Ainley Head of Wholesale Banks and Investment Firms Department UK Financial Services Authority

2. Outline • Basel II, Capital Requirements Directive and the FSA Handbook • Pillar 1 • Pillar 2 and Pillar 3 • Other important elements

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. • What does it consist of? • Pillar 1: minimum capital standards • Pillar 2: supervisory review process • Pillar 3: market discipline

4. Basel II • Basel agreements and related publications do not have the force of law; and • They are of limited application: • Scope: G:10 • Legal Basis: None • Coverage: Internationally active banks

5. CRD • 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 Committee’s 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. Pillar 1: Waiver application process • Firms must apply for a formal “waiver” of our rules to allow use of the advanced approaches, such as the internal ratings based approach to credit risk (IRB); • The application should be detailed enough to allow us, in conjunction with on-site review work, to form a complete view on a firm’s 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.

9. 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.

10. 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.

11. 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 advanced approaches, for example, limiting our on-site review work where we can rely on the work of a foreign subsidiary’s parent company supervisor.

12. 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.

13. Pillar 2: risk-based approach • For Pillar 2 we have: • Discussed with industry what we should expect to see at different types of firms; • Developed a policy for supervisory review that has 3 levels of intensity, broadly corresponding to the nature and scale of firms’ business; and • Embedded the supervisory review fully in our ARROW risk-based methodology. • In the future, Pillar 2 reviews will be fully part of our ARROW framework.

14. Other: transparency and governance • Emphasising senior management responsibility is a fundamental axiom of FSA’s 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. Conclusion • Basel II is complex and demanding for supervisors as well as firms, particularly in the context of internationally active groups; • FSA response: • “Copy out” our rules from the CRD text; • Be clear and consistent about how we handle Pillar 1 advanced approach applications; • Embed Pillar 2 in our ARROW risk based approach to supervision; • Equip our supervisory staff with the necessary resources for delivery.