The Basel Committee on Banking Supervision is in listening mode and has granted some important concessions about how the bank trading book should be governed – but banks are still concerned about non-modellable risk factors. By Justin Pugsley.

What is happening?

One banker described the recent Basel consultation on revisions to the minimum capital requirements for market risk as “beyond expectations” – a view widely echoed across the industry. Indeed, there is much for bankers to cheer about in the Basel Committee’s latest proposals on the bank trading book.

The most eye-catching concession is to replace the pass/fail profit and loss attribution test with a traffic light system when trading desks breach the requirements boundaries, which would have forced them to switch from internal models to the Basel Committee’s standardised approach. This would avoid the immediate ‘cliff edge’ situation that results in big capital penalties suddenly rendering a trading desk non-viable.

Reg rage – acceptance

Instead, there will be an amber zone, where desks in breach will face graded capital increases, giving them more time to correct the situation before the full capital penalties apply.

In line with recent trends, the Basel Committee’s own models have been made more risk sensitive and the capital penalties for trading desks on the sensitivity-based approach (SBA) have been halved for various types of market risk – a move welcomed by banks. The deadline for compliance has also been extended to 2022 from 2019, taking some pressure off compliance teams.

As widely anticipated, the Basel Committee has advocated banks share data to help them model risks related to less frequently traded instruments. This topic leads straight into one that the bank compliance professional described as the “show-stopper” in the consultation.

This is around non-modellable risk factors (NMRF), part of the fundamental review of the trading book – one of the most complex and demanding aspects of the Basel III/IV framework. The measure is of concern mainly to big global banks, which tend to have large trading books containing complex and sometime infrequently traded over-the-counter derivatives and securities. In terms of the real economy, this matters because it enables banks to create highly tailored hedging solutions for clients (that could disappear if they became prohibitively expensive from a capital perspective).

Why is it happening?

The Basel Committee launched this consultation in March because it realised many of its original proposals made in 2016 did not work as intended or were unworkable. Indeed, when it comes to NMRF, many banks had thrown in the towel over trying to comply. Fortunately for them, the Basel Committee is giving them another opportunity to make their case.

For instance, it has requested evidence around seasonality factors where certain instruments stop trading for a month during the year, which theoretically makes them unmodellable. Banks argue this is too harsh, but they need to demonstrate that the risks can still be modelled using, say, proxies or alternative approaches.

What do the bankers say?

Overall, the banks are pleased with the leeway the Basel Committee is giving on many areas of the bank trading book and they see it as becoming a more realistic framework. But they remain concerned over the NMRF and trying to find a way to make it work. This requires persuading the Basel Committee to make changes, and for that banks will have to make strong data-based arguments. Banks also point out the NMRF does not cover all risks, such as the unpegging of a pegged currency.

Another factor is that the proposed changes to the SBA (that is, its greater sensitivity) could render the internal model approach non-viable. This worries some bankers who say the SBA, in trying to compromise between simplicity and risk sensitivity, contains flaws. They argue that if it became almost universal it could create systemic risks.

Yet another issue is how some of the Basel Committee’s proposed changes on modelling – which look positive on the surface – will play out. It could take more than a year of testing to determine whether there are any unintended consequences. Even the data-sharing proposal to help with NMRF, which looks impressive on paper, may not be as compelling as it first appears. Some bankers point out they cannot share all data for confidentiality reasons; others may refuse for fear of losing a competitive advantage.

Will it provide the incentives?  

Despite some very real progress, there is clearly much research and tweaking to do before the consequences of Basel Committee’s proposals are truly understood. But at least the trading book framework is starting to look more workable – and hopefully comes closer to striking the right balance between containing risk and allowing banks to make a profit and provide services, such as hedging, to their clients. Bankers have until June 20 to provide feedback on the consultation.

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