ROYAL BANK OF SCOTLAND
3 November 2003
John D. Hawke, Jr.
Comptroller of the Currency
Office of the Comptroller of the Currency
250 E Street, SW
Washington D.C. 20219
United Sates of America
Roger W. Ferguson, Jr.
Vice Chairman
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue NW
Washington, DC 20551
United Sates of America
Don Powell
Chairman
Federal Deposit Insurance Corporation
550 17th Street NW
Washington, DC 20429
United Sates of America
James E. Gilleran
Director
Office of Thrift Supervision
1700 G Street, NW
Washington, DC 20552
United Sates of America
Dear Sirs
ADVANCED NOTICE OF PRUDENTIAL RULE-MAKING
- NEW BASEL CAPITAL ACCORD
Thank you for the opportunity to comment on your proposals for
implementing the Basel Accord within the United States.
By way of background, the Royal Bank of Scotland (RBS) is the fifth
largest bank in the world. We have significant exposure in North America,
including Retail and Commercial Banking, Asset Finance and Capital Markets
operations. The largest single business, measured by assets, is Citizens
Financial Group, Inc., a Providence-based commercial bank holding company
that operates more than 825 Citizens Bank branch offices in Connecticut,
Massachusetts, New Hampshire, New Jersey, Rhode Island, Pennsylvania and
Delaware.
Citizens Bank, with over $75 billion in assets, falls outside the "top
10" group of core banks mandated to operate the advanced approaches for
credit and operational risk by end 2006. However, Citizens, ranked within
the top twenty US Banks as measured by assets, does fall into the second
tier of Banks that may opt into the advanced approaches. The majority of
the Group's other exposures fall within the EU and will be covered by their
third Capital Adequacy Directive (CAD3). Given our geographic spread, we
are clearly interested in how the proposals will be implemented within the
US and, importantly, identify where these proposals and implementation
plans may differ from those emanating from the EU and the UK's FSA.
Our response, is in two parts:
• Our key concerns with the Basel proposals and the ANPR implementation
proposals are outlined in appendix 1. Underpinning these concerns is a
belief that the Basel proposals are too complex and prescriptive and that
the Basel Committee and/or National Regulators can go further in
simplifying the Accord to ensure its effective implementation and
understanding of it by banks, regulators and analysts alike.
• The second part includes answers to the specific questions included
within the ANPR, these are set out in Appendix 2*. Generally, we have not
answered questions in those areas, such as Expected and Unexpected
Losses, where the Basel Committee have requested further feedback by 31
December 2003.
We hope that these comments are useful to you in taking forward your
implementation of the new Basel Accord and, as importantly, during your
final deliberations at the Basel Committee through to the middle of
2004.
Please do not hesitate to contact me should you wish to discuss any
of these points in more detail.
Yours faithfully
Richard Gossage
Director, Group Risk Management
Royal Bank of Scotland Group
36 St. Andrew Square
Edinburgh EH2 2YB
HIGH LEVEL CONCERNS APPENDIX 1
Our key concerns with the framework/ANPR are as follows:
1) Home: Host Implementation and the Level Playing Field.
It is disappointing that the home: host issues have not been
sufficiently addressed, especially as the target audience for the Basel
Accord is internationally active banks. Unless greater progress is made
in discussions between regulators, the current proposals will require
banks to operate parallel systems in order to satisfy the needs of local
and lead regulators. The lack of agreement on the standards for Pillar
1, allocation of capital under AMA or principles for Pillar 2
Supervision threatens to undermine the level-playing field. Clear
principles for the resolution of home: host issues are required.
Consistency around approval and implementation approaches looks
unlikely to be achieved for internationally active banks operating
across multiple jurisdictions. Consistency can only be achieved through
agreement on standards for Pillar 1 and principles for the scope and
assessment of risk under Pillar 2. To date, there has been little
comparison of approaches for Pillar 1 and little or no focus on Pillar
2.
2) Bifurcated Approach to Capital Adequacy within the USA.
As part of RBS's response to the Basel Committee's CP3 (dated 31st
July 2003), we raised concerns about "regulatory stretch", specifically
whether the regulators will be able to recruit the right number and
quality of staff to regulate the new Capital framework. We believe,
given the bifurcated approach being adopted, that this concern is less
likely to apply within the American market.
