Banks Face Risk-Model Clampdown in Basel Trading-Book Review

Banks face an overhaul of how they calculate possible losses on securities they hold in their trading books as global regulators target discrepancies in how lenders measure the riskiness of their investments.

In a bid to address weaknesses uncovered by the financial crisis, the Basel Committee on Banking Supervision may publish draft proposals as soon as this month on capital rules for assets that banks intend to trade, according to members of the group.

It may mean “less freedom for the banks using their own models” for measuring whether they have enough capital, Sabine Lautenschlaeger, vice president of the Bundesbank and a member of the Basel committee, said in an e-mail. “The potential for banks to optimize their models with respect to capital requirements will decline too.”

Banks’ ability to reduce their capital requirements by changing how they measure the risk of losses on their assets has prompted regulatory reviews and calls from some supervisors for more reliance on non-risk-sensitive capital rules. Bankers including Jamie Dimon, chief executive officer of JPMorgan Chase & Co., have said that flexible implementation of previous rounds of Basel rules in the European Union has allowed European lenders to hold less capital against some assets compared to their U.S. counterparts.

A study of large banks found “substantial” differences in how much capital lenders thought was needed to guard against possible losses on assets, the Basel committee said earlier this year. Differences in the risk-models used by banks was an “important source” of the variation, the group said.

Undesirable Variations

Bank of England Governor Mark Carney, in his capacity as chairman of the international Financial Stability Board, has also warned of “worryingly large differences” in the results produced by different banks’ risk models.

The Basel proposals will address variations in different banks’ risk measurement and will go beyond toughening rules on how much information banks have to disclose about their models, Wayne Byres, the Basel committee’s secretary general, said in an e-mail.

“We want the new methodology to be more robust, and produce more consistent outcomes, than is currently the case,” he said.

Risk Measurement

While the Basel plans are meant to tackle risk measurement on bank’s trading books, work is also under way to tackle similar issues affecting lenders’ banking books, where they log assets intended to be held to maturity, Byres said. The committee will propose measures on that front next year, he said.

These plans “could include improved disclosure, greater supervisory scrutiny of a bank’s choices in defining its modeled risk parameters or constraints on the use of, and/or inputs into, risk models,” he said.

International standards set by the Basel committee require banks to meet minimum capital requirements, calculated as a percentage of their assets. The amount of capital that must be held is linked to the riskiness of the banks’ investments.

Banks must calculate their capital requirements using either internal models, or a standardized approach prepared by regulators, under Basel rules. The latter is based on a mix of credit ratings and minimum risk-weightings for the amount of reserves that must be used to back a particular asset.

The committee is weighing “the merits of introducing the standardized approach as a floor or surcharge to the models-based approach, which should avoid that capital requirements could be reduced below a certain level,” Lautenschlaeger said.

Impact Studies

The Basel group will carry out further consultations and impact studies once the draft plans are published, she said.

The European Banking Authority, which coordinates the work of supervisors in the 28-nation EU, said earlier this year that it may force lenders to publish more information on what’s in their portfolios because of risk-measurement inconsistencies.

Risk-model variations may affect how different banks fare in an asset-quality review to be carried out next year by the European Central Bank, Jordi Gual, chief economist of Spain’s La Caixa financial group, said in a phone interview.

“Within the EU and in particular the Eurozone it is critical that this is sorted out,” Gual said. “I don’t think we’re going to fix it at the global level. Globally it is much harder to deal with than at the European level. The best we can probably hope for is that we get more transparency in the way different banks compute their numbers.”

Financial Crisis

The review of Basel trading-book rules follows changes approved in 2009 to address what regulators said were serious failings exposed by the financial crisis. Those amendments, known as Basel 2.5, “did not fully address the shortcomings,” the Basel group said last year.

A draft version of the latest Basel plans, published last year, would change the system banks should use for calculating losses, moving from a measurement method known as Value-At-Risk, or VaR, to an alternative known as “expected shortfall.” Regulators have said that the revised approach is better at capturing the extreme losses that can occur in crises.

“The fundamental review of the trading book is dealing with the boundary between the trading book and the banking book, the fact that value at risk is inadequate as a metric when it comes to dealing with tail risk, the fact that current rules don’t take account of liquidity, and that the original rules don’t take account of credit risk in market risk exposures,” Stefan Ingves, the Basel group’s chairman, said in an interview last month.

Inherently Complex

“Trading books at large banks are inherently complex, volatile affairs,” Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., said in an e-mail.

“Alternatives to VaR may better balance risks versus industry need, but this can only be determined after review of the proposal,” Petrou said. Even if the move away from VaR is “less subject to gaming by banks, it will create tremendous arbitrage opportunities that could move trading out of the banking system. This may be Basel’s desired result, but if so, it should say so.”

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