pwc retail newsletter issue 2 (aubergine) · the member firms of the pricewaterhousecoopers network...

Inside this issue

03 Precious Plastic 2006

06 EU Savings Directive

09 Preparing for MiFID

12 Pillar 2 and risk-based

capital management

16 Offshoring at the crossroads:

Meeting the challenges of an

evolving market

January 2006

Editor: Harjeet Baura, Senior Manager,Retail Banking Group Tel: 020 7804 7687Email: [email protected]

Distribution: If you would like to receivethis newsletter by email or you would like toadd your colleagues to the mailing list,please contact Carly Taylor [email protected]

UK Retail Banking

NewsletterWelcome to the second edition of the PricewaterhouseCoopersUK Retail Banking Newsletter which aims to address key issuesand developments facing the banking industry. I hope you enjoyedthe first edition which was issued earlier this year.

In this edition we have five articles tackling a wide range of themes and topics: anoverview of the UK consumer credit card market, with a focus on cards, regulation andpersonal insolvency taken from Precious Plastic 2006, the implications of the EUSavings Directive which came into effect on 1 July 2005 and the potential impact andchallenges ahead for the retail banking sector arising from MiFID. The final two articleslook at the issue of Pillar 2 and risk-based capital management and the significantimpact it will have on today’s institutions and the challenges, benefits and futuredevelopments of offshoring in the financial services industry in our closing article entitledOffshoring at the crossroads: Meeting the challenges of an evolving market.

I hope you enjoy this edition of the newsletter. Please continue to provide us withfeedback, particularly, topics and issues you would like to see addressed in the future.Copies are available from www.pwc.com/banking

Please contact me if you would like to discuss any of these issues in more detail.

John Hitchins, UK Banking Leader020 7804 2497 [email protected]

The member firms of the PricewaterhouseCoopers network (www.pwc.com) provide industry-focused assurance,tax and advisory services to build public trust and enhance value for its clients and their stakeholders. More than130,000 people in 148 countries share their thinking, experience and solutions to develop fresh perspectives andpractical advice.

(Unless otherwise indicated, “PricewaterhouseCoopers” refers to PricewaterhouseCoopers LLP a limited liabilitypartnership incorporated in England. PricewaterhouseCoopers LLP is a member firm of PricewaterhouseCoopersInternational Limited.)

© 2005 PricewaterhouseCoopers LLP. All rights reserved. “PricewaterhouseCoopers” refers toPricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires,other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independentlegal entity.

Designed by Court Three 1205

What’s happening in theconsumer credit market?

Last year total household borrowingreached £1 trillion, causingwidespread concern. Since thenborrowing has continued its everupward trend, increasing by a further£105 billion. Total indebtedness(both secured and unsecuredlending) stood at £1.1 trillion by theend of June 2005. This translates toaround £23,000 for each adult.

Secured lending accounts foraround £918 billion of totalhousehold borrowing. Theremaining balance of £189 billionis represented by unsecuredlending (which we refer to asconsumer credit).

Consumer credit balances grew by8.4% over the 12 months to 30 June

2005. Although the trend is difficultto gauge, there are signs that overthe last six months there has been areduction in growth rates.

PricewaterhouseCoopers believesthat it is too early to say whetherthis is a short-term blip or the startof a longer-term slowdown in therate of growth of unsecured credit.However, the sector has beengrowing for several years atwhat many have regardedas unsustainably high rates.Based on recent trends,PricewaterhouseCoopers expectsconsumer credit balances toincrease by around 5% over currentyear levels, suggesting a totalbalance of around £200 billion by30 June 2006.

In Precious Plastic 2005 weestimated that 0% APR balance

Household debt continues to rise, despite weak retailsales and growing attention from the media. A rise indefault rates during the first half of 2005 has furthercontributed to the uncertain climate within the consumercredit industry. Credit providers are coming underincreasing pressure not only from fierce competition butalso from mounting regulatory scrutiny aimed at mostsources of their income. Below are some of the keyfindings from the latest PricewaterhouseCoopers reviewof the consumer credit industry – ‘Precious Plastic 2006’.

