Constitutional lessons

Operational Risk - June 2005

The French 'non' to the European constitution (this is being written before the Dutch go the polls) made me wonder whether there were lessons for us in relation to Basel and the proposed European Directive. Among the guiding principles on all sides of the discussion has been the need to act together - on a playing field which we've all rolled flat and at the same time. Fine, but then other forces come in to play - just as the French electorate has showed.

When the US effectively opted out of all but the advanced approaches, it didn't do much for international unity. Nor does it seem to have done much for national unity. Smaller banks complain that the decision has tilted the field unfairly in favour of the big guys. And remember the little guys have political clout in a system where very few states of the Union have banks which are truly international or will be opting in. The major banks continue to argue about the detail. And now the regulators have announced that the results of QIS4 have thrown up variances which are difficult to explain and may even "suggest the need for adjustments to the Basel framework". So the US rule-making process gets put back - perhaps a little, but at this stage who knows

On the other side of the water, there appears to be more of a meeting of minds between the European Commission and the redoubtable Rapporteur for the European Parliament, Alexander Radwan. But even here there are issues to be resolved. They range, at a technical level, from consumers' data protection rights to allowing insurance for the Basic and Standardised approaches - fascinating that that one continues to run. More importantly, though, are Radwan's amendments to safeguard the primacy of the Parliament, including a call-back option to the Parliament if the Directive is not fulfilling its purpose. No hiding in Lamfalussy smoke-filled rooms.

These are not idle debating points. The timetable has already begun to stretch so that the EU's twin-track approach of introducing the simpler approaches from 2007 is beginning to look less likely. And of course, when it comes to the EU, there's always the simple matter of politics. How will the French react, smarting under the referendum decision, when it comes to agreeing things under Tony Blair's presidency of the EU in the second half of the year. Will insurance for the Standardised Approach be bartered against straighter bananas? Or will more fundamental features be sacrificed for political expediency?

Then there's the Asia-Pacific region, many of whose countries have mapped out their own intentions and timetable for implementation - broadly in line with Basel, but not entirely so.

Co-ordinating timetables and content is one thing. But above that continues to lie the massive question of supervisory convergence - home/host in all its manifest forms. The Europeans have bravely put down in legislation how it might work. But already the FSA, in a fit of honesty and transparency, has announced that it doesn't really like 'hard' home/host but would prefer home/host 'lite', whatever that may mean - although I think we probably know.

Not much comfort to those many European firms which operate cross-border. They are still wondering when they will know how they are really going to be supervised, and in any case continue to lobby against the application of the Directive at solo level, with all the costly business, legal and jurisdictional problems involved. At a conference in New York in April, it was somewhat disconcerting to hear Nick le Pan, who chairs the Accord Implementation Group, urging his colleagues to resolve these thorny issues very soon. And that includes Pillar 2, which could have a more material impact on firms than the variations they find in Pillar 1. No wonder investment decisions continue to be delayed.

I was talking to a senior Japanese official recently, who intrigued me by daring to talk about B3, as a means of sorting out operational risk in particular, as well as other aspects of B2 which may have been agreed in unnecessary haste and were now being repented of. Thinking even more unthinkable thoughts, he mused as to whether it really would matter if countries were allowed to introduce Basel et al when they wanted to and not desperately try to hang together.

Perhaps he had a point. The French referendum showed how difficult convergence is. Will the European world stop turning as a result? Probably not. It will continue to be messy and new efforts will be made to make it work better. If capital adequacy reform came in around the world over a period of time, or in an imperfect way, but in the knowledge that concerted efforts would be made to improve it as soon as reasonably practical, would the sky fall in? Unlikely. Messy, yes, but catastrophic? I doubt it. It may not be where we want to start from, but it may be the only way to get to where we want to go.

John Thirlwell - Director, Operational Risk Research Forum. The views expressed in this article are those of the author.

Note: (1) Tripp, Bradley, Devitt et al, Quantifying Operational Risk in General Insurance Companies, Institute of Actuaries (22 March 2004)

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