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On 14 November 2008, the Financial Services Authority (FSA) issued a statement to explain the approach it had taken to individual bank capital frameworks as part of the plan to support the UK banking system announced on 8 October 2008. This statement sets out how we have developed that framework.
In the statement on 14 November, we made clear that the purpose of the recapitalisation scheme was to ensure that bank capital ratios were sufficiently high to provide a buffer to allow the banks both to withstand the challenging economic conditions and to continue lending on normal commercial criteria. It was not intended to create new statutory capital requirements for the banking sector.
To achieve this we made clear to those banks that participated in the overall plan that we expected them to maintain a core tier 1 capital, as defined by the FSA, of at least 4% after applying stress tests which anticipated significant future losses. The stress testing process includes some standard assumptions but is also individually tailored to the specific institutions.
As we also made clear in the statement, the consequence of ensuring that an institution would maintain a minimum of 4% required that, at the time of the recapitalisation programme, they had an adequate buffer of additional capital in place. It is acceptable and expected that this capital would subsequently be run down as it absorbed the expected losses.
Since 8 October we have continued to give consideration to appropriate long term changes to the bank capital regulatory framework. We believe that it would be preferable for the capital regime to incorporate counter-cyclical measures which lead to banks building up capital buffers in good years which they can draw down during economic downturns. This general principle has been supported by the Financial Stability Forum and is now being taken forward by the Basel Committee. The FSA's approach is fully consistent with the Basel Committee’s objectives as set out in its statement of 16 January 2. The FSA will be strongly supporting the work in this area.
In the context of a counter cyclical regime, a post-stressed ratio effectively becomes the minimum ratio. We are therefore clarifying that we are operating on the basis that we are expecting each of the participating banks to have a minimum core tier 1 of 4%. At the time of the recapitalisation we also used a tier 1 ratio of 8% to help us determine the appropriate level of buffer. We estimate 6-7% to be a comparable post stress tier 1 number to the core tier 1 number of 4%. As we emphasised on 14 November, this approach is a supervisory framework, it is not a new set of rules and the requirements set out in our Handbook will continue to apply.
We have also been working with these banks to seek to ensure that the application of the current International Basel Accord, which is implemented through the Capital Requirements Directive, does not create any unnecessary or unintended pro-cyclical effects. In particular, we are amending the variable scalar method of converting internal credit risk models from point in time to through the cycle. These changes will significantly reduce the requirement for additional capital resulting from the procyclical effect.