By Richard Thompson andPeter Kuelsheimer

Precious Plastic 2006

transfer offers were costing the industryapproximately £1 billion per year. Wepredicted the industry would take stepsto defray costs and weed out thosecustomers likely to move on at the end ofthe introductory period. Over the lastyear, many card issuers have introduceda 2% fee for balance transfers. Despitethe introduction of fees, and the likelyconsequent impact this has had on thevolume of balances being transferred,PricewaterhouseCoopers estimates thatthe lost revenue to the industry ofbalance transfers is currently in theregion of £600 million per annum.

Margins continue to beunder pressure

Over the past five years there has beena decline in average APRs charged bycredit card issuers. Although base rateshave declined, there has been asignificant reduction in spreads, largelydriven by stiff competition. Profit marginshave also recently been hit by anincrease in charge-offs.

Figure 1 above shows our estimate ofaverage net yield across the market afterdeduction for charge-offs. Our analysissuggests a reduction from around 11% ofbalances in 2000 to just under 6% byJune 2005. Although credit card debt hasincreased by over 50% over the period,there has been a similar increase in thenumber of cards in issue resulting inaverage borrowings per card showinglittle movement.

PricewaterhouseCoopers thereforeestimates that average revenue per card,before fees but after charge-offs, hasprobably halved over the past five years.This represents a significant reduction.In the long run, margin compression actsas a stimulus for greater scale. Thissuggests the potential for furtherconsolidation and increased outsourcingof back-office functions.

We have been expecting the returnof annual credit card fees in certainsituations. For issuers with apredominantly mono-line business model,there are fewer downsides should theintroduction of an annual fee result in theloss of a customer that may not havebeen profitable. However, many of themajor issuers in the UK are high-streetbanks and may have broaderrelationships with their customers acrossmultiple products. They may thereforetake a more cautious approach.

Complex drivers are behindthe increase in charge-offs

During this year’s interim reportingseason, many banks released strongresults that were tinged withdisappointing reports of increaseddelinquencies and non-payments oncredit cards and consumer loans. Whilstthe increase was perhaps unexpected,PricewaterhouseCoopers does not yetsee cause for longer-term concern,unless there is a significant deteriorationin the economic climate.

Figure 2 shows the degree to whichaverage charge-offs have increasedduring the first half of 2005.

PricewaterhouseCoopers has undertakenresearch to gain a better understandingof the causes of the upward trend incharge-offs. We examined 1,257Individual Voluntary Arrangements (IVAs)registered in July 2005 and found that:

• Insolvent individuals had, on average,taken out 11 credit cards and othertypes of unsecured loan.

• The total average debt owed wasaround £60,000, which representedon average three to four times grossannual income.

An analysis of the causes given by thedebtor indicates:

• 75% of the insolvencies were causedby living beyond means.

• Only 10% of insolvencies were causedby unemployment.

• 10% were due to divorce.

• 5% were the result of a variety of othercircumstances.

It is commonly assumed that theprimary causes of bad debts areunavoidable events such as divorce andunemployment. Our research indicatesthat three in four cases of unmanageabledebt arise from people living beyondtheir means.

4 PricewaterhouseCoopers UK Retail Banking Newsletter January 2006

Figure 1: Net interest yield after charge-offs

Source: Standard & Poor’s, Bank of England, PricewaterhouseCoopers analysis

Net

yie

ld p

erce

ntag

e

Net interest yield after charge-offs

12%

11%

10%

9%

8%

7%

6%

5%

4%Dec 00 Jun 01 Dec 01 Jun 02 Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05

In our view, economic fundamentalsare not the primary reason behind theincrease in charge-offs. Whilst interestrates have increased, debt servicingcosts are not materially higher than thelong-term average. Rather than beingdriven by macro conditions, it appearsinstead that extreme over-borrowing isbecoming more common and thesecases are also leading to higherwrite-offs. Callcredit, a credit referenceagency, has calculated that the 10% ofconsumers most over-indebted arecurrently increasing their unsecureddebts at the rate of 33% pa.

PricewaterhouseCoopers believesthat another factor is the greatersophistication and prominence of thecompanies operating in the insolvencyindustry. Insolvency practitioners anddebt management companies have beenadvertising intensively on television andin newspapers. PricewaterhouseCoopersbelieves that this is partly responsible forthe 90% rise in IVAs in the year toSeptember 2005.

