Basel Committee prepares to raise capital requirements with 'stressed VAR' test

Banks may face significantly higher regulatory capital requirements under proposed changes to the Basel II capital adequacy rules released today.

The changes are aimed at plugging loopholes in the original rules, which allowed regulatory arbitrage - leading to losses far in excess of banks' regulatory capital. In particular, the committee highlights the abuse of the trading book system - at the moment, assets held on the trading book attract lower capital requirements than assets held on the banking book. The new rules would equalise treatment, and would also impose two new requirements.

In addition to the current value-at-risk measure, the committee suggests that banks should use a stressed VAR calculation based on a period of particular market turbulence, for which the ongoing financial crisis could be a useful point of reference. And in order to capture risks that the VAR method omits, such as credit migration risk and losses due to spread widening, banks should add an incremental risk charge. Most recent losses "were not captured in the 99%/10-day VAR" the committee warned, recommending an additional charge representing default and migration risk on credit products at a 99.9% confidence level.

The charge would also incorporate assumptions on the liquidity of the products - lower-rated products are assumed to be less liquid. Importantly, the charge ignores securitisation - in the wake of the credit crisis, the committee said, it is clear that securitised products cannot be adequately modelled, so any hedges using securitisation will not be taken into account.

Equity risk has been leniently treated, with only a 4% capital charge attached to liquid and diversified equity portfolios under current rules - this would be raised to 8% under the new proposals. Capital charges will also be raised on collateralised debt obligations of asset-backed securities and for liquidity lines extended to asset-backed commercial paper, which were associated with many of the worst losses of the crisis.

See also: Stress tests were ignored in lead-up to crisis, Basel risk head says
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