The Brewery, Chiswell Street, EC1
15 July 2004
Speech by Hector Sants

  1. In my brief presentation today I shall describe how we are modernising the FSA's prudential standards for banks, investment banks and of financial firms. Key to modernisation is the revised framework, known as Basel 2, published on 26 June by the Basel Committee on Banking Supervision. In this presentation I shall first set out the context or background to the Basel 2 framework, I will then briefly describe its contents before finally turning to explain how Basel 2 will be implemented within the EU and UK. I shall throughout explain why Basel 2 is important to the achievement of the FSA's statutory objectives.

  2. Basel 2 describes itself as a "revised framework" for "international convergence of capital measurement and capital standards". It updates and, in part, replaces the earlier standards. However it goes much further than earlier standards in a number of ways.

    • Firstly Basel 2 recognises more explicitly than previous standards that capital is only one aspect of sound prudential standards. It does this through a three-pillar framework. Pillar 1 sets rule-based minimum capital requirements. Pillar 2 calls for supervisory review and the setting of bespoke capital requirements for individual firms. Pillar 3 sets disclosure requirements intended to enhance market discipline.

    • Secondly, within its Pillar 1 Basel 2 updates the Basel 1 capital requirements for credit risk. It allows banks to choose between applying a Standardised Approach and applying an Internal Rating Based Approach. The Standardised Approach follows the pattern of Basel 1 by assigning standard risk-weights to different classes of assets to adjust their values. However it does this in a far more sophisticated and risk-sensitive way than Basel 1. It makes the important innovation of allowing risk-weights for loans and other credit exposures to be based on the external rating of the counterparty or loan facility. It sets up a regime for supervisors to recognise external credit rating agencies for this purpose. The Internal Ratings Based Approach goes one step further. It allows a bank to use its own internal ratings of a counterparty's probability of default (and, under the advanced version of IRB, also of the loss given default) to determine the asset risk-weight.

    • Thirdly, Pillar 1 of Basel 2 introduces for the first time explicit capital requirements for operational risk. Here it allows banks to choose between applying formulaic approaches and using the Advanced Measurement Approach which is based on internal modelling. The decision to require capital to be held to cover operational risk was not uncontroversial. The primary response to operational risk should, of course, to be strong systems and controls and good corporate governance. However the operational risk capital charge creates a capital incentive on firms to improve their systems and controls and corporate governance.

  3. We first set off on the long journey of negotiating Basel 2 nearly five years ago. I would briefly describe our objectives in that negotiation as follows.

    • Modernisation: Basel 1 was put in place in 1988. Since then financial market have grown significantly in both size and complexity especially in the areas of securitisation, credit derivatives and the other risk mitigation and management techniques. In practice supervisors, including the FSA, have responded to innovation in the financial markets by supplementing Basel 1 by national rules. However this has had led to a lessening of international convergence in standards. Also such ad hoc national solutions which need to keep at least within the broad framework of Basel 1 can only go so far. A more radical modernisation was needed. Basel 2 now achieves this aim and sets out detailed explicit standards for when and how securitisations, credit derivatives and other risk mitigants should be recognised.

    • Risk sensitivity (without pro-cyclicality): Basel 1 sought to assign risk-weights to asset classes that were risk sensitive. However it did this only very crudely as the asset classes used were very broad. Basel 2 within its Pillar 1 now sets risk-weight based on external credit ratings under the standardised approach and on internal credit ratings under the IRB approach, both of which are significantly more risk-sensitive than Basel 1. And as, within Basel 2, the IRB is itself much more risk sensitive than the standardised approach, both approaches have been calibrated so as to provide an appropriate incentive for banks to move to the IRB approach.
      Ensuring that capital standards are risk sensitive and are up to date with market objectives – the first two FSA negotiating aims for Basel 2 which I have just listed – is of course important to achieving our statutory objectives of protecting consumers and maintaining confidence in the financial system.