Whilst this is a positive effect of the bifurcated approach, we
remained concerned about the very high entry standards being proposed
for operational risk. As it currently stands, banks that can achieve the
ANPR standards for credit risk but feel less comfortable about adopting
the advanced approach for operational risk at the initial implementation
date will be forced to remain on Basel 1. We urge the US Regulators to
discuss transition arrangements with other regulators so that a more
flexible approach can be accommodated particularly if it is consistent
with a bank's overall implementation plan approved by the home
regulator.
For banks like RBSG with large US subsidiaries, such an approach also
gives rise to a catch-22 situation. For example, if the current approach
to operational risk remains unchanged, then it is possible that our US
subsidiary would remain on Basel 1. However, there is no guarantee that
the home regulator, the FSA, would allow such an approach. We are then
faced with a potential scenario of having to run separate frameworks to
satisfy the requirements of various regulators.
3) Complexity & Prescription.
The Pillar I rules of the new Accord are highly complex. We still
believe, despite the Madrid announcement of the Basel Committee and the
pragmatism incorporated within ANPR, that there is a real risk that key
stakeholders - bankers, regulators, investors and market commentators
will not fully understand these proposals. The complexity and
prescription has a knock-on impact on cost and benefits, approval and
ongoing supervision.
We believe that the time has now come to adjust and simplify Basel 2
in order to preserve the significant amount of effort that has been
invested to date. We believe that the Accord can be more closely aligned
to banks current and evolving risk management practice. This could be
more effectively achieved through a simpler Pillar 1 and Supervisory
agreement on principles for the management of risk and capital under
Pillar 2. Such a framework, based on a holistic view of risk management
grounded in the Use Test, would minimise the risk to the financial
system as a whole.
We are currently working with the Institute of International Finance
(IIF) on proposals regarding possible simplifications to Basel 2, which
will be shared with the US Regulators shortly.
4) Stifling, rather than facilitating, innovations in Risk
Management.
RBS remains concerned that the Basel proposals, incorrectly
implemented, could stifle innovation in risk management, especially as
the most advanced banks already use approaches that surpass Basel 2 in
sophistication. We have consistently advocated that without greater
flexibility built into the Accord, sections of the new rules run the
risk of being obsolete by 2007.
Despite these concerns, which are still valid, we were pleased by the
ANPR commentary that the calculation methodologies set out in the Basel
Committee’s 3rd Consultative Paper represent only a sub-set of the
possible calculation methodologies, and that banks are free to use any
calculation and validation methodologies which meet the qualitative and
quantitative standards required. We believe this is a practical and
appropriate position and that such flexibility should be reflected
within the main Basel Accord.
In addition, we would welcome further clarification from the Agencies
around how the application and assessment process will operate in
practice for those banks which opt in to the Basel 2 approaches, and in
particular, the way in which issues regarding differences in approaches
from parent to subsidiary will be treated.
5) Arbitrage.
The current Accord is simple, arbitrage opportunities are few in
number but large in effect. Banks and regulators know such arbitrage
opportunities. We fear that the complexity and scope of current
proposals will create more opportunities for arbitrage than they
eliminate.
6) Theoretical Underpinnings (Data and data availability).
History, on which Basel 2 estimates are based, is not always a good
predictor of future performance. Banks do not have the same quantity or
sufficiency of data for all portfolios. Portfolios do not behave in the
same way and cannot, realistically, be assessed on the same basis. It is
unlikely that institutions will be able to estimate the probability of
default for all their borrowers on a consistent basis as this data is
just not available for all portfolios, especially high quality ones,
where data sharing is unlikely to be able to offer a solution. Banks
will continue to have to deploy expert judgement in their grading
processes, making comparability of outputs difficult. For this reason, a
more flexible portfolio-by-portfolio approach based approach to Pillar 1
model approval is, in our view, required.
A false sense of security has been created by the much-publicised
assumption that better risk measurement for determining minimum
regulatory capital will constitute good risk management and necessarily
make banks safer. We fundamentally believe that what reduces a bank's
risk to the financial system is how it measures risk within an
appropriate risk framework coupled with expert judgement. This is best
achieved through agreement on (and implementation of) robust Pillar 2
processes, founded on sound principles for the measurement of risk and
capital. * Appendix 2 can be inspected and photocopied at the FDIC's
Public Information Center, Room 100, 801 17th Street, NW., Washington,
DC between 9 a.m. and 4:30 p.m. on business days.
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