Doubts over UK regulator's resources to test models
Bankers are asking if the Financial Services Authority has the capacity to meet Basel II demands over validation
Britain's bankers question whether the country's chief financial sector watchdog has adequate resources to validate banks' ability to meet the demands of the more advanced approaches to measuring risks under the Basel II bank safety rules.
The question's raised by the readiness of the regulator - the Financial Services Authority (FSA) - to be flexible and less prescriptive in implementing the Basel II rules and by the sheer scale of the rules handbook required, says Simon Hills, head of the prudential capital and risk team at the British Bankers' Association (BBA). The BBA is the trade association for banks, both British and foreign, operating in the UK. Its 250 or so member firms hold 90% of the UK banking sector's assets.
Hills was commenting on the FSA's January consultation paper* on implementing the European Union's Capital Requirements Directive (CRD), the law that will bring the EU version of the Basel II bank capital adequacy rules into effect in the UK.
The CRD is modelled, with some modifications, on the complex, risk-focused Basel II upgrade of international bank capital adequacy rules designed by the Basel Committee. The January document is the first of two consultation papers on CRD implementation planned by the FSA for this year. The paper - designated CP 05/03 - concentrates on areas where the UK is expected to have discretion in deciding the new safety framework. The deadline for comment on CP 05/03 is April 29. The FSA is holding a London conference on CRD and Basel II implementation on March 10.
The second consultation paper - containing the entire draft handbook text for implementing the CRD - will be issued as soon as possible after agreement on the final text is reached by the EU's Council of (national) Ministers and the European parliament, which is expected after the European summer.
FSA managing director Hector Sants said in a press statement that the introduction of CRD will mark a huge step forward in developing a modern capital framework that will improve the risk sensitivity of capital standards for firms across the EU. "Considerable uncertainties remain, however, not least in the timing of its introduction," he added.
The BBA's Hills says the January paper "does what it says on the box - and at 861 pages, including 13 annexes and one appendix, a very large box it is too."
"But there are still many questions left unanswered," he adds.
Among them is whether the FSA does have sufficient resources in terms of expert staff to assess the qualifications of banks to adopt the Basel II advanced approaches to risk measurement under the FSA's so-called waiver application process. Under this process the internal ratings based approach (IRB) to measuring credit risk and the advanced measurement approaches (AMA) to assessing operational risk will be implemented by waivers from FSA rules.
High expertise needed
It supervises around 650 banks and several thousand businesses that could fall into the investment firm category under the CRD. The task of assessing qualifications for the advanced approaches won't be as extensive as these numbers might imply, analysts note. Many of the banks will opt for the simpler, standardised CRD approaches to measuring their risks, analysts note. And most investment firms won't be concerned at all with the advanced approaches as they aren't involved in credit risk and many will continue with current EU capital rules for operational risk under a special dispensation from the CRD.
But the Basel II rules form the most sophisticated supervisory regime yet devised and demand a high level of expertise from both regulators and bank risk managers.
FSA officials say the agency has the resources to oversee the putting in place of the CRD. But industry analysts note that the FSA has, like regulators elsewhere, seen a succession of key people on the Basel II project enticed away by banks and other organisations wanting to secure their expertise. The FSA says it pays competitive median salaries but it has said it expects competition for its staff to get more intense as the time for implementation of CRD and other measures approaches.
Unfinished business
Hills says there are still other significant areas of unfinished business. These include the questions of the treatment of low default loan portfolios, the boundary between retail and corporate credit, concentration risk and stress testing.
Some of these issues are best answered at the international level to ensure that Basel II delivers the competitive equality it promises. But others need to be discussed in the sub-groups of experts set up by the FSA to help tackle some of the very technical issues, Hills adds.
"We hope this will be achieved before the second CP, with the final handbook text in it, is released," he says.
In the January paper the FSA acknowledges that there are no specific references to low default portfolios in the draft CRD, but the agency believes it should be possible to include them in the IRB approach. It's working with the banking industry on ways to achieve the CRD requirements, aiming to complete the work in the first half of 2005.