    • Pro-cyclicality: One consequence of making capital requirements more risk sensitive is that they increase during times of recession when credit risk increases. Whilst on a micro level this is sensible on a macro level this would lead to the banking sector withdrawing or restricting credit lines to consumers and businesses leading to a further deepening of the recession. This in turn would lead to still higher capital requirements etc. This type of self reinforcing economic behaviour is referred to as pro-cyclicality. The danger of pro-cyclicality was recognised at an early stage in framing Basel 2 by the Basel Committee as whole including the FSA. For the FSA in particular pro-cyclicality is a threat to the achievement of our statutory duty to maintain confidence in the financial system. This danger has been met in the design of Basel 2 in a variety of ways. I will mention just two. First, banks are encouraged to base their Pillar 1 calculation of required capital on a so-called "through the cycle" estimate of probability of default. Second in assessing capital adequacy under Pillar 2, a bank is required to be mindful of the particular stage of the business cycle in which the bank is operating and to conduct rigorous, forward-looking stress testing that identifies possible events or changes in market conditions that could adversely impact the bank.

    • Overall capital: A key objective for Basel 1 – which is also important for the FSA in the context of its statutory duty to maintain confidence in the financial system – was to help ensure the safety and soundness of the international banking system and so to help promote international financial stability. Basel 1 led to an increase in capital held by internationally active banks and, arguably, to a decrease in the systemic vulnerability of the world financial system to disruption from banking crises. However despite the progress made in Basel 1 there have, of course, been several significant banking crises, e.g. most recently in Asia, although (arguably) the impact of these crises has been significantly muted compared to pre-Basel 1. This led the Basel Committee – and the FSA – to conclude that there was no basis on which either significantly to decrease or increase the total capital in the world banking system and that consequently the aim should be to calibrate Basel 2 so as broadly to achieve the same capital requirements in aggregate worldwide. This does not, of course, mean that Basel 2 need be identical to Basel 1. At level of individual banks or banking groups, as between different types of banking business such as retail or commercial and even at the level of a Basel member nation itself the aggregate Basel 2 capital requirement might be more or less than under Basel 1.

    • International convergence: Basel 1 is the most successful international regulatory standard in history within the financial services sector. It provides a single, clear and simple capital standard that has gained almost universal acceptance within developed and developing economies including the major economies of the US, EU and Japan. A key FSA aim for Basel 2 – in line with the FSA's statutory duty to have regard to the international character of financial services and markets and the desirability of maintaining the competitive position of the United Kingdom – was that in the process of modernising and improving Basel 1 not to lose or lessen that degree of international convergence. The first step in progress toward this aim was achieved with the endorsement of the Basel 2 framework by the G10 Central Bank Governors and Heads of Supervision. This is now to be followed by national implementation within the Basel member nations and more widely.

    • Clear and proportionate standards: One reason that Basel 1 gained widespread acceptance in both developed and developing economies was its clarity and relative simplicity. These were aims also for Basel 2. At first glance as the new Basel 2 framework document is 238 pages of closely written text one might think that these objectives have not been met. However clarity as much depends upon how the framework is implemented as how long the text is. Also much of the detail in the text reflects – as is needed to meet our "modernisation" objective – the increasing complexity and diversity of financial markets across the world and the increasing sophistication of risk measurement and management techniques. Neither the FSA nor the Basel Committee, of course, invented this complexity, diversity and sophistication in markets and techniques but we do need to respond to it. In addition to being clear it is important to the FSA – bearing in mind our statutory duty to that effect – that the Basel 2 standards be proportionate. This has been achieved first by recognising that hard "Pillar 1" capital rules are only one aspect of sound prudential standards, by basing those capital rules on risk-based measures and by providing choices or alternative methods such as the IRB and AMA – even though this is a further source of more detail in the framework. This allows banks to match the sophistication of their capital calculation to the sophistication of their own risk management.

  4. Although the Basel 2 framework text was published on 26 June, this does not bring the Basel Committee's work on Basel 2 to an end. There will be at least two important strands of continuing negotiation: the joint Basel/IOSCO trading book review and the overall recalibration of the Basel 2 proposals.

    • Recalibration: as already noted one of the stated aims of the Basel Committee was to leave the overall level of capital in the system broadly unchanged worldwide. The Basel Committee's third quantitative impact study ("QIS 3") showed that this goal had been broadly achieved. However QIS 3 was based on the proposals set out in Basel's Consultation Paper 3 published in 2003. Since CP3 several significant changes have been made to the Basel 2 framework. A recalibration of the framework is therefore needed to ensure the overall capital objective is met. The recalibration is to be based on the data obtained from the parallel running by banks of the Basel 2 framework during 2006.

