Today, the Basel Committee issued a second proposal on the fundamental review of capital requirements for the trading book.
The first proposal, issued in May 2012, described a number of specific measures to improve trading book capital requirements. The second proposal provides more detail on the approaches introduced in May 2012, and sets out a draft text for a revised market risk capital framework.
The key features of the proposed revised framework include:
- A revised boundary between the trading book and banking book. The new approach aims to create a less permeable and more objective boundary that remains aligned with banks’ risk management practices, and reduces the incentives for regulatory arbitrage.
- A revised risk measurement approach and calibration. The proposal involves a shift in the measure of risk from value-at-risk (VaR) to expected shortfall so as to better capture “tail risk”, and calibration based on a period of significant financial stress.
- The incorporation of the risk of market illiquidity, through the introduction of “liquidity horizons” in the market risk metric, and an additional risk assessment tool for trading desks with exposure to illiquid products.
- A revised standardized approach for calculating market risk capital requirements that is designed to be sufficiently risk-sensitive to act as a credible fallback to internal models, and still appropriate for banks that do not require sophisticated measurement of market risk.
- A revised internal models-based approach, encompassing a more rigorous model approval process and more consistent identification and capitalization of material risk factors. Hedging and diversification recognition will also be based on empirical evidence that such practices are effective during periods of stress.
- A strengthened relationship between the standardized and the internal models-based approaches. This is achieved by establishing a closer calibration of the two approaches, requiring mandatory calculation of the standardized approach by all banks, and requiring mandatory public disclosure of standardized market risk capital charges by all banks, on a desk-by-desk basis.
- A closer alignment between the trading book and the banking book in the regulatory treatment of credit risk. This involves a differential approach to securitization and non-securitization exposures.
The Basel Committee is also considering the merits of introducing the standardized approach as a floor or surcharge to the internal models-based approach. However, it will only make a final decision on this issue following a comprehensive Quantitative Impact Study, after assessing the impact and interactions of the revised standardized and models-based approaches.
Comments on the proposal are due by January 31, 2014.
Potential U.S. Implementation: In a speech delivered on July 7, 2012, Federal Reserve Governor Governor Daniel K. Tarullo stated that: “depending on the results of the fundamental review of the trading book currently underway in the Basel Committee, we may want to return to market risk capital requirements at a later date. I, for one, am particularly interested in exploring possible standardized capital requirements for market risk as a back-up for model-derived risk weights, just as we now do for credit risk [under the Collins Amendment capital floor].”
Basel Committee, Fundamental Review of the Trading Book – Second Consultative Document (Oct. 2013) available here: http://www.bis.org/publ/bcbs265.pdf