In an effort to curb excessive borrowing,all of the major clearing banks have nowagreed to share ‘positive data’ onborrowing levels and account operation.To date only some lenders have providedthis data to the credit bureaux, limitingthe ability of lenders to get a full pictureof each borrower’s financial position. It isestimated that 6% of consumers owemore than their entire gross salary inunsecured debt.

PricewaterhouseCoopers believesthis is a positive move both for theconsumer credit industry and forconsumers. Use of this data forassessing credit applications, and alsothe subsequent monitoring of acustomer’s behaviour could help toreduce cases of extreme over-borrowing.

Consumer credit under theregulatory spotlight

The provision of consumer credit is firmlyin the regulatory spotlight. There are anumber of inquiries being conducted bydifferent regulatory bodies. The Office ofFair Trading has identified the creditindustry as one of its five ‘prioritysectors’. Whilst the agenda in the pasthas had a clear focus on improvingtransparency, many lenders now feel thatregulators are focusing on their sourcesof revenue, line by line.

The current regulatory approach isfragmented, addressing almost everyaspect of the consumer credit market inseparate inquiries by different regulators.This approach fails to take into accountthe impact of any individual regulatoryrequirement on the sector as a whole.Institutions adjusting to constraints onrevenue in one area will look to otherrevenue streams. Will the overall costreduce for consumers? Probably not.However, the incidence of payment willalmost certainly change. It remains to beseen whether it will be more equitable.

Copies of Precious Plastic 2006can be obtained fromwww.pwc.com/uk/preciousplastic orLi-Ann Liew on 020 7212 6213

Contact Us

Richard ThompsonPartner, Valuation & StrategyTelephone: 020 7213 1185Email: [email protected]

Peter KuelsheimerManager, Valuation & StrategyTelephone: 020 7804 5328Email: [email protected]

PricewaterhouseCoopers UK Retail Banking Newsletter January 2006 5

Figure 2: The degree to which average charge-offs have increased duringthe first half of 2005

Source: DTI, Standard & Poor’s, Office of National Statistics

Figure 2: Charge-offs and IVAs

Charge-offs IVAs and bankruptcies

Cre

dit

card

cha

rge-

off

rate

Total numb

er of IVAs and

bankrup

tcies

5.0% 35,000

30,000

25,000

20,000

15,000

10,000

5,000

4.5%

4.0%

3.5%

3.0%Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05

This long-awaited inception date,however, does not mark an end,but merely the end of the beginning;now financial institutions and otherpaying agents must put the realwork in hand to ensure they will becompliant with their obligationsunder the Directive going forward.Various issues have arisen which arelikely to have a broad impact acrossthe market, and over the next fewmonths a number of actions willneed to be taken, in accordancewith the timetable implicit in thenew regime.

Who does this affect?

The Directive covers paying agentswho make savings incomepayments to, or receive them for,“relevant payees and residualentities in prescribed territories” –that is, EU individuals and a limitedrange of EU entities. The concept ofsavings income under the Directiveis quite broad. Therefore, not onlybanks, building societies andinvestment managers are likely to

be within scope, but also financialdealers, accountants, lawyers andtrust companies.

Even at this relatively late stage, it issurprising how many institutions donot realise that the Directive mayaffect them. It is worth consideringwhether you are in scope – even ifthe result of your deliberation is toconfirm that the Directive doesnot apply.

Classifying customers

In addition to establishing whetheryou deal with income that is withinscope, it is essential to knowwhich of your customers are subjectto Savings Directive reporting. Know Your Customer (KYC)documentation should enable you todetermine where your clients areresident (or deemed to be resident),and this determination should resultin a classification being enteredonto your records, which formost institutions will meancomputerised systems.

Despite a sometimes rocky road, and after a gestationperiod that kept many of us wondering what themountain’s labours would bring forth, the EU SavingsDirective came into effect on 1 July 2005.

By David Frood andMichael Andrews-Reading

EU Savings Directive

Systems

As with any significant change, thepractical part of implementation lies inthe modifications you may need to maketo your systems. If you are coming into areporting regime for the first time, it isessential that the people responsiblefor your systems understand what isrequired. Not only clients within scope,but also income within scope mustbe captured when it comes topreparing returns.

Procedural changes andtraining needs

Operational staff also need to beconfident in meeting their responsibilities.This may mean that training sessionswill be appropriate, so that thedocumentation requirements which applyfor all customers aquired from 1 January2004 can be met, and so that clients whoare identified as being within scope canbe properly recorded. After all, a systemis only as good as the data that isentered into it.

