Key Points:

The Basel Committee earlier this month issued a consultative document presenting its initial policy proposals for fundamental reform of capital standards for bank trading books.

In July 2009 the Basel Committee on Banking Supervision introduced a set of revisions to the Basel II market risk framework to reduce its cyclicality and increase the overall level of regulatory capital for trading activities.

At the same time it initiated a fundamental review of the trading book regime, seeking to address shortcomings in the overall design of the regime and weaknesses in risk measurement under both the internal models-based and standardised approaches that were exposed during the financial crisis.

The consultative document issued on 3 May 2012 sets out the Basel Committee's intended direction of reforms to the trading book regime and solicits comments in advance of concrete proposals.

The Basel Committee specifies the following key areas of focus in its review.

Reassessment of the boundary between the trading book and the banking book

Under the present regime a key determinant of the regulatory boundary between banking book and trading book exposures is the bank's intention to trade.

The Basel Committee criticises the "intent to trade" test as being difficult to police, insufficiently restrictive and subject to regulatory arbitrage. It proposes two alternatives: a "trading evidence"-based boundary and a "valuation"-based boundary. The first option could result in narrower trading books while the second would more likely result in expanded trading books.

Calibration to stressed conditions

The Basel Committee notes that a key feature of the trading book regime prior to the financial crisis was its reliance on risk metrics calibrated to current market conditions. It goes on to explain that this resulted both in undercapitalised trading book exposures going into the crisis and market risk capital charges that proved procyclical at the height of the crisis.

The Basel Committee intends to develop a capital framework for the trading book that is calibrated to a period of significant financial stress (as opposed to current market stress), thereby enhancing absorption of loss during critical periods and reducing the cyclicality of market risk capital charges.

Moving from value-at-risk to expected shortfall

The metric used to capitalise trading book exposures is a value-at-risk (VaR) measure aimed at capturing the risk of short-term fluctuations in market prices. The Basel Committee notes that use of the VaR method stems largely from historical precedent and industry practice, and that weaknesses in the method have been identified such as its failure to capture tail-risk (ie. where the risk of extreme price movements is in fact greater than assumed in the normal distribution).

The Basel Committee sees the "expected shortfall" method for determining regulatory capital requirements as more desirable than the VaR method. Despite recognising operational challenges that would come with the proposed move, the Basel Committee believes that those challenges would be outweighed by the benefits of adopting a method that is more sensitive to assessing tail-risk.

Factoring in market illiquidity

The Basel Committee notes that the existing regime for capitalising trading book exposures does not adequately take account of the risk of severe impairment of market liquidity seen in the recent financial crisis.

The Basel Committee's proposed approach to factor in market liquidity risk consists of three elements. The first one involves the introduction of a concept of "liquidity horizons" to represent the time required to sell a financial instrument, or hedge all its material risks, in a stressed market without materially affecting market prices. Exposures would be placed into one of five "liquidity horizon" categories ranging from 10 days to one year.

The second element involves incorporating the varying liquidity horizons in the regulatory market risk metric to capitalise the risk that banks might be unable to exit or hedge risk positions over a short time period.

The third element involves enhanced capital requirements associated with jumps in liquidity premiums, subject to meeting specified criteria.

Alignment of the internal models-based and standardised approaches to hedging and diversification

An important element of the Basel Committee's proposals is to more closely align the treatment of hedging and diversification between the internal models-based and standardised approaches to capitalising trading book exposures. Its guiding principle is that the capital framework should only recognise hedges if they are likely to prove effective – and can be maintained – during periods of market stress.

To this end, the Basel Committee proposes to limit the large latitude currently afforded to users of the internal models-based approach to recognise the risk-reducing benefits of hedging and diversification. At the same time, the Basel Committee aims to increase the risk sensitivity of the standardised approach, in part by factoring in increased recognition of hedging.

Revision of internal models-based and standardised approaches

The Basel Committee is proposing changes to the internal models-based and standardised approaches, including a closer link between their calibration. For the internal models-based approach, other proposed changes include measures to reduce model risk, such as a more granular models approval process at the trading desk level and constraining diversification benefits.

A revised standardised approach would be intended to be more risk-sensitive and act as a credible fallback to internal models, and on this point the Basel Committee seeks feedback on what it calls a "partial risk factor approach" and a "fuller risk factor approach".

The appropriate treatment of credit

The Basel Committee notes that a particular area of focus for its review has been the treatment of positions subject to credit risk in the trading book. Currently, default risk and migration risk are modelled separately for the purposes of capital charges. One motivation behind the review was to simplify the patchwork of capital charges applied to the trading book, but the consultative document explains that combining default and migration risk within an integrated market risk framework introduces unique modelling challenges. For that reason, the Basel Committee is considering whether default and migration risk should continue to be modelled separately in the trading book.

What happens now?

Comments on the consultative document are due by 7 September 2012. After considering feedback the Basel Committee intends to release for comment a more detailed set of proposals to amend the trading book regime under the Basel III framework. The consultative document offers an opportunity to participate in the overhaul of the trading book regime and is a helpful indication of the shape of reforms to come.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.