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: use of the regulatory framework
Banks (and other financial institutions) are regulated entities (see INTM267701). As such they are required by their regulator to maintain a certain level of capital to support their financial assets. From a supervisory perspective capital provides a buffer that enables a bank to absorb losses without the interests of the depositors being adversely affected. In general terms, the more risky the asset, the more is the capital required to support it. Thus, capital follows risk and regulatory capital is determined in a banking context by attributing a risk weighting to the financial assets.
Because there is a regulatory framework that banks adhere to, this framework can be used to help calculate the capital that a permanent establishment (PE) would have if it were a separate enterprise. Once assets have been correctly attributed to the PE they can be risk weighted to establish the amount of capital that is required to support them.
Assume that Bank X:
- is required by its regulator to maintain a minimum capital ratio of say 11%. This will mean that the minimum amount of capital that it is required to hold for regulatory purposes will be 11% of its risk-weighted assets.
- has assets of £1000M, all of which are risk weighted at 100%.
Bank X will be required to hold a minimum of £110M capital i.e. £1000M x 100% x 11%.
Now assume that Bank Y:
- is also required to maintain regulatory capital of 11%
- also has assets of £1000m but they are all risk weighted at 50%
Its minimum capital requirement will be correspondingly lower i.e. £1000M x 50% x 11%, so its capital requirement will be at least £55M. Of course the bank may well hold a higher ratio of capital than its regulator requires for its own capital management purposes.
What the legislation in CTA09/Part 2/Chapter 4 aims to achieve here is an attribution of capital, primarily equity capital, to the PE for tax purposes. If less capital has actually been allotted to the PE this will give rise to an interest disallowance and lead to a tax adjustment. HMRC is effectively looking at a percentage of capital, on which funding costs will be disallowed, giving rise to a higher profit/lower loss and ultimately an adjustment to tax. HMRC will be looking for a degree of pragmatism and are not expecting PE’s to apply the precise and detailed requirements of the capital adequacy regulatory regime, especially if there would be very little change in the end result if they were to do so.
The formulation of rules on bank capital is the domain of the Basel Committee on Banking Supervision. The 1988 Capital Accord set a minimum capital standard of 8% (of risk-weighted assets) for banks in the industrialised world. Most industrialised and emerging market countries are signed up to the Basel Accord, but in practice there is some variation in the way in which the different regulatory regimes apply the rules. The rules applied by the FSA are derived from EU directives which themselves are derived from the Basel Accord. The 1988 accord dealt primarily with credit risk and it has since been recognised that credit risk alone is not always a good indicator of a bank’s financial condition. A new framework, Basel II, was been designed to improve the way in which regulatory capital reflects credit risks, and also operational risk. There is detailed guidance about the attribution of capital to foreign banking permanent establishments in the UK is at INTM267730 onwards.
Whilst the current regulatory regime deals primarily with credit risk, market risk is also taken into account, and market risk in the trading book is referred to in more detail in INTM267719.