INTM267752 - Foreign banks trading in the UK through permanent establishments: The approach in determining an adjustment to funding costs - STEP 2: Risk weighting the assets - the Basel II regulatory regime: Operational and Pillar 2 risk

The thin capitalisation approach requires that the UK branches of overseas banks should hold the same amount of capital to that which a similar UK bank would hold. For regulatory purposes, UK banks are now required to hold capital to support operational risk and risk identified under Pillar 2. Therefore the UK branch of a foreign bank should also take into account such capital, in addition to capital supporting credit and market risk, when preparing a capital attribution tax adjustment (CATA). Such risk is difficult to qualify and even more difficult to attribute. The basic principle remains, however, that risk should be attributed to the function. Hence if a full factual and functional analysis shows that a particular element of operational risk or risk identified under Pillar 2 is managed by a particular function, then the capital to support, and the reward for assuming, such risk should follow that function.

In this respect the OECD Report on Attribution of Profits to Permanent Establishments (at Part 3, Paragraph 104) offers a pragmatic approach by which operational risk is to be allocated proportionately to other risks attributable to the PE. This is on the basis that the part of the enterprise with the greatest exposure to credit and market risk is, all other things being equal, the part with the greatest exposure to operational risk. This approach may not be suitable in every case, but it may appropriately be used unless the particular circumstances enable a more reliable and measurable assessment and attribution of operational risk and the reward for such risk to be made.

For the interim period operational risk and risk identified under Pillar 2 may therefore be attributed on this basis. That is, after calculating its overall risk in these categories, the bank would attribute a proportion of the risk and the capital required to support it to the UK branch in the same ratio that the UK branch’s credit and market risk bears to the bank’s overall credit and market risk. After the end of the interim period HMRC will review this approach.