CP05/3 unravelled How the latest CP impacts your Basel II pro r gramme* Marc r h 2005

Transcription

1 CP05/3 unravelled How the latest CP impacts your Basel II programme March 2005 *

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3 Summary CP05/3 Strengthening Capital Standards is the first of two FSA consultations planned for 2005 dealing with the implementation of the Capital Requirements Directive (CRD). The second paper with the entire draft Handbook text implementing the CRD will be published following final agreement on the Directive, perhaps in the autumn. The new rules will replace much of the Handbook on prudential controls for banks, building societies and investment firms. Consultation closes on 29 April The new rules will replace much of the Handbook on prudential controls for banks, building societies and investment firms This very large CP gives important insights into: CRD and policy developments; FSA rule developments, especially in relation to capital planning, stress testing and groups; and The application process for more advanced approaches to credit and operational risk. The CRD implements the Basel Accord in the EU. This CP supersedes CP189 of July The paper contains important material for firms preparing their approach to Pillar 1 minimum capital requirements for credit and operational risk, but firms also need to expand their implementation plans to include capital planning and assessment processes (Pillar 2), and the FSA application process itself. Pillar 3 disclosure requirements also need to be considered. Firms will automatically transfer to the standardised approach for credit risk and one of the simpler approaches for operational risk unless they obtain a waiver from the FSA allowing them to use a more sophisticated approach. Firms wanting to use the Retail or Foundation Internal Ratings Based approach (IRB) from 1 January 2007 need to apply in Those wanting to use Advanced IRB or Advanced Measurement Approaches (AMA) for operational risk must apply by Q4 2006, but can apply earlier if ready. Firms need to be ready for a review of individual capital ratios on the back of CRD implementation and the new approach to Pillar 2. All firms need to be ready to discuss internal capital planning and assessment processes from 1 January Firms will need to assess whether they require some disapplication of consolidated supervision. Banks will want to consider the implications of what appears to be a more restrictive approach to solo consolidation and integrated groups. Investment firms will need to assess whether they can continue to make use of the CAD waiver under its new terms. Limited licence investment firms will want to consider the capital impact of the FSA s approach to the expenditure-based requirement. Firms that are planning to use the simplest approaches still need to plan for new approaches to credit risk mitigation, operational risk controls, Pillar 2 capital planning and Pillar 3 disclosure requirements. Summary 1

4 FSA consults on CRD/Basel implementation This document considers CP05/3 Strengthening Capital Standards. This is the first of two FSA consultations planned for 2005 dealing with the implementation of the Capital Requirements Directive (CRD). The second paper, with a complete set of near-final rules is currently scheduled for the fourth quarter of 2005, but this timing is dependent on the CRD being finalised in the summer. Some issues continue to be in flux until then, and are subject to developments in Basel and the EU. Consultation on this CP closes on 29 April 2005 This note considers: The FSA approach to national discretion Scope of application The FSA approach to implementation Obtaining a waiver Key Policy Developments Individual Capital Requirements and the ICAAP; The treatment of groups; and The treatment of investment firms. Timing constraints and areas of continuing discussion Other significant but ultimately more technical issues are contained in section two. A programme manager s checklist is contained in section three. The FSA approach to national discretion The FSA will implement the CRD by copy out. This means that the rules will be based on a copied-out version of the Draft Directive, with little additional guidance. The Committee of European Banking Supervisors (CEBS) is developing guidance on the more significant national discretions. The FSA will follow that guidance unless manifestly inappropriate for the UK. The FSA defines superequivalence narrowly CRD is the first major directive to be implemented since the UK made a commitment not to be superequivalent unless justified. That said, the FSA defines superequivalence narrowly and regulatory capital is an area where the FSA is not afraid to require more than the minimum (annex 5 to the CP lists 31 cases). The FSA can also interpret the CRD strictly. The FSA argues that this is not superequivalence, but for firms this may be a distinction without a difference. 2 FSA consults on CRD/Basel implementation

