Banks Face Tougher Basel Capital Rules for Trading Books

Banks face a toughening of global capital rules on swaps, bonds and other securities that they intend to trade, as regulators seek to make lenders more resilient to crises.

The Basel Committee on Banking Supervision, which brings together supervisors from 27 nations including the U.S., U.K. and China, proposed an overhaul of its bank trading-book rules, seeking to limit discrepancies in how lenders measure the riskiness of their investments.

The draft rules would better capture the kinds of losses that banks might suffer in “a period of significant financial stress,” the Basel group said in a statement on its website today. Regulators are seeking a “comprehensive revision” of global rules to capture banks’ trading-book risks.

Banks’ potential 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., blamed flexible implementation of previous rounds of Basel rules in the European Union for enabling the bloc’s lenders to hold less capital against some assets compared to their U.S. counterparts.

Retained Earnings

Regulators require banks to have minimum amounts of capital, such as shareholder equity and retained earnings, on their balance sheets, to ensure that they can cope with losses they incur in their day-to-day activities.

The Basel plans 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 during episodes of systemic turmoil.

The measures would also toughen the approval procedures that banks have to go through if they want to be allowed to use internal models to measure their capital requirements.

Unintended Consequences

“While the aim of making the trading operations of banks safer is laudable, the consequences of measures to achieve this are uncertain and may indeed present different risks to financial stability,” Richard Reid, a research fellow for finance and regulation at the University of Dundee in Scotland, said by e-mail.

Such measures may “drive trading operations into even less well-regulated and transparent segments of the financial system which itself of course may present stability problems,” Reid said.

The Basel group said it would seek views on the measures until Jan. 31.

“We want the new methodology to be more robust, and produce more consistent outcomes, than is currently the case,” Wayne Byres, the Basel committee’s secretary general, said in an e-mailed response to questions last month.

Banking Books

Today’s proposals concern assets that banks intend to sell before maturity, as opposed to those they intend to hold to maturity, which are listed in their banking books.

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

Today’s measures seek to incorporate lessons learnt from the study so that there is consistent implementation of capital rules across banks, the Basel committee said.

Asset Risk

Capital requirements are set as a percentage of a bank’s assets, with the value of the assets weighted in line with their riskiness.

Banks must calculate the level of risk using either internal models, or a standardized approach prepared by regulators. 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 Basel group said it’s weighing whether banks that use internal models should nevertheless be forced to apply the standardized approach “as a floor or surcharge” to their capital requirements.

The committee said it will only make a final decision on this issue after conducting an impact assessment.

The Basel proposals also seek to toughen the boundary between bank’s trading and banking books to prevent banks simply shifting assets between them to in ways designed to lower their capital requirements.

Further Step

The plans mark a further step by the Basel group to overhaul it’s capital requirements in response to the financial crisis unleashed by the collapse of Lehman Brothers Holdings Inc. in 2008. A first round of changes, known as Basel 2.5, was published in 2009, and then incorporated into a broader overhaul of the group’s rulebook, known as Basel III, which was issued the following year.

In addition to the plans announced today, the Basel group is in parallel also working on a detailed overhaul of its capital rules for securitized debt, in a bid to revise and build on 2009 changes. It published draft plans last year that it said would increase overall capital requirements for securitizations.

The Basel committee is part of the Bank for International Settlements and seeks to co-ordinate the work of bank regulators. Its rules aren’t automatically binding and must be implemented by member nations to take effect.

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