Back to the drawing board for trading book rules

The Basel Committee is preparing to conduct a fundamental review of its trading book rules in 2011, even before a package of changes to the market risk framework has come into force. What are regulators trying to achieve and how is the industry responding? Joel Clark reports

Given the considerable political pressure on the Basel Committee on Banking Supervision to complete the Basel III reform package by the end of the year, it was little surprise when a detailed update to the Group of 20 (G-20) leading economies on October 19 focused mainly on the progress of the capital and liquidity reforms. But there was more. Buried deep inside the 16-page report was the committee's most substantive statement yet about a major stream of work that looks set to consume regulators and bankers alike next year - namely, a fundamental review of the trading book.

Although major changes to the market risk capital framework have already been agreed and are in the process of being implemented, the Basel Committee believes there is more to be done to correct the flaws exposed by the financial crisis. In the G-20 update, the committee revealed it would complete a fundamental review of the trading book by the end of 2011, looking in particular at whether the distinction between the banking and trading books should be maintained, how trading activities should be defined and how trading book risk and market risk should be captured by regulatory capital.

Although the committee has not yet provided any more detail, market participants are braced for the possibility of substantial alterations to the current framework. The review is understood to be driven partly by regulators' desire to iron out the inconsistencies and double counting that may have arisen as a result of the numerous measures covering market risk published since the financial crisis.

In July 2009, the Basel Committee finalised a major set of changes to the market risk capital framework, including the introduction of an incremental risk charge (IRC), meant to capture trading book losses due to default and migrations, a stressed value-at-risk measure, designed to ensure VAR models consider the impact of a period of stress on trading books, higher risk weights for resecuritisations and a comprehensive risk measure for correlation trading.

That collection of measures, dubbed Basel 2.5, is scheduled to come into force from December 31, 2011. Combined with existing market risk charges and the new Basel III capital charges for counterparty credit risk and credit value adjustment, they amount to what many see as an unwieldy framework that is not sustainable in the long term.

Regulators insist they had no choice but to put the collection of market risk measures in place quickly in response to the heavy losses incurred in trading books during the crisis, but they agree with market participants that the patchwork of measures is unsustainable as a long-term regulatory capital framework. The trading book group, a subcommittee of the Basel Committee, has been given the task of drawing up a more elegant framework.

As far as some members of this group are concerned, there are few limitations to the scope of the fundamental review. A previous appraisal in the wake of the Basel II agreement in 2004, which led ultimately to the IRC, was conducted with instructions not to tamper too much with existing arrangements. This time, regulators say they will start with a completely clean slate. If it is deemed necessary, the group could choose to redefine the line between the trading and banking books, or even tear up the VAR framework and look for an alternative measure of market risk.

This kind of talk has driven the industry to prick up its ears, but some bankers are frustrated by the Basel Committee's failure to properly explain the objectives of the appraisal. Having started to prepare for the Basel 2.5 measures, despite concerns about its feasibility, banks are anxious to understand the scope of the fundamental review and assess its implications.

"We support the need to fundamentally review the prudential framework for trading activity, because the current framework suffers from inconsistencies, double counting and calibration issues that need to be addressed. And equally, when you have a patchwork of measures, there will always be cracks where risks are not fully captured. But it's not yet clear exactly what the review will entail and it would be helpful if the Basel Committee could clearly set out the scope, objectives and principles of the review," says Manoj Bhaskar, head of market risk methodology and regulatory modelling at HSBC in London.

While the Basel Committee might have kept the fundamental review under wraps as it worked to complete Basel III this year, one national regulator has been more vocal. The UK Financial Services Authority (FSA), a supervisor that has become accustomed to front-running international regulatory agreements, has consistently stressed the need for a more wide-ranging review of the trading book.

"There should be very major changes to trading book capital, increases of three times or so, since this is the key area where the existing regime was seriously deficient, failing to require adequate capital against risky trading activities," said FSA chairman Adair Turner in March 2009 when he unveiled the Turner Review, his roadmap for regulatory reform.

The Turner Review blamed the current regime for allowing banks to hold low levels of capital against assets in the trading book, in the mistaken belief they could be sold or unwound rapidly. While recognising the Basel Committee's efforts to address such problems with the introduction of the stressed VAR measure, the IRC and higher risk weights for resecuritisations, the FSA still called for a "more radical review of trading book risk measurement and capital adequacy requirements". At that time, the supervisor expected the review to begin in 2009 and be completed by December 2010, but the project has now been pushed into 2011 as the regulatory community has devoted itself to the challenges posed by Basel III.

While the Basel Committee's trading book group has yet to begin detailed work on the fundamental review, the issue has clearly not receded from the FSA's agenda. On August 25, the regulator published a lengthy discussion paper, The prudential regime for trading activities: a fundamental review, which gives the clearest indication yet of the kind of changes the Basel subcommittee might eventually consider. The paper looks in detail at the weaknesses in the current trading book regime and makes 16 recommendations, broadly grouped into three areas: valuation practices; coverage, coherence and capital; and risk management and modelling.

The FSA has already discussed the proposals with banks, and will close the general consultation on November 26, with a feedback statement expected early in 2011. The feedback will serve as a useful indicator of the industry's views on a number of the key issues that will fall under the scope of the Basel Committee's study. One of the most important areas will be the simple question of whether to maintain the existing boundary between the banking book and the trading book.