5 The CRD applies to all deposit-takers, other than credit unions, and to investment firms Scope of application The CRD applies to all deposit-takers, other than credit unions, and to investment firms. For most firms, it will involve a move from the Basel 1 approach to the new standardised approach for credit risk (which firms may defer until 1 January 2008) and the simpler approaches for operational risk. Note that some investment firms will not be subject to the operational risk charge (see below). Firms will automatically transfer to the standardised approach for credit risk and one of the simpler approaches for operational risk unless they obtain a waiver from the FSA allowing them to use a more sophisticated approach. FSA stresses that firms aiming to adopt an Internal Ratings Based (IRB) approach to credit risk and/or Advanced Measurement Approach (AMA) to operational risk face a significant challenge to undertake the necessary systems and risk management work required. Firms planning to adopt an advanced approach should be in contact with the FSA already or should urgently get in touch with their supervisor. Firms that will undergo the transition to the simpler approaches will still find much that is relevant in this CP and should not neglect the implementation work they face. This CP reemphasises the thrust of the FSA s approach to supervision The FSA approach to implementation This CP re-emphasises the thrust of the FSA s approach to supervision: Senior management responsibility: It is for senior management to run the firm and to oversee risk management, developing appropriate tools for this. Use test: The risk management and capital planning approaches must be integrated into the management of the institution and make sense in that context. Approaches developed for regulatory purposes only will be rejected. Documentation: All policies and risk management approaches must be fully documented. If it is not documented, it does not exist. Data accuracy: Firms need to set internal standards and develop methods for assessing compliance with them. Ensuring data integrity needs to be part of senior management oversight of IRB models, and reflected in the waiver application. This is a major challenge as data does not always get the profile it requires. Further, as FSA requirements in this area are not explicit in the CRD/Basel, it may be an issue that has not been addressed by gap analyses. Validation/Show me: Firms will be expected to be able to explain and justify their choices and show that they are robust and make sense for the firm. Conservatism: Firms will be expected to use appropriate conservatism in developing their estimates of probability of default (PD), loss given default (LGD) and exposure at default (EAD) and to base these on experience in a downturn. For example, in the area of mortgages, the FSA will argue that estimates based on data that do not go back to the early 1990s will generate imprudently low capital requirements. Where firms do not tackle such issues effectively under Pillar 1, the FSA will set additional capital charges under Pillar 2. 3 FSA consults on CRD/Basel implementation

6 The FSA sees the new capital framework as a way of improving risk management and capital standards in the industry as a whole over the next five to ten years. The FSA will be looking for high standards of risk management and monitoring. For many firms that will imply a step change in performance. The FSA will not implement the CRD to enable a pre-agreed number of firms to qualify to use the IRB or AMA approaches or apply lowest common denominator solutions. This leaves firms with a full and evolving agenda. The FSA s expectations will not remain static and firms on advanced approaches will have to refine and validate their risk management approaches and techniques continuously. The FSA warns that failure to do so will lead to a review of a firm s eligibility to retain foundation or advanced status. Firms need to incorporate waiver applications into their planning Obtaining a waiver Firms have hitherto focused their implementation efforts on the development of their approaches to credit and operational risk. They now need to begin to consider the mechanics of their applications for a waiver and incorporate key FSA requirements (such as documentation) into their plans. Firms wanting to use the Retail or Foundation IRB from 1 January 2007 need to apply in the second half of 2005, and no later than 31 December. Applications: The transition to the CRD is based on eight windows for applications (or waves in FSA jargon). Each window has its own cut off date for application. A firm applying for the Retail or Foundation IRB for use by January 2008 should select from waves 1-5 the one that suits them best. Firms targeting a date after January 2008 should make contact with the FSA 18 months before it is planned to use the new approach, with a formal application at least 12 months cutover. FSA urges firms to apply as early as possible. It will give priority to firms whose preparations are most advanced. For Advanced IRB and AMA, there is a window of Q for applications. Firms are free to submit an application earlier if they feel sufficiently prepared. Firms must be realistic about their timetable and ambitions and be in a good state of readiness when they apply - it is a demanding process Firms must be realistic about their timetable and ambitions and be in a good state of readiness when they apply. It is a demanding process. The FSA will rely where possible on work carried out by firms themselves, together with any independent review work that has been commissioned. Key to success is the involvement of senior management: the waiver application and the information provided must be signed off by the firm s chief executive. Application review process Pre-application work: will include information gathering (including asking firms to complete parts of the application pack on a draft basis and to submit documentation) and firm-specific review work. FSA may use special visits to review IRB or AMA approaches even in advance of a signed application Information required from firms as part of the application: This includes: A high level overview of the firm s approach to capital and risk management, its governance structure and its implementation plans, including its rollout plan. 4 FSA consults on CRD/Basel implementation