On stress testing, the paper notes that given the benign economic climate in the UK over recent years, it is quite likely that many firms will not have sufficient data for `procyclicality'. But the draft CRD requires estimates be based on long runs of data to capture the behaviour of models over full cycles and that both loss given default and conversion factor estimates must be appropriate for an economic downturn.
European timetable
Meanwhile, uncertainties about the European timetable for implementing the CRD are restricting the room for manoeuvre for bringing the rules into effect.
UK planning, for instance, is taking two possible start dates for the rules into account. The UK still favours a single start-date of January 1, 2008. But the European Commission, which is the executive arm of the European Union and responsible for initiating financial regulation, wants a two-stage start spread over 2007 and 2008.
The paper says one uncertainty is whether EU member states and the European Parliament will agree the implementation timetable proposed by the Commission.
The Commission's draft directive proposes the CRD should apply from January 1, 2007 for firms using the simpler and intermediate Basel II approaches to measuring their credit and operational risks, and from January 1, 2008 for those using advanced approaches. The Commission's timetable is broadly in accord with that recommended by the Basel Committee. And as a Basel Committee member, the UK agreed at the time with the Committee's decision to go for a staggered implementation timetable.
The FSA says there's also considerable uncertainty about the timing of the final agreement on the CRD text in general between the Council of Ministers and the European parliament.
The agency says the CRD text must be agreed by June or July this year if it is to give member states the 18 months normally allowed for implementation and to ensure the EU rules come into force on the same date as the Basel framework. But the parliament is not expected to give its first opinion on the draft directive until April/May 2005, the FSA notes.
The FSA says the CRD is the first major EU directive to be implemented since it and the UK Treasury decided not to be `superequivalent', that is go beyond the minimum necessary to comply with an EU directive, unless there is a clear reason for doing so. The paper proposes a limited number of `superequivalences' relating to capital, groups and the regulatory capital of integrated groups.
In general, the FSA intends to follow a `copy-out' approach to implementation, which means the rules will generally be based on a copied-out version of the draft directive, with the provision of additional guidance only where this is clearly justified.
The FSA says it's taking a clear, forward looking approach to the strengthening of capital adequacy. This is particularly important in relation to the IRB and AMA approaches.
Firms wishing to exploit the potential for reducing their capital under the advanced approaches must convince the FSA that they have credible plans for improving systems "that will deliver a single step change in their risk management and monitoring".
"It is important for firms to understand that we view the CRD/Basel framework as a prudential tool to enable us to improve the risk-sensitivity of the capital standards of the industry as a whole in coming years," the agency says.
"It is not solely a means to ensure that a maximum number of firms operate the advanced approaches from the date the new rules come into force."
Other constraints on the timetable include the treatment of certain of counter-party credit risk and trading-book items. The Basel Committee and the International Organization of Securities Commissions (IOSCO), the Madrid-based umbrella body for the world's stock market regulators, are jointly reviewing the issues.
The FSA acknowledges that not being able to incorporate the outcome of this trading book review into the CRD in a timely fashion "could be problematical", particularly for large investment banks and major banking groups in terms of system development and potential capital impact.
The joint Basel Committee/IOSCO working group plans to issue a consultation document by April, a tight deadline that would enable incorporation into the CRD during the European Parliament's review of the law.
Transitional arrangement
That would allow finalisation of the provisions sufficiently in advance of January 1, 2008 to allow time for them to come into force on that date.
The UK has also secured a transitional arrangement which would delay the implementation of the trading book aspects of the CRD. This would enable EU member states to continue applying the current Basel I rules in respect of trading book positions at least until January 2009, pending implementation of the trading book review outcome.
The FSA's paper makes no mention of the fourth quantitative impact study (QIS 4) that it previously has said it plans in order to test the CRD's effects on UK firms. But it does note that a further QIS - QIS 5, in effect - will be undertaken later this year by the Basel Committee to test the calibration of Basel II, which has now caused a good deal of confusion among bankers (see page 1). It seems the FSA may encourage banks to go ahead with the QIS 4 exercise, but it plans to put its main efforts into QIS 5 which will cover the 13`Basel Committee member countries and possibly other countries as well.
*The FSA's consultation paper CP 05/03 - Strengthening capital standards - is available on www.fsa.gov.uk.