Establishing the paying agent

Given the number of different parties(sometimes in different jurisdictions)through which payments can pass, andthe differing roles that the variousparticipants can have, it is important todetermine at an early stage who thepaying agent is. Any questions about theidentity of the responsible paying agent

should ideally be resolved well inadvance of the Directive’s reportingrequirements coming into effect,and such decisions should beproperly documented.

Key dates

Reportable interest paid or received on orafter 1 July 2005 is within scope, and willneed to be included in an institution’sSavings Income returns for the yearending 5 April 2006.

Anyone who is already furnishing annualreturns of interest to HMRC undersections 17 or 18 Taxes Management Act1970 will know that the reportingrequirements under these two parallelregimes are also changing. From 1 July2005, interest paid to, or received onbehalf of, individuals reportable under theSavings Directive will no longer bereportable under s17/18. The list of fullyreportable countries and territories unders17/18 has accordingly been amendedfor this tax year’s returns. S17/18 returnsfor 2004/2005 were adapted inanticipation of the Savings Directiveregime, so that format changes shouldalready be in place. Of course, relevantinterest paid or received between 6 Apriland 30 June 2005 inclusive will need tobe dealt with under the old rules.

A crucial difference between the s17/18reporting regimes and the EU SavingsDirective is that the new regime requirespaying agents to notify HMRC that they


Anyone who is already furnishing annual returnsof interest to HMRC under sections 17 or 18TMA 1970 will know that the reportingrequirements under these two parallel regimesare also changing.

are within scope, so that they may beissued with notices to report. Thisnotification must be lodged with theRevenue by 19 April 2006.

The first returns, therefore, will be due forlodgement by 30 June 2006.

This due date for the returns is importantto the Revenue and it is expected thatit will seek to enforce it firmly; it too has adeadline under the Directive, because by5 October 2006 information is due to beexchanged with foreign tax authorities.

Validating your readiness

Often, organisations make considerableinvestment in planning and implementingchange, but fail to review what has beenput in place in order to assess whether itis effective.

In particular, the changes to proceduresand systems mean there are always risksthat not everything has gone accordingto plan. The surest way of determiningwhether you can meet your newresponsibilities is to test your newsystems and procedures, rather than waituntil the Revenue comes to do this for you, which could be two or three yearsaway – long enough to enable weaknesses to grow into significant

problems. In addition to expertexternal advice, it is a good idea to factoryour Savings Directive and relatedreporting obligations into your internalaudit programme.

HM Revenue & Customs

The Revenue has also invested heavily inthe new regime. It has been engaged forthe past year in a series of ‘help visits’across the financial sector. This has hada dual purpose: It seeks both to informinstitutions about their responsibilities,and to gain an understanding itself ofhow the Directive is likely to impact.It is now investing in an audit programmewhich will test compliance, and whichis likely to start in the latter part ofnext year.

Contact Us

David FroodTax Director, Banking & Capital MarketsTelephone: 020 7212 5545Email: [email protected]

Michael Andrews-ReadingSenior Manager, Tax InvestigationsTelephone: 020 7804 4359Email: [email protected]


What will MiFID mean forregulated firms in the UK?

MiFID is intended to create aharmonised set of Conduct ofBusiness (CoB) rules in all EUMember States. In the UK, the FSAwill replace its existing CoB ruleswith an entirely new set of CoBrequirements based around theMiFID rules.

What are the mostsignificant requirementsfor retail firms?

The MiFID requirements will affectmany of the business functionswithin all EU investment firms. Forthe retail sector some of the keychanges are in the following areas:

• Customer agreements

• Customer classification

• Assessment of client suitabilityand appropriateness

• Provision of investment advice

• Information to clients

• Information aboutfinancial instruments

• Safeguarding customer assets

• Best execution

• Organisational requirementsincluding compliance andrisk control

• Outsourcing of criticaloperational functions

• Record keeping

Although these are all concepts thatare currently regulated by the FSA inits existing CoB sourcebook, therevised rules will require firms toreassess their policies, proceduresand customer documentation in allthese areas.