7 The firm s self assessment against relevant standards. A summary of the firm s approach to governance, the use test, data management and integrity and to validation. Details of the models being used. On-site visits: The number of visits will depend on the size and complexity of the firm and will involve FSA staff from relationship management teams and risk review specialists in credit risk, operational risk, systems and modelling. Parallel running: Firms will need to undergo parallel running before a decision is taken. Shadow and formal waiver processes: Rules have to be in place before a waiver can be granted. This is unlikely to happen before October To facilitate the process of transition, the FSA will use shadow applications until then. FSA s response to a shadow application will be a statement of how it will respond to the formal application absent a change in circumstances or the CRD. This will have the status of individual guidance. Firms that have made a shadow application will have to make a formal application when the rules are in place. This can be by a short letter. Fees: All waiver applications, shadow or otherwise, will involve an as yet unspecified fee. In addition, the largest firms will be asked to contribute to a special fee for designed to raise 2m that the FSA will spend on the Basel/CRD project. Key policy developments CP05/3 is rich in content. The policy is a lot clearer than the often opaque text of proposed rules, and there is clearly a lot of devil yet to be disinterred from the detail. Section 2 contains some of the more significant developments. We would draw attention to the following that either have particular impact or require early action from firms: Individual Capital Requirements and the ICAAP; The treatment of groups; and The treatment of investment firms. The ICAAP implements Pillar 2 - senior management must own and be responsible for it Individual Capital Requirements and the ICAAP The CRD requires firms to have an Internal Capital Adequacy Assessment Process (ICAAP). This, together with the supervisory review of the ICAAP, is the FSA s approach to Pillar 2 of the Basel Accord. There is no prescriptive definition of an ICAAP. It is for senior management to own and be responsible for its own process which the FSA will review through the ARROW assessments. Supervisors will look to assess whether the capital held is adequate to cover: Basic risks covered by Pillar 1; Risks not fully captured by Pillar 1; Other risks specific to the firm; and 5 FSA consults on CRD/Basel implementation

8 Risk factors external to the firm. The ICAAP must be complemented by stress and scenario testing. For sophisticated firms, the FSA is likely to expect to see something close to an approach based on economic capital. Less sophisticated firms will be expected to look at all the material risks that they run and assess whether they hold sufficient capital against them. This will feed into Individual Capital Guidance (ICG), which is the ratio that an individual firm will have to meet at all times. The more the firm is able to demonstrate that the ICAAP is thorough, objective and prudent in capturing and quantifying all the risks it is exposed to, the more the FSA is likely to align ICG closely with the ICAAP. ICG will also be the mechanism through which the FSA imposes additional capital requirements to deal with deficiencies in risk management and in dealing with Pillar 1 implementation issues such as data accuracy. Firms should be ready for a review of individual capital ratios Firms should be ready for a review of individual capital ratios. Firms adopting the standardised approach and Foundation IRB will have ICGs in place for 1 January Banks and building societies applying for advanced status will retain existing requirements for the period between 1 January 2007 and 1 January 2008, unless there is a material change in circumstances or the evaluation of the ICAAP identifies material risks. The FSA will also review the ICAAPs of investment firms which opt to go straight to advanced approaches to assess whether any ICG should be given for the interim period pending the next ARROW review. All firms should be ready to discuss their ICAAP with the FSA from 1 January 2007, though discussions with the larger firms may commence ahead of this. Some additional material on the ICAAP is contained in the Annex. Firms neglect this aspect of the Basel/CRD Framework at their peril and need to focus on developing ICAAP in their implementation plans. There are important modifications to solo consolidation and the integrated groups regime The treatment of groups The provisions of the CRD apply both to individual firms and to groups. The FSA is proposing to take advantage of a number of the national discretions that allow it to modify the requirements for firms that are members of groups. These include: Solo consolidation of subsidiaries that are, in substance, divisions of the firm. Note that the FSA propose interpreting some of the CRD requirements in a way that may tighten up the current approach of IPRU(Bank). In particular, it is suggested that any liabilities of the parent to the subsidiary must be repayable on demand. This could restrict the activities that can be undertaken by solo-consolidated subsidiaries. A waiver from the FSA will be needed to permit the use of solo-consolidation. An integrated group regime for exposures arising from business where risks are managed on an integrated basis. The FSA will restrict integrated groups to UK entities in the first instance. The FSA will not apply limits or require capital against exposures at the solo level in either the trading or non-trading books between members of a UK integrated group. Firms may apply for a waiver from these limits under specified conditions and form a wider integrated group. Note that the geographical restriction is more restrictive than the current regime for banks. 6 FSA consults on CRD/Basel implementation

