Regulators issue key trading book proposals
BASEL - Banks and investment firms seem likely to give a mixed reception to new regulatory proposals dealing with their trading book risks, published on April 11, as part of the ambitious rewrite of the capital adequacy rules for banks around the world.
These trading book proposals follow a year-long review of the risks attaching to the trading book-related activities of banks and investment firms, and the consequent level of capital necessary to ensure solvency in a crisis.
The proposals represent one of the main unfinished aspects of the new Basel accord (Basel II) governing bank capital, which was published last June following six years of negotiations. The proposed rules that resulted from those negotiations are viewed by some financial firms as more appropriate to risks in the banking book than the trading book.
To address this criticism, a review of the trading book has been undertaken by a working group set up jointly by the Basel Committee, architect of the new risk-based capital regime, and the Madrid-based International Organisation of Securities Commissions (IOSCO), an umbrella body for securities regulators around the world. This working group was chaired by Oliver Page, head of the major financial groups division of the Financial Services Authority, Britain's financial regulator, and Michael Macchiaroli, associate director at the US Securities Exchange Commission.
The working group's trading book proposals were issued as a 91-page consultative paper.* Comments from the public must be lodged by May 27, 2005. There is only relatively short period for comment because of the tight timetable that regulators and lawmakers must now work under if Basel II is to be implemented as scheduled from January 2007, in the EU member states and some other countries. A similar consultative paper was issued on Friday by the European Commission, which has had the task of transposing Basel II into EU law.
This law, the Capital Requirements Directive, currently before the European Parliament, will have to be amended to include the trading book proposals.
There is similar time pressure on US regulators, who are due to publish their Proposed Notice of Rulemaking by mid-year. This is a legal text that will set out the new capital rules for US banks applying Basel II, including the trading book aspects.
The trading book review covers five main issues:
· the treatment of counterparty credit risk for over-the-counter derivatives, repurchase agreements and securities financing transactions, and of cross-product netting arrangements;
· the treatment of double-default effects for covered exposures, in relation to the trading book, but also banking book;
· the short-term maturity adjustment, in the internal ratings-based approach under Basel II, for some trading book-related items;
· improvements to the current trading book regime, especially with respect to the treatment of specific risks; and
· the design of a specific capital treatment for unsettled and failed transactions.
In the case of counterparty credit risk (CCR), the proposals offer three alternative ways in which exposure at default might be calculated. One is an internal model method using the concept of expected positive exposure (EPE), which has been strongly advocated by many banks. Another is the current exposure method (CEM), the risk sensitivity of which is now viewed as fairly limited. It is the least sophisticated of the three methods. The intermediate method in terms of the level of sophistication is the standardised method. The proposal is that all three methods should be available to all banks and investment firms.
In addition, cross-product netting will now be recognised if banks and investment firms meet certain criteria. Previously, it was not permitted at all.
Double default is also recognised for the first time, under the proposals. Bankers have argued that where a loan is guaranteed by a third party there is less risk of them losing their money. There is only a low probability that both the borrower and the guarantor will both default, they say. The proposals suggest a method for calculating correlation of such a double default based on a White Paper issued by the US Federal Reserve. But there are fairly tight parameters on the quality of guarantors that can be accepted. They must be rated A-minus or above.
If both the borrower and the guarantor are of good quality, the proposed formula gives more capital relief than the existing method, known as the substitution approach. Under this approach, the level of the capital charge is related to either the borrower or guarantor, but not both. If, under the new proposal, the credit quality of both borrower and guarantor is not particularly high, then the capital calibration might be higher than under the old method. In that case, banks will be allowed to choose whether to use the double default method or the old substitution method.
On the issue of short maturities, the working group's proposals make virtually no change to the existing approach. Neither is there much change proposed to trading book definitions. But new capital charges are proposed for unsettled and failed transactions. Some countries have such charges already, but this is not harmonised under the existing, Basel I accord.
The impact of the total package of proposed changes on the capital levels of banks and investment firms is a major unanswered question. Firms with large trading books seem set to get capital relief from the counterparty risk proposal, while many banks will get a capital reduction from the double default proposal. What is less certain is the extent to which these benefits will be offset by other proposals that raise the capital charge.
A hostile response from the banking industry could force regulators to rethink their proposals. However, bankers face a dilemma. If the trading book proposals have to be reconsidered, there will be no possibility of meeting the current legislative and rulemaking timetables in the US and EU. That will mean a delay to the whole implementation of Basel II, which few bankers will like to see. There have, anyway, been fairly continuous discussions over the trading book issues between regulators and representatives of the banking industry.
*The Application of Basel II to Trading Activities and the Treatment of Double Default Effects.
