The industry is putting on a brave face when commenting on the latest proposals for the EU Capital Adequacy Directive, but all is not as it seems. Even though the legislative text implementing Basel II in Europe contains some fairly significant departures from the original framework, industry associations are keeping their powder dry for now. Remarkably, nearly every industry association contacted for this article claimed to be happy with the EU Capital Adequacy Directive (EU CAD) as proposed, when asked to comment for attribution. "For the most part, we’ve got what we wanted," says Simon Hills, a policy director at the British Bankers Association in London. Stephen Fisher, an official who looks after capital adequacy and banking supervision issues at the Federation of European Banks in Brussels, says: "Operational risk is not too much of an issue for us at this stage. I imagine individual banks will take up issues on a case-by-case basis."Why the bland commentary from these industry groups, who are usually quite game when asked for a pithy sound bite or two? It has everything to do with the uncertainties surrounding the upcoming political process the EU’s legislative text will have to go through before it is finalised by the EU Council, including a sojourn in the European parliament.Scratch below the surface, however, and one can find disquiet with several of the changes that the EU text contains. To begin with, the implementation timetable continues to be the subject of serious discussion among all interested parties. After much debate, the European Commission (EC) decided to maintain the same implementation deadlines as those contained in the final Basel II framework—that is, firms on the simpler approaches would implement by the end of 2006, while firms attempting the advanced measurement approach (AMA) for operational risk and the advanced internal ratings-based approach for credit risk would have an end-2007 deadline. It was no secret that the UK Treasury was pushing for a unified end-2007 deadline for all approaches. But EC officials say the Basel timetable turned out to be the "compromise" approach. One source says those consulted were "pretty evenly split", there was a "slight majority in favour of Basel bifurcated approach". But UK banking executives aren’t concerned. BBA’s Hills says: "Our view is that the end of 2007 is the right time. The chances are that the EU CAD is going to get delayed in the processes of getting it through parliament, so it may wind up being the end of 2007 anyway."Another controversial element of the new draft of the CAD is the addition of a temporary beta for investment firms in the trading and sales business line under the standardised approach. Until the end of December, 2012, investment firms that derive more than 50% of the firm’s total revenues from trading and sales may apply a beta of 15% to that business line, instead of the normal 18%. The European Commission official says: "This is based on our impact surveys. Just as the alternative standardised approach (ASA) was designed mainly for small banks predominantly active in retail or commercial banking, the temporary 15% beta has been directed at those institutions most hit by a potential double counting between market risks and operational risk." The EU released a separate Review of the capital requirements for EU investment firms – 2004 quantitative impact study, main conclusions in late July. The qualifying criteria for all three approaches also vary significantly from those outlined in Basel II. Under the basic indicator approach (BIA), there are no specific qualitative criteria, such as fundamental standards for op risk management. Although the Basel II framework doesn’t specifically specify such requirements either – as the BIA is the simplest approach for op risk – it does however suggest that banks should comply with its February 2003 publication, Sound practices for the management and supervision of operational risk. This qualification is absent from the CAD.Various criteria under the standardised approach are also different from Basel II. To begin with, the treatment of negative gross income is less generous than it is under the Basel II document. Under Basel II, negative capital charges in any of the eight business lines may offset positive capital charges in other business lines "without limit". However, in the EU CAD, "if for any given observation, the sum of net interest income and net non-interest income is negative, this figure shall be assigned the value zero". "Most EU delegates were against compensation between negative and positive figures," says the EU official, "and wanted to stick to the methodology used for the third quantitative impact study, which assigned a zero value to negative income figures." The official adds that one can "easily discover uneasiness in the Basel text about compensation between negative and positive figures" in references to the issue in the Pillar II section on the subject. The EU CAD also differs in its approach to the transparency of the business line-mapping process. While Basel II requires that the mapping process must be "clearly documented" and that "written business line definitions must be clear and detailed enough to allow third parties to replicate the business line mapping", the EU CAD has no such explicit requirements. The Basel II document also says "documentation must, among other things, clearly motivate any exceptions or overrides and be kept on record". The CAD is silent on this subject, as well as the last principle outlined in Basel II, "processes must be in place to define the mapping of any new activities or products". The EU CAD puts more restrictive language in for the ASA as well. To use the ASA, a firm must derive 90% of its income from retail and commercial banking, and it must convince regulators that "a significant proportion of its retail and/or commercial banking activities comprise loans associated with a high probability of default, and that the alternative standardised approach provides an improved basis for assessing the operational risk." The ASA under the EU CAD also does not specify what the betas will be under that approach, but instead allows supervisors to specify individually. Industry executives expect that this portion of the document will be looked at very closely by MEPs from the accession countries, which include