9 The above concessions, previously restricted mainly to banks (though some building societies have used solo consolidation), will be open to all firms. Limited licence firms should escape the operational risk charge. Large firms will need to wait for the Trading Book review for certainty about their capital regime The treatment of investment firms Large investment firms will have to await the outcome of the Trading Book Review for a better picture of how they will be impacted by the CRD. In the meantime, there is some good news for some investment firms and for groups of investment firms both on operational risk and on the application of consolidated supervision. The FSA proposes to exempt limited licence and limited activity investment firms from operational risk capital requirements. Limited licence firms are those that may not deal on own account. Limited activity firms are those that essentially act as matched principals and only take positions incidentally. The FSA believes conduct of business rules are a more effective way of mitigating operational risk for these firms and that operational risk capital requirements are disproportionate to the risks these firms pose to the UK financial system. All investment firms, including those exempt from the operational risk charge, will be required to comply with the general risk management standards set out in the Draft Directive that take up the Basel Sound Practices Paper. There is likely to be significant overlap between these requirements and the MiFID. In addition, the FSA may disapply consolidated supervision for some investment firm groups. The FSA already does this under the CAD waiver. The CRD contains a similar national discretion although it is modified in some ways that may restrict its availability to some firms. In particular: The waiver operates on a a case-by-case basis. This means that a formal waiver will be required rather than the current notification based approach. All investment firms in the group must be limited licence or limited activity firms, including any third-country investment firms. An investment firm will not be able to apply for a waiver from consolidated supervision if its group contains either a credit institution or an investment firm that is not limited The financial holding company parent of the group must pass a form of capital adequacy test. The financial holding company must have enough capital to cover the aggregate requirements of entities in the group plus intra-group contingent liabilities. Most limited licence firms should also see Pillar 1 capital requirements fall as a result of a change in the expenditure based requirement. This will now be based on fixed overheads rather than total expenses and the capital requirement will be the higher of (a) the fixed overhead requirement and (b) the market and credit risk requirements, rather than being the sum of the three. This removes two areas of superequivalence and the FSA estimates that firms will see a fall of 10-25% in capital requirements. This gain may, of course, be offset by the FSA approach to Pillar 2. Basel and CRD are still moving targets Remaining uncertainties - Timing constraints and areas of continuing discussion Basel and CRD are still moving targets. Implementation is taking place as the texts are still being finalised. There are a number of uncertainties and firms will need to factor these into their plans and keep an eye on developments: 7 FSA consults on CRD/Basel implementation

10 Date of entry into force: the standardised and intermediate approaches in the CRD should be implemented from 1 January The more advanced options go live on 1 January The UK would prefer a single implementation date of 1 January FSA is planning for both possibilities. The final CRD: The timing of final agreement on the CRD is uncertain. In order to allow 18 months for implementation and to ensure that the CRD goes live on the same date as Basel, the text needs to be agreed by June/July However, the European Parliament is not expected to give its Opinion on the CRD until early summer, and cannot constitutionally do so until it has received the July proposals in a sufficient number of languages. This has yet to happen. Supervisory convergence: CEBS is working on implementation and supervisory practice, notably on Pillar 2 topics and areas of national discretion. This could lead to the revision of some of the FSA s proposals. MiFID: The Committee of European Securities Regulators (CESR) is also working on aspects of the Markets in Financial Instruments Directive (MiFID), including scope of application, systems and controls, and on the regime for rating agencies. This work could impact on the CRD. Additionally, some investment firms and dealers in commodity derivatives currently outside the scope of CAD could be brought within the scope of the CRD. The trading book review: Basel and IOSCO are reviewing the treatment of certain counterparty credit risk and trading-book related items. Investment firms in particular, but also major banking groups will want to see the results of this review incorporated into the CRD. It is expected that a consultation document will be published in April. This should enable incorporation of these proposals during the European Parliament s consideration of the CRD. Calibration: A Quantitative Impact Study (QIS) on the market impact of Basel across the G10 will be undertaken this year. This will be a further input into the final calibration of the Basel model. And just when you thought that the end was coming into sight And just when you thought that the end was coming into sight Forthcoming attractions include Regulatory change of this magnitude inevitably affects regulatory reporting. FSA has just released a paper on integrated regulatory reporting (DP05/1 Integrated Regulatory Reporting (IRR) for: Deposit takers, principal position takers and other investment firms subject to the Capital Requirements Directive.). CEBS has also just released a paper on a common approach to regulatory reporting of solvency and (in addition to any consultations on aspects of CRD implementation) will be releasing a further paper on regulatory reporting of the balance sheet and other financials in March. Amendments to the provisions on group and concentration risks are likely. The EU will be conducting a review of the Financial Groups Directive in 2007, and 2007 will also see the EU review the provisions on concentration risk in the Banking Consolidation Directive, which incorporates the Large Exposures Directive. Basel will review the definition of capital by 2009 to take account of market developments and innovation. This will, almost inevitably, be accompanied by a parallel review at EU level. Firms will be relieved to know that any changes which result from this review will be introduced after the CRD has been implemented. 8 FSA consults on CRD/Basel implementation

