Banks to miss CAD deadline

Date: 09/11/1995

By Tim Jones

SLUGGISH implementation of European Union law, combined with software problems, mean a key piece of banking legislation due to enter into force in January is likely to be widely ignored.

Banks have less than two months to get themselves in shape for the 31 December kick-off of the Capital Adequacy Directive (CAD), a law designed to protect the financial system against market risk.

Yet only the UK and France have made real progress in readying their banks for the necessary changes and even in these countries delays mean the deadline will be hard to meet. In Germany, banks are unlikely to be ready until early or mid-1997.

While the directive has been enacted throughout the EU, the real spade-work of the central bank and supervisory authorities in providing guidance to banks on implementation has hardly begun.

“For Germany, being one of the prime movers, to be coming in 12 to 18 months late is disgraceful,” said one financial sector analyst. “While Germany is the obvious offender, it would appear that in most countries in Europe little has been done.”

The CAD was agreed in March 1993 to ensure institutions do not hold too little capital to cover risk. It establishes a common framework for monitoring the market risk of investment firms, including position risks, counter-party/settlement risks and foreign exchange risks.

By its very nature, the CAD requires sophisticated computing. It measures “general market risk” to banks caused by fluctuations in a market and “specific risk” from the nature of the issuer of a product.

Computer systems must create historic simulations to predict the risk that a certain financial instrument might have in the future. On the basis of this, the banks will report on their market risk position to the central banks.

This task has been onerous, even in those countries most advanced in implementation. A new report from accountancy firm Touche Ross found that 30&percent; of banks would be unable to comply with the CAD. Many claimed to have underestimated the project staffing requirements for CAD and a third said other projects had been adversely affected by its demands on resources.

“The CAD presents one of the most challenging pieces of legislation with which the banks and other financial institutions have had to comply,” said Touche Ross partner Steve Almond. “There are complex issues of compliance and reporting to address, and related systems infrastructure needs to be put in place in a relatively narrow time-scale.”

As recently as August, more than 30&percent; of banks had failed to select their software supplier while, for those who had, the integration of CAD reporting systems with existing accounting and risk management systems was causing problems.

Simply having their trading book policies assessed by the Bank of England could take up to three months. Yet the problems in the UK pale into insignificance compared with those in other European countries.

“The UK market is much more advanced in its implementation than its European neighbours. As it stands, most other states will not achieve full CAD implementation by 1 January 1996, with the only likely exception being the major French banks,” says Andrew Mann, a senior manager in Touche Ross' financial sector practice.

While in the UK the problems have centred on systems more than anything else, some other EU countries have failed even to get to first base.

This has led to suspicions that some member states are holding back on implementation in anticipation of new proposals on market risk from the Basle committee on banking supervision, which are due to enter into force in 1997.

“That way they can save the banks from a 'double whammy' in systems costs,” an analyst said.

The CAD looks at the capital requirements of banks and investment houses on a transaction-by-transaction basis, and does not integrate its analysis of market risk across the whole range of financial products.

Instead, it adds up bits of capital according to each element of risk attached to a financial instrument. For example, a bond denominated in foreign currency would be risk-assessed according to its interest rate position risk as well as exposure for foreign currency shifts.

The Basle rules would amalgamate this with all the other positions in all other currencies and provide a more integrated picture, assessing the bank's risk position as a whole.

While all this could lead several countries into infringement actions brought by the European Commission, analysts believe a blind eye will be turned until the Basle proposals are enforced.