    • The trading book review: A joint review, with IOSCO, of the capital standards for trading book activities has commenced. This was initiated partly in response to complaints from industry that the capital standards set out in Basel 2 for counterparty credit risk within the trading book were inappropriate. However in addition it will also take up wider supervisory concerns including reviewing some aspects of how capital standards for market risk within the trading book are set. The hope expressed by the Basel Committee, which it has been careful not to harden into a promise, is to put in place at least some of the reforms from this review in time for the initial implementation date of Basel 2. The industry is lobbying hard for this ambitious date to be achieved. Within Europe, any changes flowing from the Trading Book Review will need to be put before the European Parliament before its first reading of the C.R.D which will be the vehicle for implementing the new Basel Framework in Europe.

  5. Implementation of Basel 2 has two aspects: legislative enactment and practical implementation. Within the EU legislative implementation takes place in two stages. First an EU directive is enacted and then the provisions of that directive are enacted into national law by each EU member state. Within the UK enactment into national law will be by a combination of HM Treasury regulations (under the European Communities Act) and FSA rules. I want to take this opportunity today to delivery some key messages as to how we shall handle both the legislative and practical aspects of implementation.

  6. As already mentioned legislative implementation of Basel 2 in the EU is achieved first by enactment of an EU directive. This is the Capital Requirements Directive which was published as a proposal by the EU Commission [yesterday /14 July].

    • This proposed directive implements Basel 2, but also goes a lot further.

    • Basel 2, as with previous Basel standards, applies only to internationally active banks. However within the EU established practice is to apply the same capital standards to all regulated financial firms other than insurance companies. The same standards are thus applied to all banks and building societies, whether large or small and whether active internationally or only within the UK.

    • The same standards also apply with some exceptions and exemptions to the non-bank sector including investment banks and investment firms. The extent and detail of those exceptions and exemptions is a key element in the negotiation of the proposed directive.

    • Publication as a Commission proposal is only the first stage in the legislative process for enactment of the Capital Requirements Directive. The EU Council of Ministers and EU Parliament now need to consider and, if they wish, amend the directive. For the Council the detailed work is done by in working groups at which HM Treasury officials will lead supported by FSA staff.

  7. It is, of course, for HM Treasury rather than the FSA to set the UK objectives, but I will briefly set out some broad principles that might be relevant to those objectives:

    • Parallelism between the CRD and Basel 2: that is the CRD should enact, in broad terms, the standards set out in Basel. That is not to say that there need be an exact parallel between the texts of the two documents. Basel 2 is written in language appropriate for a non-legal 'Accord' between supervisors. The CRD needs to be written with the formal precision of a legally binding text.

    • Balance between group and solo capital requirements: Basel 2 sets standards that are primarily aimed at internationally-active banking groups. The CRD applies the Basel 2 standards at both the group and solo levels. This is appropriate as it is solo legal entities, not groups, which carry out regulated business such as taking deposits. However this needs to be balanced against the need to reflect economic substance as well as legal form when defining the solo/group scope of capital requirements as is done at present in our "integrated groups" and "solo consolidation" regimes.

    • Proportionate application to smaller firms and firms with limited activities: Basel 2 was written with only internationally-active banks in mind. The CRD will apply to all banks and all regulated financial firms. Some aspects of Basel 2 need to be, and in the Commission proposal have been, rewritten so that they apply in a proportionate way to all firms.

    • Appropriate balance between the four Lamfalussy levels: the aim of the Lamfalussy reforms is to help ensure consistent, proportionate and flexible regulatory standards apply within the EU.

    • A realistic and practicable start date: HM Treasury, the FSA and the UK industry have strongly argued for a single end-2007 start date. The Commission proposed directive sets out staggered start dates from end-2006 to end-2007.

  8. I have spoken now at some length about the negotiation of the Basel 2 framework and the on-going negotiation of the Capital Requirements Directive which gives effect to that framework within the EU for banks and other regulated financial firms. I shall now say a few words about how we propose to implement that directive in the UK. In particular I shall outline:

    • How we are setting strategic objectives for the UK implementation;
    • Some immediate high-level messages to the industry on its implementation; and
    • Our approach for on-going industry communication.

  9. I shall set out our five objectives in a moment, but in order to give the context for these objectives would first make two points. In practice the real difficulties from applying the strategic objectives are likely to come from circumstances in which two or more objectives point in different directions. The objectives apply to all aspects of how the FSA will in practice apply the standards in the CRD, but are particularly relevant to those areas in which a high degree of supervisory judgement is needed. These include applying the entry criteria to a regulated firm who wish to use the Internal Ratings Based Approach for credit risk or the Advanced Measurement Approach for operational risk; and applying the "Pillar 2" supervisory review to a regulated firm.

