The attribution of capital to foreign banking permanent establishments in the UK: The approach in determining an adjustment to funding costs - STEP 2: Risk weighting the assets: Financial Services Authority regulatory rules
There are numerous regulatory rules and requirements but those that are of particular significance here are the rules pertaining to a bank’s capital. In particular there are capital adequacy requirements (sometimes referred to as CAD as they are based on a number of EU directives) and there are large exposure limits. The relevance of the large exposure limits is dealt with in section INTM267720 and the rest of this section will focus on CAD requirements and in particular the FSA regulations for the risk weighting of assets.
For most banks carrying on a traditional loan business, credit risk - the risk of loss as a result of the failure of their borrower to meet its obligations - is one of the principal risks they face. It is therefore principally credit risk which is taken into account when risk weighting assets on the banking book. Credit risk can arise in respect of both on and off balance sheet assets, and international agreement has established a way of weighting both the on-balance sheet and off- balance sheet items to reflect this risk.
Credit risk may also arise in connection with the CAD trading book requirements although these primarily deal with market risk. Market risk is the risk that the market price will move against the bank so that when the position matures it will make a loss.
Whilst the risk-weighting framework for both the banking book and the trading book is briefly referred to below, the examples given are illustrative and not exhaustive. Precise details of the FSA regulatory regime can be found via the FSA website and the rules on the risk weighting of assets are in the Interim Prudential Source Book for banks .
The information given at INTM267715 onwards is intended to provide some background on the risk weighting of on- and off- balance sheet assets, and on the treatment of credit risk and market risk in the trading book. Some of these issues and the calculations involved are complex and, as HMRC is adopting a pragmatic approach, the fine detail of the FSA regime will not be appropriate in all cases. That is, as already mentioned above, HMRC is attempting to attribute a percentage of capital, on which funding costs will be disallowed, giving rise to a higher profit or lower loss and ultimately an adjustment to tax where less capital has in fact been attributed. Therefore, PE’s are not expected to apply the precise and detailed requirements of the FSA capital adequacy regime where application of the detailed rules would produce very little change to the practical outcome.