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?  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

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

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

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

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?

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

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

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’

The current timetable RBCD issues CP189 Phase 1 CP (Jan) Phase 2 Phase 3 Prudential Source Book PSB Final text IRB & AMA applications Waivers Discuss individual capital Supervisory review: policy development Preparation for IRB/AMA approvals Interlinked Devise FSA policy

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

The main challenges for banks - 2  IT systems  Data adequacy: capture and storage - by  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

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

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?

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

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

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

Conclusion Michael Ainley Head of Wholesale Banks Department Financial Services Authority, UK 18 May 2004