11 Section 2: Significant policy developments Basel will undertake a review of the definition of capital by 2009 Definition of capital The definition of capital has not been materially changed by the CRD, though there are some consequential impacts and some greater alignment with Basel. The criteria for including capital instruments in Tier 1 have been restated and to some extent reinforced. The FSA has integrated into its draft rules the policies on capital adopted in PS 115 on innovative Tier 1. Preference shares (and PIBS for building societies) are restricted to 50% of Tier 1. Dividend pushers may not be included in Tier 1 or Upper Tier 2 instruments. In a reversal of PS115 to reflect CRD, the FSA will require the full deduction of material holdings of the capital instruments of financial institutions. Basel will undertake a review of the definition of capital by Individual Capital Requirements/Pillar 2 The CRD requires firms to have an Internal Capital Adequacy Assessment Process (ICAAP). It requires supervisors to review and evaluate firms ICAAPs as part of their Supervisory Review and Evaluation Process (the SREP). In setting out its thoughts on how this might work, the FSA has drawn on the principles set out in CEBS May 2004 CP. CEBS is doing further work on Pillar 2 so requirements may evolve. FSA will not prescribe an approach to ICAAP FSA will not prescribe an approach to ICAAP. It is for senior management to own and be responsible for developing an approach that is appropriate to the activities of the firm. Only high level principles have been set out. These will be supplemented with additional material covering: The information all firms should consider when developing their ICAAP and that will be part of the FSA s review and evaluation. A requirement that firms adopt an approach which is proportionate to their size and relevant to the nature of their business. A requirement that firms carry out stress tests and scenario analyses. Examples of the risks firms in different sectors may be exposed to and how they might assess the extent of their exposure to those risks. A requirement that a firm s ICAAP provides information both on the amount of capital it considers appropriate, and on the composition of that capital. A requirement that groups break down their group-level ICAAP so FSA can evaluate the extent to which diversification benefits have been incorporated into the underlying assumptions. 9 Section 2: Significant policy developments

12 The FSA will not: Prescribe particular methodologies to quantify risks; List exhaustively the risks a firm needs to consider; Set any particular calibration parameters for stress tests; Require particular scenarios to be examined; or Define any overall confidence level as it has done in the insurance sector. For firms applying for advanced model approaches, the waiver process will be used to identify aspects of the firms approaches which cannot be addressed in Pillar 1. Accordingly, a significant proportion of the assessment of ICAAP may be informed by the detailed work to be performed as part of the approval process. For firms adopting the standardised approaches, the FSA will develop a template that identifies those elements unlikely to be adequately catered for by the standard model and so require supervisory review. Firms claiming diversification benefits can expect the FSA to be sceptical The FSA has opted to maximise risksensitivity in its approach to national discretions Where a firm is a member of a group, the FSA is concerned that capital is held by the right legal entities within the group. For groups, the ICAAP should be based on the consolidated financial position of the UK group and the total capital estimated as appropriate for the group then allocated to each group member, according to its risk profile. For firms that are not part of a UK group, or for investment firms using the waiver from consolidated supervisions, the ICAAP should apply at the solo level. Firms claiming diversification benefits can expect the FSA to be sceptical. It argues that the calibration of Pillar 1 already reflects the diversification benefits appropriate for a large diversified group with something like a 99.5% confidence interval over a one year period. Unless a firm can demonstrate an explicit confidence level in its ICAAP, the FSA will expect a firm to base its assessment of capital adequacy by comparing current resources with the capital required under Pillar 1, together with the capital required to meet risks not covered by or only partially covered by Pillar 1. Credit risk Standardised approach On the standardised approach, there are a number of areas where the FSA has had to make choices. In general, the FSA has opted to maximise risk-sensitivity in its approach to national discretions. Key options include: Risk weighting exposures to banks according to the rating of the institution, and using an option to give a preferential risk weight to short term exposures. Applying a 35% risk weight to mortgage lending up to an 80% LTV threshold (75% under CP189), the portion over 80% attracting a risk weight of 75%. Applying a 100% risk weight to UK exposures secured by commercial real estate. Where a regulator in another jurisdiction applies a 50% weight to such lending locally, UK firms will be allowed to use a 50% weight for local lending. 10 Section 2: Significant policy developments

