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 3 Pillar 1 Pillar 2 • Ensure adequate capitalisation of firms • Encourage the development and usage of better risk management techniques • Minimum capital requirements • Market discipline

5. Basel 2 • Basel agreements and related publications do not have the force of law; and they are of limited application toG:10 Internationally active banks 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. 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 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.

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 subsidiary’s 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 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. 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 1:25 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 CRD’s 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 firm’s assessment

44. Firm’s assessment Supervisory assessment Pillar 2: What is it? Dialogue Review and evaluate risk and control factors Identify and assess material risks Identify mitigating controls and Identify amount of capital in relation to business plan, strategies, and profile Review and assess the firm’s risk assessment challenge Produce capital number and assessment 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 Firm UK non reg • 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 group’s overseas operations. DE sub US sub

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

48. This does not mean the UK consolidation group must have its own set of processes, strategies and systems. Consolidation: UK Sub-group of an EEA or Non-EEA Group 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. ICAAP SREP Quantitative assessments Capital planning Qualitative assessments Intermediate assessment CRR or ICAAP FSA’s approach to the SREP

50. Pillar 2 assessment process (SREP) Pillar 2 assessment process (SREP) Internal Internal planning planning Submission request Submission request Initial Initial review review Questions/discussion Questions/discussion Arrow risk assessment interacts with the SREP Arrow risk assessment interacts with the SREP FSA FSA detailed initial review review Discuss findings Discuss findings with firm with firm FSA panel process FSA panel process Formal notification Formal notification FSA Pillar 2 Timeline • Starting point is the result of the firm’s ICAAP or the capital resources requirement (CRR) • Steps are iterative • Interwoven with Pillar 1 Waiver Process & Arrow