The Financial Services Authority published its latest guidance on the implementation of Basel II via the European Capital Directive. The guidance provides firmer insight into how these rules - particularly in the areas allowing for national discretion - will be applied by U.K.- regulated credit institutions and investment firms.

The latest consultative paper, CP05/03, brings the FSA a step closer to being one of the first among European national regulators to interpret how the directive would be applied locally. Feedback on the paper is due by April 29, 2005.

Hector Sans, FSA managing director, said that the latest consultation paper would give firms a better understanding of how they should prepare for the FSA's proposal to implement the Capital Requirements Directive in the U.K. He also encouraged all firms to consider the implications of the forthcoming changes. "The introduction of the Capital Requirements Directive will mark a huge step forward in developing a modern capital framework that will improve the risk sensitivity of capital standards for firms across the EU," he said. "Considerable uncertainties remain, however, not least among them, the timing of its introduction."

At the moment there is still some uncertainty regarding the timing of the final agreement on the CRD, said the FSA. For one, in order to allow member states the 18 months normally prescribed for execution and to be in time for the new Basel Accord's implementation at the end of next year, a new text would have to be presented by June or July 2005. The European Parliament is not expected to deliver its draft opinion on the preliminary directive before April or May this year, said the FSA.

Some changes

For U.K. banks opting to apply the standardized approach, the FSA has proposed a cautious policy that will require banks to hold more capital for loans with an LTV greater than 80%. "Some respondents asserted that the majority of losses on such lending occurred above 90% LTV," reported the FSA. "It was also suggested that a 75% risk weight was too high, given the levels of payment protection prevalent in the U.K. mortgage market, and 50% was proposed as a more appropriate marginal risk weight."

After discussing the issue with the Council of Mortgage Lenders, and reviewing data from individual firms, the FSA proposes applying an 80% LTV threshold to be reviewed every three years. The portion of the exposure up to 80% LTV attracts a 35% risk weight, and the portion above 80% LTV attracts a marginal risk weight of 75%. To guard against banks shifting portfolios to higher LTV lending, more capital will be required for loans with an LTV greater than 80%.

For example, analysts at Royal Bank of Scotland stated that under the FSA proposals, a U.K. RMBS master trust with a weighted average 60.4% LTV would have an average pool risk-weight of 36.8%. Meanwhile, holding all of the notes from the program on balance sheet would be equivalent to a 44.0% risk weight under the standardized approach. Analysts noted, however, that much is due to a capital deduction for funding the reserve piece, accounting for almost half the capital consumed.

Analysts said that this higher deduction will lead to an active market for nonbank junior investors to fund the capital intense reserve fund and could also encourage bank securitization of residential mortgages, where the junior pieces would be sold and the senior notes retained and sold when funding was required.

The FSA will also provide more favorable risk weightings for covered bonds. Up to now, the lack of legislation meant U.K. banks issuing covered bonds were required to hold more on balance sheet capital at 20% risk weightings. The FSA proposes adopting the EU UCITS directive on covered bonds where certain covered bonds will be assigned 10% risk weightings when investors adopt the standardized approach.

Firms following the Internal Ratings Based approach will be required to factor in an economic cycle in their loss given default and probability of default calculations in addition to the five to seven year data coverage required under the EU capital directive. "For banks with insufficient data, expected to be the majority of institutions - the LGD and the PD data presented should be modeled to reflect an economic cycle," RBS analysts explained. The FSA will also define default as 90 days plus past due for corporate and SME retail exposures and 180 day plus for other retail exposure.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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