13 Applying a 150% risk weight to collective investment undertakings that do not have an external credit rating, private equity investments and to equity investments in venture capital firms and vehicles. Applying a 10% risk weight to covered bonds. The FSA has moved in the direction of greater flexibility, but this leaves the burden of proof on firms IRB approach The FSA has clarified the entry criteria for the IRB approach and has moved in the direction of greater flexibility, but this leaves the burden of proof on firms. Firms will have to justify their approaches and justify their choices for their circumstances. IRB systems must have an essential role in both risk management and decision making to satisfy the use test, but this does not necessarily mean an exclusive or primary role. Firms will be expected to explain the validation of their model and the approach to ongoing validation when applying for a waiver. The FSA notes that firms are not presently able to explain why experience differs from their estimates or to have established tolerance levels around their estimates as required by the CRD. A firm planning to use an IRB approach must have completed roll-out to materially all of its portfolios within three years. A firm planning to use an IRB approach must have completed roll-out to materially all of its portfolios within three years The FSA has maintained its proposal that 15% of the portfolio can be outside the IRB approach without breaching materiality. Key proposals include: Experience requirement All firms must have three years experience prior to adopting an IRB approach. However, the CRD permits firms intending to adopt the retail or foundation approaches to have experience of at least one year if adopting IRB prior 31 December The FSA will require firms using the Advanced approach to corporates, institutions and sovereigns to meet the full experience requirement from day one. Data requirements changes introduced to the CRD now permit a national discretion relaxing the data requirements relating to retail exposure class and foundation corporate exposure class for all new applicants beyond The FSA will not prescribe a rating philosophy, leaving firms free to pursue approaches based on through the cycle, or point in time estimates, subject to them being able to justify their choices and discuss the impact of the cycle on their estimates. The FSA begins with the presumption that LGDs are not zero, even though internationally, regulators have only specified an LGD floor for mortgages (on a transitional basis). The FSA will require firms using the Foundation IRB to calculate a maturity adjustment 11 Section 2: Significant policy developments

14 Two issues of particular concern to firms are the role of stress testing and the treatment of low default portfolios (LDPs). In this consultation the FSA has suggested a way in which the Directive requirements on stress testing should be interpreted, including in relation to movements in the economic cycle. The FSA believes that it should be possible to include firms LDPs in the IRB approach. The outcome of this will depend on the work of CEBS. The FSA has drawn a number of lessons from the thematic visits Retail exposures The FSA has drawn a number of lessons from the thematic visits: Retail scoring models tend to be built over observation periods of less than the required 5 years. The FSA stresses that the performance of models used to calculate regulatory capital needs to be calibrated over sufficiently long periods to ensure robust calculations in the event of an economic downturn. For SMEs, the FSA will be superequivalent by requiring firms to set out a policy defining SME exposures to ensure the consistency of types of assets that are classed as exposures to SMEs. This policy will also have to set out the procedures for transferring assets from retail SMEs to a corporate treatment when the boundary is breached. SME assets that no longer meet the retail criteria must be treated as corporate exposures. This reverses the policy in CP189 that permitted firms to keep such assets in the retail portfolio but apply the corporate calculation. The retail definition of default for non-sme products has now been fixed at 180 days past due. However, this is only part of any definition of default, which should be treated as a fixed backstop to other indicators of unlikeliness to pay. These may well be triggered in advance of the days past due component of the definition of default. Firms should consider in their models (and demonstrate) how default on one facility will influence the PD of another facility for the same obligor. FSA will consider exempting firms from this requirement if they can demonstrate that the use of this information will not make a material difference to their capital. This may pose problems for institutions that manage products entirely separately, and where one division may not even be aware that a customer may also be a customer of another part of the wider firm. All firms, even those not subject to the operational risk charge, will at least have to meet basic risk management standards Operational risk The FSA has provided additional detail on the various approaches and the national discretions associated with them. Firms using the Basic Indicator Approach will have to meet the general risk management standards of the CRD that are drawn from Basel s Sound Practices paper. For investment firms there is likely to be considerable overlap between these standards and the requirements of the Markets in Financial Instruments Directive. The FSA will offer the Alternative Standardised Approach as an option for firms with a preponderance of retail and commercial banking. Firms wishing to use this approach will need to demonstrate that it is superior in their case to the normal 12 Section 2: Significant policy developments

