Basel Committee release revised incremental risk charge proposal

The Basel Committee on Banking Supervision released revised proposals for the charging of capital for incremental risk (IRC) in the trading book on July 22.

The rules, developed in conjunction with the International Organization of Securities Commissions, are in response to the credit crisis, which saw banks rack up billions of dollars in losses in illiquid structured credit products. And the rules follow on the back of a missive in April, in which the committee warned it would modify aspects of the Basel II framework.

The rules replace previous proposals on an incremental default risk charge, first introduced in July 2005 and expand on a consultation paper released last October. Their scope now encompasses a broader range of risks beyond default - in particular, credit rating migration, spread widening and equity prices.

This follows a realisation that most of the losses suffered by banks in recent months were not due to actual defaults, but to credit migrations, widening spreads and a lack of liquidity, and as such would not have been captured by an incremental default risk charge.

Similar to the October 2007 proposals, the committee allows banks to use their own models and proposes the IRC be measured at a 99.9% confidence interval over a one-year capital horizon. But the IRC must encompass all positions except those whose valuations depend solely on commodity prices, FX rates or the term structure of default-free interest rates - for instance, debt securities, equities, securitisations, collateralised debt obligations and other structured credit products. The charge must also capture default risk, credit migration risk, credit spread risk and equity price risk.

The Basel Committee simultaneously released proposed revisions to the Basel II market risk framework. Under the new guidelines, banks must update their data sets for value-at-risk calculations every month and must have processes in place to update data sets more frequently if market prices are volatile.

In another tweak to existing rules, the Basel Committee emphasises that banks must use observable market prices for valuation purposes whenever possible. Actual market prices should be used even when the market is less liquid, unless those prices are the result of a forced liquidation or fire sale.