  10. (The first objective) The FSA will apply Pillar 2 and interpret Pillar 1 with the aim of achieving capital standards for regulated firms that are proportionate to their risks and that give appropriate incentives to good risk management.

  11. (The second objective)The FSA will interpret and apply Pillar 3 with the aim of achieving risk disclosures that are relevant and reasonable (in terms of costs and benefits) relative to the aim of encouraging market discipline.

  12. (The third objective) The FSA's application of the standards in the CRD should be broadly equivalent in practice to other EU Member States and should also appropriately take into account how Basel 2 is being implemented in other key jurisdictions.

  13. (The fourth objective) The FSA will seek to achieve early clarity on the key policy and practice choices that are project critical to regulated firms' implementation plans. The FSA will base its policy and practice choices on an open and transparent process of both formal and informal consultation.

  14. (The fifth objectives) The FSA will base its supervisory practice in applying the CRD on its Arrow Framework. Where a regulated firm is supervised under Arrow on a "relationship basis" the key supervisory decisions arising from CRD, such as for example the application of pillar 2, need to be based on a dialogue with the regulated firm appropriate to that relationship.

  15. I have now listed some objectives for the FSA's implementation project. However the FSA's project is only one aspect of UK implementation. Of no less importance are the implementation projects of banks and other regulated financial firms and here I would draw attention to a few key FSA messages.

    • It is important to some firms for both regulatory and reputational reasons to move to the Internal Ratings Based Approach for credit risk or the Advanced Measurement Approach for operational risk. Access to the IRB and AMA is not automatic simply because a firm, even a large bank, has applied for it. Both IRB and AMA place significant reliance on a regulated firm's own systems as the basis for the calculation of regulatory capital. The FSA will only accept an application to use IRB where a regulated firm has strong risk management and corporate governance over its credit risk processes and systems including its IRB system, the IRB system plays an essential role in how the firm actually manages its business – the so-called "use test" – and the IRB system adequately incorporates all available information relevant to credit risk.

    • These are challenging standards even for those banks and other regulated firms, whether large or small, that are today at the cutting edge of credit risk management.

    • Large banks should not fall into the misconception that simply because they are large it is inevitable that they will be ready to meet the IRB standards. Conversely smaller regulated firms should not assume that simply because they are small the IRB standards are beyond their reach. This is not the case especially if they are strong niche players who understand their markets and customers well. Similar comments apply to the AMA as for the IRB.

  16. To the key messages I have just given I would add one more. The FSA and industry implementation projects are necessarily very closely linked. Good on-going communication between the FSA and industry is therefore essential to the success of these projects. We will of course be using a variety of methods to continue and improve this communication. I would draw attention to a few of these.

    • We have set up a High-level Advisory Group chaired by myself that includes senior representatives from the industry, HM Treasury and Bank of England to help us review progress against our implementation objectives.

    • At a working level we have set up five industry standing groups that respectively focus on credit risk, credit risk mitigation, securitisation, operational risk and capital and group issues. A further standing group on market risk is to be set up that will focus on trading book issues.

    • We shall also be posting Basel information on our website including the terms of reference for the Advisory Group and the standing groups, papers that are put to these groups and minutes of the meetings. We shall be publishing our draft application pack for the IRB approach in the next few days together with an explanation of the application process and the timelines for making applications. The timelines are at present based on the start date in the Commission proposed directive of end-2006 rather than the UK preference of end-2007. We are also developing our substantive standards for entry to the IRB and AMA. These will be formally consulted upon early next year but we shall be giving updates on our latest thinking on our website through answers to frequently asked questions. These questions and answers will focus on those areas in which regulated firms need early clarity so as not to be held up in building their systems.

  17. I have now briefly described the Basel 2 framework itself, how it will be implemented within the EU through the Capital Requirements Directive and how that directive in turn will be implemented in the UK. Basel 2 and the Capital Requirements Directive are, as I have said, key to how we shall be setting prudential standards for banks and other regulated financial firms. The aim of prudential standards is to help increase the safety and soundness of banks and other regulated financial firms which are an important part of how we achieve our statutory objectives of consumer protection and maintaining market confidence. Prudential standards – and Basel 2 in particular – will therefore remain a key priority for the FSA's senior management and for myself in particular.

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