The Basel Committee on Banking Supervision has released proposals aimed at how banks should calculate risk in their trading books. While the recommendations are not binding, if adopted, they are likely to raise banks’ capital adequacy requirements. The guidelines build on a report presented to G7 finance ministers and central bank governors in April.

The proposed risk guidelines and changes to the Basel II framework were, in part, shaped by the losses incurred this past year in banks’ trading books due to the current market turmoil. Historically, default risk was already reflected in a bank’s value-at-risk (VaR) model. However, the VaR framework first formulated in 1996 to model and measure risk has largely proved inadequate in the current environment. The proposals accordingly consider a number of changes to strengthen prudential oversight.

The new proposals ask that banks hold capital against not only default risk, but against other sources of price risk, such as those reflecting credit downgrades, significant moves on credit spreads and equity prices. The decision was taken in light of the recent credit market turmoil, which has led to a number of major banking organisations to report large losses. Most of those losses were not captured in the 99%/10-day VaR, notes the Basel Committee guidelines. The current VaR framework ignores differences in the underlying liquidity of trading book positions. With a focus on short-run P&L volatility, the VaR capital charge also does not fully reflect price movements over periods of several weeks or months.

Liquidity

“The (bank) losses have not risen from actual defaults but rather from credit migrations (downgrades) combined with widening of credit spreads and the loss of liquidity, therefore, applying an incremental risk charge covering default risk only would not appear adequate,” according to the proposals. “The incremental default risk charge would not have captured recent losses in CDOs of asset-backed securities and other restructurings held in the trading book.”

During the recent credit market turbulence, liquidity in many parts of the securitisation markets dried up, forcing banks to retain exposures in securitisation pipelines for prolonged periods of time. This has prompted the Basel Committee to prod banks into paying particular attention to the appropriate liquidity horizon assumptions in their incremental risk charge models.

Within a given product type, a non-investment grade position would be expected to have a longer assumed liquidity horizon than an investment grade-position: one month for equities and benchmark interest rate derivatives traded in liquid markets such as Eurodollar interest rate derivatives and one year for re-securitisations. “While the risk factors incorporated into a bank’s incremental risk charge and 10-day VaR calculations generally will overlap to some degree, the committee has not yet determined how any double-counting adjustments should be computed.”

The Basel Committee, which was established by the G10 central bank governors, will now receive comments from the industry on its proposals through October. The committee’s current membership consists of senior representatives of bank supervisory authorities and central banks from 13 countries. Its members are expected to move forward with the appropriate adoption procedures in their respective countries.

VB