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FDIC Federal Register Citations


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.

Last Updated 11/12/2003 regs@fdic.gov

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