CP189: the FSA yet to clarify rules for key op risk issues

LONDON - UK firms are faced with more questions than answers in the operational risk portions of the latest consultation paper from the FSA, CP189: Report and first consultation on the implementation of the new Basel and EU capital adequacy standards, issued in mid-July.

Said an FSA official, "we think waiting here was better than jumping ahead of Basel/EU and UK discussions".

CP189 follows on from discussion paper 13, issued in July 2002, but it does not include information on the FSA’s approach to either pillar II (supervisory oversight) or pillar III (market discipline) of the revised Basel Accords. Nor does it offer draft rules or guidance, which will be covered in new Prudential Sourcebook text, expected to be published by the FSA in mid-2004.

ORIAG future in doubt
The paper does not cover operational risk systems and controls, which were discussed in CP142. The final version of CP142 is expected in September, for implementation in September 2004. The FSA also noted that the ORIAG will publish a document detailing common elements of the AMA. However, those participating in the ORIAG said they did not know if and when their report would be ready. Current and former participants in the group said they thought the body was "searching for a mission" thanks to lack of guidance from the FSA and lack of interest from participants in sharing what could be proprietary information on internal op risk systems. Only one set of minutes for the group has been posted on the FSA website since January. An FSA official acknowledged that the group "needs to collectively decide how ORIAG could function best in the future, or whether its tasks might usefully revert to other groups".

In CP189, the FSA has taken a flexible approach to the partial use of the AMA with TSA. In the credit risk arena, the agency set specific goals for the timing and scope of adoption of the IRB within a firm, once it begins to utilise the approach. But with the AMA, the FSA said "hard limits for roll-out are likely to be meaningless" because of the developing nature of the discipline, and because there "may be business lines and loss events to which firms may never be able to apply an AMA". The FSA has also declined to define, for now, what proportion of a firm would be expected to adopt the AMA in order to qualify as an AMA institution for regulatory purposes. CP189 said, "we will not be able to reach a final decision on roll-out of requirements for the AMA until we are clearer on the level of the standards for entry to the AMA".

The FSA is also taking a flexible approach to the data definitions so crucial to the development of loss databases for the calculation of the capital charge under the AMA. It is proposing to "allow firms to collect data according to the definition and threshold that they regard appropriate", but is placing the onus on firms to justify their decisions. The FSA added, "this is an area where we may seek to rectify any inconsistencies between firms, in this case in their use of data, by using pillar II".

In addition, the UK watchdog is seeking comments on the level of standards for the TSA, in relation to the BIA - CP3 outlined standards that were substantially higher for the TSA than in previous drafts, but the EU Cad stuck with previous, lower standards in its July draft. Says Richard Metcalfe, co-head of European policy at the International Swaps and Derivatives Association (ISDA) in London, "One of the objectives of the Basel Committee was to put op risk on senior management’s agenda. They have clearly succeeded, and for some risk managers, the toughness of the rules proposed has been helpful in clearly reinforcing the mandate of the op risk function".

ASA still under review
The FSA declined to commit itself to the ASA for op risk, although the EU Cad includes it as an option. The ASA was developed in CP3 to prevent double counting of operational risk capital charges under TSA for firms with high margins, including many emerging market banks. The FSA said it would "keep our approach under review" and await feedback on the subject in the CP3 and latest draft of the EU Cad.

To become an AMA bank, firms must apply for a waiver from TSA from the FSA. Priority for FSA application review will be given to firms the FSA feels are most likely to comply with the requirements, and to firms with significant overseas operations that will require co-ordination with overseas regulators. More specific details of the approval process will be published in early 2004, according to CP189. But this process has proved controversial. Many banking officials are objecting to the waiver process on the credit risk front, where firms may have to apply for a waiver for each exposure group, which could generate, as one lobbyist said in understated manner, "a lot of paperwork". It is unclear how firms would have to apply to use the AMA, across an institution. The FSA official pointed out that Basel II requires supervisors to actively approve banks’ AMA, and "this makes the waiver to get the AMA the logical route", but that the FSA will be listening to comments. The deadline for feedback on the paper is November 14.

CP189 can be found at: www.fsa.gov.uk/pubs/cp/189/index.html.

A detailed timetable for banks who wish to comply with Basel II by the December 31, 2006 deadline can be found at:
www.fsa.gov.uk/international/basel_timetable.html.Operational Risk