Under rules set out in the Basel Committee's 1996 market risk amendment, assets can be held in the trading book, becoming subject to a market risk capital charge and fair value accounting, so long as the positions are kept "either with trading intent or in order to hedge other elements of the trading book". Many participants have recognised the flaws in that approach - a bank may be able to demonstrate simple trading intent for a particular asset, but then find it is unable to sell because of a sudden lack of liquidity during a crisis.

"The crisis clearly showed that many positions held in the trading book turned out to be not as tradable as anticipated, and this is being reflected in the new framework. One of the main problems in the crisis was that instruments thought to be highly liquid were not, so liquidity has an important role to play in deciding what kind of instruments go into the trading book," says Andrés Portilla, deputy director on regulatory affairs at the Institute of International Finance (IIF) in Washington, DC.

The FSA paper recognises the same issue and recommends any redefinition of the boundary between the two books must incorporate both market liquidity risk and funding liquidity risk. Additionally, the paper raises the possibility of a third book that would hold traded credit instruments. Given the structural difference between the credit sector and other markets, and the high level of risk that is retained by banks through the provision of credit to the real economy, the FSA believes a separate credit spread risk capital requirement could potentially be applied to traded credit assets held in a third book. But industry observers say crafting changes to trading book eligibility will be complex.

"Redefining the boundary between the two books is going to be a really difficult issue that will require a lot of careful consideration. While we could potentially measure liquidity in current markets to incorporate liquidity into the rules, one of the things we learnt from the crisis was that liquidity can decline in markets that previously looked liquid. The one thing we know about crises is the next one won't be like the last one," says David Murphy, head of risk and reporting at the International Swaps and Derivatives Association in London.

Another issue discussed in the FSA paper is the shortcomings in the VAR framework. The FSA argues VAR modelling failed to accurately capture risk for a variety of reasons - not least, the fact VAR models rely on historical data, and economic conditions had been extremely benign in the years leading up to the crisis. Some believe the addition of a stressed VAR calculation as part of Basel 2.5 will be sufficient to rectify this shortcoming.

"Stressed VAR should correct for the most salient deficiencies that were evidenced in the crisis and there is no clear consensus yet on whether we need something different for regulatory capital purposes. Some banks are moving towards a more integrated approach to credit and market risk anyway, and that would imply less direct reliance on VAR," says the IIF's Portilla.

But the FSA is not content with stressed VAR and suggests the Basel Committee should fully assess alternative market risk measures that may better capture the risks across the economic cycle. One possible alternative would be an expected shortfall approach, which measures the expected loss that would be incurred once a certain confidence level has been breached. But given the amount of work that has gone into VAR modelling over the years, there is some reluctance to completely reinvent the wheel.

"Banks have invested a great deal in the VAR infrastructure and we shouldn't discard it unless it is totally deficient. It's certainly true that some VAR models didn't perform well for some portfolios, but there are other areas where VAR worked fine, so we should consider hanging on to that approach and perhaps supplement it where necessary," says Isda's Murphy.

Aside from redefining trading book eligibility and considering alternative market risk measures, a number of other issues were raised in the FSA paper and are likely to be considered as part of the fundamental review. They include more robust standards and guidelines for the valuation of traded instruments, and an increased focus on regulatory stress testing to supplement model-based approaches to trading book capital.

But given the fundamental nature of the Basel review, it could go even further than the FSA paper and touch upon areas not yet considered. Some market participants are concerned that, despite the overarching desire to correct the patchwork nature of the current framework, there is a danger regulators might end up just bolting on extra charges to capture deficiencies exposed by the crisis.

"A fundamental review should not simply create more capital charges in specific silos as a result of analysis of the crisis. Regulators have put too much focus on capital adequacy in the past, and when it comes to the trading book, there will be ways to avoid such charges by hedging positions to reduce the risk. They need to start looking more holistically at the activities of institutions rather than trying to capitalise small pockets of risk," says HSBC's Bhaskar.

Another worrying aspect for both regulators and market participants is the time frame: in the G-20 update, the Basel Committee said the review would be completed by the end of 2011. Given the complex nature of trading book capital, some have suggested a single year will not be long enough to allow the trading book group to properly impact-test its proposals and consult with the industry before passing them up to the committee for approval.

"Such a fundamental review of a significant component of the regulatory framework ought to be based on close dialogue, especially if the goal is to have more risk-sensitive requirements. In particular, it will be essential for the industry to provide data, so that multiple approaches can be tested while they are still in a formative phase. Close dialogue, with clear and adequate deadlines, will allow the industry to participate in impact studies in an efficient way, avoiding situations that would result in banks participating on a best-efforts basis with excessively short consultation periods," says the IIF's Portilla.

Even regulators admit the end-of-2011 deadline is unrealistic and the review will have to be a multi-year process if it is to be completed with appropriate diligence, consultation and impact assessment. Bankers say the current focus on Basel 2.5 implementation means they would also need more time to properly consider the implications of the reappraisal.

"Internally we are very busy trying to meet all the existing requirements by the end of next year, and we will need to be operationally ready much earlier. We simply don't yet have the time or the resources to look in detail at the fundamental review," says the head of risk methodology at one European bank.