Despite the likely deferral of implementation untilNovember 2007, the potential impact of the Markets inFinancial Instruments Directive (MiFID) on the retail sectoris of such significance that all firms should already beassessing the impact of the proposed requirements ontheir business.

By Stuart Crotaz

Preparing for MiFID

Is this purely acompliance issue?

Although the compliance department willbe heavily involved in implementing theMiFID requirements, there is also likelyto be a significant effect on firms’ ITsystems, particularly for client datamanagement and record keeping.Above all, the involvement of seniormanagement will be critical to the MiFIDimplementation project to ensure thatstrategic opportunities during this periodof change are identified and addressed.

Identify your stakeholders

As a result of the complexity of thechanges and the interdependencybetween IT architecture, procedures andcompliance controls, getting the earlyinvolvement of stakeholders from allrelevant areas of the business will becritical to achieving a fully integratedsolution to the challenges thrown up byMiFID. The initial brief for stakeholdersis to provide senior management with anassessment of the areas of the businessthat will be most affected and the way inwhich the current business model needsto be altered to meet the requirements.This should result in the firm identifyingthe budget and resources that will berequired for 2006 and an initial timetable.

How significant will the changebe to the business overall?

Even with grandfathering or othertransitional measures, MiFID presentsenormous organisational challenges,affecting key areas of the business. It willalso impact the way markets operate.Firms need to consider not only changesto their internal procedures and systemsbut also to the procedures by which, andthe systems through which, they willinterface with the new market structureand other market participants.

What is the timetable forpublication of the FSArequirements?

The delay in finalising the level 2measures by the European SecuritiesCommission has already caused a delayto the anticipated FSA consultationprocess. It is now expected that betweenFebruary and April 2006 the FSA willpublish its implementation proposals onSystems and Controls (combining bothCapital Requirements Directive and MiFIDrequirements) and Financial Promotionsand will culminate in the full MiFIDConsultation Paper. By the end of 2005the FSA is proposing to publish a‘pathfinder’ document that may highlightthose areas it believes may be of mostsignificant impact to the UK market.


Although the compliance department willbe heavily involved in implementing theMiFID requirements, there is also likely tobe a significant effect on firms’ IT systems,particularly for client data management andrecord keeping.

So is it too early to beconsidering the effects forthe UK?

The majority of requirements have nowbeen agreed at EU level, with only asmall number of proposals likely to beamended. Many of the MiFID rules will beimplemented under the ‘Lamfalussy’process, whereby national regulators willnot be able to alter the requirementshanded down from Brussels. For theremaining MiFID requirements, the FSAhas committed not to ‘goldplate’ EUlegislation. Therefore many firms havealready established a MiFID project teamand are beginning to assess the impactto their business. As the FSA rules maynot be published until April 2006, waitinguntil the UK rules have been establishedmay leave it too late to successfullyimplement the MiFID requirements

What should firms do next?

In order to determine which areas ofthe business will be most significantlyaffected by the changes, firms should becarrying out a high-level gap analysisbetween the existing UK CoBrequirements and the level 2 proposals.This will allow senior management tounderstand which areas of the businesswill be most affected and therefore targetresources most effectively. Many firmsare also establishing MiFID ‘drivers’ or

steering groups to co-ordinate theprocess and report in to the projectsponsor at Board level.

Benchmark yourself againstthe market

As well as assessing the businessagainst its own internal timetable, firmsshould be actively involved in the workbeing carried out by the market tradebodies as well as the periodic updatesfrom the regulator. External assessmentwill be key to ensuring that the firmkeeps pace with market developments.

The year ahead

MiFID should not be considered solelyas a regulatory change, but needs to beunderstood in the wider context of afundamental business change which willneed to be embraced across the firm.It is only in this way that regulatedinvestment firms will be able to make asuccessful transition into the new MiFIDworld, avoiding the pitfalls as well astaking advantage of those opportunitiesthat may result from this process.

This is a critical change managementprocess that will need to be driven fromthe highest management level and thatwill require training for a wide rangeof key staff across the business toensure that the firm continues to meetregulatory requirements.

Contact Us

Stuart CrotazSenior Manager, Financial ServicesRegulatory Practice, Banking andCapital MarketsTelephone: 020 7213 8576Email: [email protected]


Having addressed the implicationsof Basel II’s Pillar 1, financialinstitutions are now beginning toconcentrate on Pillar 2. It isbecoming apparent that Pillar 2makes significant demands of banksand other institutions. For many, thiswill involve a big advance in riskmodelling, as well as a greaterconsideration of risk when settingperformance objectives andevaluating capital levels.