Poland, Czechoslovakia, and other emerging European nations that might find the ASA handy for application to their remaining domestic banks. Perhaps most surprisingly, the EU CAD takes several of the qualifying criteria for the standardised aproach (STA) that were included specifically for internationally active banks and applies them generally. This includes a requirement to track operational risk data across the firm, including material loss data. Also included are provisions for management reporting and specific operational risk reports and a somewhat watered-down requirement that the op risk assessment system be "closely integrated into the risk management process of the credit institution". One industry association executive says: "The UK Financial Services Authority kept telling us not to worry, that this section of text would be changed in the CAD. But it hasn’t been, so we are all wondering what happened."On the other hand, the EU CAD’s qualitative qualifying criteria for the AMA is substantially less stringent than what the Basel II document requires. For starters, it requires that firms have "an independent risk management function for operational risk", while the Basel II document suggests "an independent operational risk management function that is responsible for the design and implementation of the bank’s operational risk framework". The difference is subtle but important – CAD assumes that the op risk department will be a division of risk management, while Basel II leaves the door open for op risk to report in to any member of senior management. Basel II then goes on to outline the responsibilities of the op risk department, while the CAD is silent on this subject. The CAD is also much less explicit in other areas. While it requires regular reporting of op risk exposures and losses, Basel II goes on to specify that reports should be sent to business unit senior management, senior management and the board of directors. Another example of this less stringent approach is the fact that although both the CAD and Basel II insist on regular reviews by internal and/or external auditors, only Basel II requires that review to be of both the activities at the business units and of the independent op risk management function. Basel II also specifically states that "it is necessary that auditors and supervisory authorities are in a position to have easy access, whenever they judge it necessary and under appropriate procedures, to the system’s specifications and parameters." The CAD is silent on this subject. However, in the quantitative criteria area, the EU CAD is stricter than Basel II. While Basel II eased up on the 99.9% confidence interval soundness standard in the final version – it acknowledged that such a tough soundness standard might not be appropriate in all circumstances – the EU CAD stands firm, stating that "the operational risk measure must capture potentially severe tail events, achieving a soundness standard comparable to a 99.9% confidence interval over a one-year period". Says one industry association executive: "Basel had a lot more helpful elaboration around that point."The problem with the Basel II text was that it was "too fudgy", says the EU Commission official. Because the CAD is a legislative document, the Commission needed "to provide legal clarity in a binding text." He says he expects the Committee of European Bank Supervisors (CEBS) to develop many of the more "practical aspects" of the CAD for implementation. There are other areas where the CEBS might soften the approach of the CAD as well. While Basel II now requires "relevant" external data, the CAD simply requires "external data". On top of this, the CAD has a new requirement, that "credit institutions must have documented procedures for assessing the ongoing relevance of historical loss data, including those situations in which judgement overrides, scaling, or other adjustments may be used, to what extent they may be used, and who is authorised to make such decisions". Basel II contains no such text. On the other hand – surprisingly – the EU CAD does not require that firms use the "official" definition of operational risk for its AMA calculations. Also, the level of specific detail and requirements in place under the subsections of external data, scenario analysis and business environment and internal control factors subsections is less than in Basel II. For example, Basel II says "the framework and each instance of its application, including supporting rationale for any adjustments to empirical estimates, must be documented and subject to independent review within the bank and by supervisors". In contrast, the EU CAD simply says the framework must be documented and subject to independent review both within the firm and by supervisors. There were other omissions from the CAD text that might get a closer look. In the area of insurance as a form of operational risk mitigation, the EU CAD sticks fairly closely to the Basel text, with one exception – it does not require the disclosure of a description of a firm’s use of insurance for mitigating operational risk. Also, under the BIA, there is no specific reference to outsourcing – which was added to the Basel Committee document during the final drafting stages to indicate that "calculations should be gross of operating expenses, including those paid to outsourcing service providers".On the big issues of home-host, firms claim to be pleased with the approach that the CAD proposes, where the home supervisor takes the lead and the host regulators form a "supervisory college". But this agreement was made mostly among the finance ministers and regulators of the old EU countries – accession countries whose regulators might be forced to effectively give up oversight of their domestic banking industry through this approach might take a different view, say observers. Once the European parliament returns in September and takes up debate on this issue, there is no doubt that some of these textual differences will blossom into fully fledged debates. In the meantime, says one industry association executive, "I’m spending my summer in my office, instead of at the beach, preparing for this."Both the EU CAD text and the new impact study in investment firms can be found at:http://europa.eu.int/comm/internal_market/regcapital/index_en.htmOperational Risk...
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