The fundamental review of the trading book is due for completion by the end of 2015, but impact studies have thrown up some alarming results.
What’s happening?
In the wake of the financial crisis, the Basel Committee on Banking Supervision (BCBS) hastily threw together a set of higher capital charges on market risk in June 2010, dubbed 'Basel 2.5' by the industry. In May 2012, the BCBS launched the fundamental review of the trading book, designed to provide a well-considered framework that aligned capital requirements more accurately with risks, without necessarily raising the overall capital allocation on the trading book any further than Basel 2.5.
Regulators pledged to the governments of the G20 countries that they would complete this far-reaching overhaul by the end of 2015. A quantitative impact study (QIS) taking into account all elements of the new regime – an internal modelled approach (IMA) and a standardised sensitivities-based approach (SBA) – was completed in October 2015.
What’s new?
One crucial new idea running through the fundamental review is that supervisors should be able to approve internal models on a desk-by-desk basis. This would allow supervisors to instruct banks to transfer specific trading desks back to the SBA if questions were raised about the integrity of internal models for that asset class.
But the QIS results have prompted alarm over the possible impact of desk-level approvals. A joint study by the International Swaps and Derivatives Association (ISDA), the Global Financial Markets Association (GFMA) and the Institute of International Finance calculates that the SBA would entail an aggregate average increase of 4.2 times in capital requirements compared with the current framework. This would also be between 2.1 and 4.6 times higher than the capital charges generated by the new IMA, depending on asset class.
“One of the objectives of the fundamental review was to narrow the gap between internal models and the standardised approach, which, in theory, would make it easier for regulators to remove internal model approval for those banks failing internal model tests. However, the analysis shows capital levels could jump by more than four times following a move from internal models to the standardised approach, which could put a severe strain on banks,” says Mark Gheerbrant, head of risk and capital at ISDA.
A second major concern is that the BCBS is currently working on proposals to use the standardised approach as a floor for internal models across market and credit risk. Like the fundamental review, the BCBS told the G20 in November 2014 that it would complete the work on capital floors by the end of 2015.
“If the standardised approach floors land anywhere around where we expect – which is at 70% to 80% of the standardised approach capital charge – then we are looking at massive increases in capital for trading books. That would really change the structure of market liquidity and banks’ ability to be market-makers will be heavily reduced,” says Jouni Aaltonen, a director of prudential regulation at the GFMA.
What’s the impact?
There is a wide range of asset classes potentially affected by the fundamental review to an extent that could undermine the economics of bank trading desks for those securities. The three industry associations are playing up the potential impact on the real economy. Securitisation, which is a key plank of the EU’s capital markets union proposals, would be hit with a capital charge that Mr Aaltonen says runs to about 50% of exposure for the most senior tranches, and quickly rises above the maximum possible loss for other tranches.
“The businesses that will be hardest hit will likely be those most important for the real economy, such as credit to small and medium-sized entities, securitisation and small cap equities. This could make it more expensive for end users to raise funding. The rates market will also be affected, which will affect government bond markets,” says Mr Gheerbrant.
What’s the alternative?
More time. The industry agrees on the need for a fundamental review, and suggested the original concept for the SBA after Basel’s first draft standardised approach produced even more distorted results. But the industry associations are now calling for regulators and banks to be allowed sufficient time to “develop the required infrastructure in order to test, refine and properly calibrate” key elements of the market risk framework.
“The G20 commitment is based on the idea that 2015 is the deadline to complete the post-crisis regulatory reforms, but the industry sees the Basel 2.5 changes as the crisis response on market risk. The fundamental review is meant to be a long-term framework. We had expected some reallocation of capital between different asset classes, but there is a big cliff effect between the IMA and standard approaches,” says Mr Aaltonen.