Matching approachto institution

Under Pillar 2, a financial institution’sobligation is to comply with Principle1 (see Figure 1), which states:“Banks should have a process forassessing overall capital adequacyin relation to risk profile, and astrategy for maintaining capitallevels.” Financial institutions haveconsiderable flexibility as to howthey approach compliance, andmanagement can demonstratecompliance when presenting itsInternal Capital Adequacy

Assessment Process (ICAAP)document during the supervisoryreview process.

Supervisors emphasise thatinstitutions should introduce capitaladequacy assessment models whichare appropriate for their businesses.They do not advocate excessivereliance on economic capital, orquantitative models, leaving thedecision to the institution. To quotefrom the speech made by JohnTiner, Financial Services Authority(FSA) chief executive, at theFinancial Times Bankers Awards:“Will common sense triumph overmathematics? As the ranks ofquants and rocket scientists grow,we should not lose sight of thelimitations of sophisticated andcomplex financial modellingtechniques.”

Even so, there is an expectation thatmany larger, more sophisticatedinstitutions will themselves elect toemploy economic capital. In its thirdconsultative paper, ‘The application

The wide-ranging implications of Pillar 2 are only nowcoming into focus.

By Richard Barfield

Pillar 2 and risk-based capitalmanagement

of the supervisory review process underPillar 2’ (May 2004), the Committee ofEuropean Banking Supervisors (CEBS)distinguishes between sophisticated,complex institutions and less complexones. It states that while institutions willnot be required to use formal economiccapital models, adopting such a modelwould be consistent with meeting therequirements of Pillar 2 and “it isexpected that more sophisticatedinstitutions will elect to do so”.(ICAAP Guidance 9c).

Those not opting for this route havea number of alternatives, ranging fromBasel’s approach to estimating capitalfor Pillar 1 risks plus a simple subjectiveassessment of other risks, through toearnings-at-risk modelling andsophisticated stress testing.

Economic capital modelling is nota panacea; it does have limitations.For example, how many banks have therequired 200 years’ time series of datatheoretically required to model a 99.5%confidence level over one year? Even ifthey do, we know that the past is notalways a good predictor of the future.Related to this, the statistical behaviourof tail data (which is the data that driveseconomic capital) often differs from thebehaviour of more frequently observeddata. Lastly, several risk types aredifficult to quantify and correlationeffects between risk types can be hardto measure.

Scepticism is healthy. While the processof quantifying risk is very worthwhile, it isimportant to do it with your eyes open tothe limitations. More importantly, anyoneadopting risk-based capital managementneeds to do so for business reasons, notjust to satisfy regulatory requirements.Only then will it be relevant and gain anytraction with the business.

Management’s perspective

Management needs to consider anumber of questions to ensure that Pillar2 risks are covered. It needs to ask howeffective its capital managementprocesses are and it needs to considerwhether roles and responsibilities aresufficiently clear, including how muchsenior management needs to know aboutthe processes.

In general terms, there is the issue ofhow to embed risk-based capitalmanagement in management reportingand business-as-usual processes.Implicitly, management needs to considerwhether it currently places sufficientemphasis on performance indicatorslinked to capital. Adjustments may benecessary to meet the general principleof Pillar 2, and to convince the FSA thatmanagement is serious about aligningrisk and capital management.

Finally, management needs to considerwhat its ICAAP submission should looklike. The principle-based approach ofPillar 2 means that there is no prescribed


Figure 1: Pillar 2 - Principle 1

Basel II - Pillar 2, Principle 1 - the Internal Capital Adequacy AssessmentProcess (ICAAP)

“Banks should have a process for assessing overall capital adequacy in relation torisk profile and a strategy for maintaining capital levels.”

• Board and senior management oversight

• Sound capital assessment

- Policies and procedures... to measure... all material risks

- Process to relate capital to level of risk

• Comprehensive assessment of all risks

• Monitoring and reporting

• Internal control review

format. Institutions operating in multiplejurisdictions also face the question ofhow many ICAAP submissions mayneed to be prepared to satisfy differentregulators. There seems to be anemerging industry view that several maybe required.