15 standardised approach and that the latter leads to significant double counting of risk. The FSA will apply a 15% charge to the Trading and Sales business line in the standardised approach as a transitional measure until end Fees for outsourcing should not be deducted from income in order to calculate the relevant indicator under the Basic or Standardised approaches. This is to prevent outsourcing becoming a means of transferring operational risk capital between firms. Intra-group outsourcing will therefore not result in an overall reduction in operational risk capital. AMA must encompass internal data, external data, scenario analysis and business environment and control factors Advanced Measurement Approaches Much is still being decided in CEBS. The FSA sets out various issues on the Advanced Measurement Approaches (AMA) still under consideration: The use test: The FSA expects firms to demonstrate that they have an embedded culture of risk management, and that the operational risk framework brings together the measurement and management of operational risk. The risk measurement system must be credible and not built for regulatory purposes. The qualitative aspect of the framework is just as important as the quantitative element. A firm must be able to demonstrate that data inputs are accurate, reliable and credible and its validation techniques are robust. The quantity, quality and reliability of data being input into the risk measurement system are fundamental to the AMA approaches. The FSA is likely to issue guidance on minimum expectations for the validation process Documentation of systems of control in general and risk management systems in particular is central and should be considered throughout the design and implementation of AMA. This is essential for the waiver process. CRD will require the FSA to validate the operational risk measurement system. However, the FSA sees firms as primarily responsible for validation that should encompass qualitative and quantitative elements. Validation processes and outcomes should be subject to independent review. The operational risk capital charge should capture both expected and unexpected losses, unless a firm can demonstrate that expected loss is adequately captured in internal business practices. The FSA view is that it will be a significant challenge for a firm to demonstrate that future income when calculated on budgeting and pricing assumptions properly recognises and accounts for expected loss. A measurement system must encompass internal data, external data, scenario analysis and business environment and control factors. It must attain the equivalent of a 99.9% confidence interval. Credit risk mitigation The new credit risk mitigation framework will have a significant impact on firms regulatory capital, in particular how collateral is recognised as a risk mitigant. The definition of eligible collateral has been broadened as has the number of different approaches for calculating regulatory capital. Firms using approaches based on the volatility adjustment may see an increase in regulatory capital whilst firms permitted to use recognised internal 13 Section 2: Significant policy developments

16 models may see a reduction. The proposals for credit derivatives and guarantees are considerably more detailed than current rules. Securitisation The prohibition of implicit support remains a key aspect of the FSA framework and it has taken the opportunity not only to clarify what it understands by implicit support, but also to go further than the CRD requires by derecognising risk transfers from securitisation after the first case of implicit support. To obtain capital relief, the risk transfer offered by a securitisation must be significant. Credit risk transfer will only meet this test when the proportion of risk transferred is commensurate with, or exceeds, the proportionate reduction in regulatory capital when comparing the firm s securitisation positions and the underlying exposures. Regulatory reporting will remain the primary source of information for the FSA Pillar 3 The FSA will adopt a risk-based approach to monitoring and enforcing firms compliance with the market discipline disclosure requirements. The FSA expects the market to play a key role in monitoring and enforcing compliance with the disclosure requirements. Not all the disclosures will be formally reportable to the FSA, which will continue to derive its primary source of information from regulatory reporting. It will be the responsibility of firms senior management to determine the level of disclosure having due regard to the definition of materiality in the CRD (a disclosure is material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions). It will also be the responsibility of firms senior management to determine whether information falls into either the proprietary or confidential category. The FSA does not intend requiring firms to routinely publish their disclosures more regularly than annually or to set deadlines for the publication of such information. Disclosure must be timely and firms should assess for themselves whether some disclosures should be made more frequently. The FSA expects the location and medium of disclosure to be decided by a firm s senior management. Their decisions in this area may be influenced by interaction with the accounting standards disclosure requirements. However, if all disclosures are not located together, firms must clearly indicate the location and medium of the remaining disclosure items. The FSA does not currently intend to issue formal guidance on the level of verification to be applied to disclosures which will not be covered by statutory audit. 14 Section 2: Significant policy developments

