FSA aim to be "pragmatic and proportionate" on Basel II implementation

In a speech to the British Bankers' Association 9th Annual Supervision Conference, Callum McCarthy has said the FSA intends that the costly implementation of the Basel II framework through the Capital Requirements Directive (CRD) should be "pragmatic and proportionate". But whilst acknowledging the significant burden of cost and effort, McCarthy welcomed the revised methods for calculation of regulatory capital requirements introduced by Basel II as an important "step forward", particularly for firms adopting the more advanced approaches.

The FSA Chairman said that substantial improvements in risk management over the last decade were one of the hallmarks of the strength of the British banking industry today. The new Basel II Accord recognises these positive changes by rewarding banks with the possibility of reducing their capital reserves for unexpected losses, a fact that McCarthy said should not be forgotten as banks consider the fundamental changes imposed by the EU's Capital Requirements Directive.

Included in the FSA's pragmatic and proportionate approach is the recognition that firms may, for the time being, need to continue using "fit-for-purpose solutions" that reflect current limitations in data and techniques. However, the FSA will still want to see firms making improvements to their systems in due course.

The FSA will also be looking for assurance that firms have confidence in the outputs of their credit and operational risk models which is the basis of the so called 'use test'. This seeks to ensure that a firm's risk assessment or measurement system is not just implemented to determine regulatory capital requirements but is actually embedded in the risk management practices of the firm (i.e. used in practice). McCarthy said that the more the FSA can see a firm is willing to trust and use outputs for key elements of internal decisions and processes, the more confident they will be in allowing the models to be used as the basis of regulatory capital decisions.

McCreevy also highlighted the important role senior management would need to play in the oversight of CRD implementation and also, more importantly, with the operation of the systems once they have been approved. Whilst the FSA was not expecting all senior executives to have a detailed knowledge of how models have been built, they did expect a level of understanding sufficient to provide adequate challenge to their development and ensure proper monitoring of the effectiveness of those systems in operation.

In closing his feedback on CRD, McCarthy made reference to the deferred Basel II implementation timetable recently published by the US. He said that this will cause problems for EU banks with significant operations in the US, but is something the FSA wish to see "eased" if not solved.

The full text of Callum McCarthy's speech, "Translating Europe into the UK" including his comments on the implementation of the Capital Requirements Directive is available on the FSA website.