Among those institutions usingeconomic capital, there is a spectrumof applications. Some employ it primarilyas a risk management tool; others use itextensively in their day-to-dayoperations; some are cautious aboutrelying on it excessively.

From a shareholder perspective,management of capital for risk maynot be particularly high on the list ofpriorities. Primarily, shareholders areconcerned with earnings forecasts,return on equity, growth prospectsand cost control.

The FSA’s view and approach

For the FSA, Pillar 2 has a role thatoverarches other elements of thesupervisory process. Keith Pooley, theFSA’s Pillar 2 programme leader in theWholesale and Prudential Policy division,says: “Pillar 2 has an overriding influenceon capital. I would describe it astranscending all regulatory requirements.It is effectively the totality of the way thatsupervisors understand their role. Howwe assess the business risks; how weassess the quality of the controls; and,

at the end of the day, how we assess youas a business.”

The regulators have intentionally keptguidance to general principles to ensurethat internal capital adequacyassessment processes suit the widespectrum of different types and sizes offirms. In line with this, the supervisor’sreview is primarily a top-downassessment of banks’ capital adequacyassessments. Pillar 2’s Principle 2 isbroad in nature, stating that supervisorsshould “review and evaluate banks’internal capital adequacy assessmentsand strategies, as well as their ability tomonitor and ensure compliance withregulatory capital ratios…(and) takeappropriate action if not satisfied with theresult of the process”.

When it comes to reviewing the ICAAP,the regulator will make a top-downassessment, applying its existingknowledge of an institution’s overallbusiness profile and its internalgovernance, and the supervisor doesreserve the right to make furtherenquiries where necessary. The ICAAPwill be a key input into the supervisoryassessment of how much regulatorycapital should be held.

The FSA regards both the qualitative andquantitative objectives of Pillar 2 asimportant, and its supervisoryassessment will include determining thecapital buffer which should be held above


Pillar 1 capital. It does not, however,regard Pillar 2 as necessarily beingadditive to Pillar 1. Although on mostoccasions Pillar 2 will lead to a capitalbuffer over and above Pillar 1, the reviewof Pillar 2 could, theoretically, lead to acapital discount. It is important to notethat the FSA regards stress testing asbeing a key part of the ICAAP due to thequalitative nature of some of the risks.Figure 2 summarises the keycomponents to be considered.

When assessing, reviewing andevaluating the ICAAP, the FSA goesthrough several stages. First it makesa quantitative assessment of the materialPillar 1 risks, the risks not covered byPillar 1 and Pillar 2 risks. Secondly, itexamines capital planning, looking athow the business plan affects currentand future capital needs. Finally,referring to the findings of the Arrow

risk management programme, it makesqualitative assessments of monitoringand control, internal governance andoversight. From this process, the FSAmakes a supervisory judgement, whichincludes Individual Capital Guidance andIndividual Liquidity Guidance.

The challenge

What is clear is that each regulated firmneeds to be sure of how it will complywith Pillar 2 from the boardroom to therisk management department. For many,this will require far-reaching changes.

Contact Us

Richard BarfieldDirector, Valuation & StrategyTelephone: 020 7804 6658Email: [email protected]


Figure 2: A regulator’s perspective: the key components

A regulator’s perspective - PricewaterhouseCoopers view

This article is based on a presentation given byRichard Barfield, PricewaterhouseCoopers andKeith Pooley, FSA on 20 September 2005 at theLondon Underwriting Centre as part of thePricewaterhouseCoopers Banking & CapitalMarkets Seminar Series.

Market

Operational

Credit

Disalloweddiversification

Market

Operational

Credit

Pillar 2 risks

Concentration

Diversification

Regulatorycapital

Economiccapital forPillar 1 risks

Basel IIPillar 1minimum

Basel IIregulatorycapital

Bank’s ICA

Stress tests

Peer comparison

Qualitativeassessment

The strategic question is no longerwhether to offshore, but what,where and how much. ‘For alloperationally-driven activities, wehave to ask ourselves “why arewe doing it here and could we getmore value for money doing it in anoffshore location?”,’ said AndrewRobinson, Head of ABN Amro’sOffshoring Centre of Expertise in‘Offshoring in the financial servicesindustry: Risks and Rewards’,a global survey carried out byPricewaterhouseCoopers inassociation with the EconomistIntelligence Unit in the summerof 2005.