17 Section 3: Programme Managers Checklist Action Submission of IRB/AMA waiver application packs Finalise model building and independent validation Still tackling technical issues Don t forget outsourcing issues Still work to be done on data management ICAAP implementation completed by stress and scenario testing Tease out group and solo issues Undertake required QIS Look at market discipline/reporting Must not forget training Programme Manager Notes The timing of the submission of the IRB/AMA application will depend on a firm s intentions for its risk approach and capital calculations. A firm wanting to use Foundation IRB for Corporate, Bank and Sovereign exposures or IRB retail from 1/01/2007, must submit a signed application pack in the six-month window closing on 31 December The Basel Committee has published two documents on ratings validation which are very relevant to validation work (Studies on the validation on internal rating systems, Working Paper N.14). These need to be incorporated into implementation plans. In CP05/3 the FSA clarifies specific topics, such as stress testing, default definition, treatment of low default portfolios. These clarifications need to be incorporated into implementation plans. Credit risk mitigation, securitisation, and large exposures issues need to be considered. Firms using third party solutions and external data to determine risk parameters (PD, LGD, EAD) are required to demonstrate that the use of such solutions and data are appropriate for them, with particular reference to the nature of the firm s portfolio and that any outsourcing is subject to proper controls. CP05/3 stresses that there is much more to do in improving data quality. Unless firms have data of sufficient quality, they will not be able to derive all the benefits that may be available from the new approaches, nor report regulatory capital adequately. They may also face additional capital charges under Pillar 2. Firms are required to set their own standards for assessing data accuracy and demonstrate how they satisfy themselves that IRB data standards are met. The detailed approach to Pillar 2 implementation is being refined. There is a close relationship between Pillar 1 and 2, with the shortcomings in Pillar 1 reflected in Pillar 2. Developing an ICAAP should be an increasing priority of programme managers and needs to involve the most senior management, since the ICAAP is expected to be a key management tool for the institution. ICAAP and Pillar 1 approaches are developed at group level. Firms will need to be able to explain capital allocation around the group, and will also need to modulate Pillar 1 approaches to the circumstances of individual group companies or local regulators if required. Solo consolidation and integrated group issues need to be explored. A further Quantitative Impact Study (QIS) on the market impacts of the Basel Framework across the G10 participant countries will be undertaken this year and will be critical in calibration of the final Accord. Firms need to identify and understand IFRS/Basel 2/Sarbox overlaps as they develop approaches to disclosure. Regulatory reporting also needs to be considered. Banks need to develop a common language and definition of all aspects of the Accord. It is imperative that Risk, IT and Finance understand the key aspects of the Accord in order that regulatory requirements and the use test are satisfied and benefits are realised. The upward management/training of senior colleagues should not be neglected. 15 Section 3: Programme Managers Checklist

18 Contacts If you would like to discuss any of the issues arising from this paper, please speak to your usual contact at PricewaterhouseCoopers, or one of the people listed below. John Tattersall UK regulation Patrick Fell UK regulation Richard Smith Risk advisory Giles Triffitt Operational risk Richard Quinn UK & EU regulation Richard Barfield Capital management Stephen Burke Investment management +44 (0) (0) (0) (0) (0) (0) (0) If you would like further details of our financial services publications, please visit or contact Kirsty Parker on +44 (0) or by at PricewaterhouseCoopers ( provides industry-focused assurance, tax and advisory services for public and private clients. More than 120,000 people in 144 countries connect their thinking, experience and solutions to build public trust and enhance value for clients and their stakeholders. ("PricewaterhouseCoopers" refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.) Copyright All rights reserved. PricewaterhouseCoopers refers to, a limited liability partnership incorporated in England. is a member firm of PricewaterhouseCoopers International Limited. 16 Contacts