The findings highlighted the growingscale and sophistication of thisevolving market. More than 80% ofrespondents have alreadytransferred some of their operationsoffshore and all but 6% will havedone so by 2008. The proportionthat offshore between 10% and20% of their workforces will virtuallydouble in the next three years andthe transfer of knowledge-basedactivities such as financial researchand modelling is set to increase by20% over the same period.

Although cost savings is by far thenumber one driver for offshoring,many respondents now recognisethe broader benefits. These includeenhanced strategic flexibility,improved quality of service, theability to focus more closely on core

Offshoring in financial services is set to increase andmove steadily up the value chain. Yet only half of FSorganisations are satisfied with the overall resultsaccording to a recent PricewaterhouseCoopers study.How can banks overcome the challenges and realise thefull benefits of moving operations offshore?

By Niall Mowlds and Mark Stephen

Offshoring at the crossroads:Meeting the challenges of anevolving market

competencies and increased access totalent and technology, all factors thatcould become ever more critical ascompetition in the UK banking sectorheightens and the labour market tightens.

No quick fix

While the impetus for offshoringcontinues to grow, only half of the 156respondents were actually satisfied withthe overall impact. Around a third wereconcerned about attracting qualifiedpersonnel, a deterioration in the quality ofservice and cultural differences betweenhome and host markets. Others hadfound that the anticipated cost benefitshad failed to materialise.

In part, these difficulties reflect theheightened operational, regulatory andreputational risks of managing activitiesin offshore locations, which have beenbrought into sharp focus by the recentpublicity over security breaches.Organisations need to demonstrate tocustomers and regulators that they haveas much, if not more, control over theiractivities as they did before theywere offshored.

The problems are also symptoms ofoffshoring’s rapid expansion. In particular,competition for suitable personnel ismounting in locations popular with UKbanks such as Mumbai and Bangalore,which is in turn leading to salaryescalation and high staff turnover. Simplyupping pay rates is clearly costly and

easy for competitors to replicate.Instead, around four-fifths of respondentsrecognise that training and careerdevelopment are the most effective waysto retain offshore employees. The surveyalso highlighted the value ofperformance-based pay in sustainingefficiency and motivation.

Ultimately, it would appear that manycompanies may have underestimatedthe time, cost and effect of movingoperations offshore and the potentialimpact on their customers and residualstaff. Proper appraisal of the mostsuitable locations and partners are clearlyessential. A gradual migration or use ofcaptive operations may also be requiredto overcome any possible cultural,infrastructure and governance issues.

Future developments

As today’s main centres of offshoringbegin to reach capacity, others will cometo the fore. Our survey revealed thatrespondents expect China to surpassIndia as their leading offshore location.In turn, such operations could providea launch pad for developing domesticbusiness in these increasingly affluentemerging markets.

As offshoring becomes morecommonplace and the activities moresophisticated, the distinctions betweenhome and host operations may beginto blur. For example, specialist creditanalysis teams from several different


Ultimately, it would appear that manycompanies may have underestimated the time,cost and effect of moving operations offshoreand the potential impact on their customers andresidual staff.

continents may find themselves workingtogether on a common project. One clearbenefit of such co-operation will be inhelping to ease any staff resistance orcultural barriers.

Conclusion

Offshoring can help banks to cut costs,improve efficiency and enhance strategicflexibility. However, companies thatoffshore jobs solely as a cost savingstrategy or do not approach projects withcaution may fail to reap the full benefits.Effective offshoring demands strategicclarity, realistic targets and planning forthe long haul. As the market evolves,opportunities will grow, but so will thechallenges, and the organisations thatsucceed are likely to be those thatdo more than just seek to emulatetheir predecessors.

To download a free copy of‘Offshoring in the financial servicesindustry: Risks and Rewards’ please visitwww.pwc.com/financialservices

Contact Us

Mark StephenPartner, PerformanceImprovement ConsultingTelephone: 020 7804 3098Email: [email protected]

Niall MowldsDirector, PeformanceImprovement ConsultingTelephone: 020 7804 0866Email: [email protected]


Companies that offshore jobs solely as a costsaving strategy or do not approach projects withcaution may fail to reap the full benefits.

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