Models could lose appeal under new trading book rules

Panellists expect capital and complexity to jump under revised trading book regime, removing the incentive to obtain modelling approval

Fewer banks will seek approval to model their trading book capital requirements if a review of the current framework results in higher capital levels and a heavier workload, panellists at the Trading and Investment Risk conference in London warned this morning. That would be "a loss for the banking industry", according to Manoj Bhaskar, global head of regulatory and risk analytics at HSBC.

In some cases, banks that are already licensed to use the internal models approach (IMA) might revert to the standardised, regulator-set alternative, said Jerry English, head of trading book capital management at Lloyds Banking Group. "There is a real fear that the boundary point at which it makes sense to have IMA permission will change as a consequence of this – and it will mean there will be less banks with IMA permissions in future," he said.

HSBC's Bhaskar compared that to moving from "PC to iPad and then going back to the PC again". The capital modelling regime has a host of benefits over and above the ability to calculate capital requirements more accurately, he argued. "I don't think regulators will shed too many tears about that, but it's a loss for the banking industry as a whole if we lose our coverage of internal models, because there are a lot of benefits modelling brings with it – the level of controls, the level of consistency and the way we manage our risk becomes a lot more industrialised in some ways."

Both Bhaskar and English said they expect capital to rise under the revised regime. The third panellist, Rita Gnutti, head of internal model market and counterparty risk at Intesa Sanpaolo, warned the proposed new rules would require a drastic overhaul of existing modelling practices.

The current trading book capital framework, known as Basel 2.5, was rushed out in the aftermath of the first phase of the financial crisis, and adds five calculations to the standalone value-at-risk charge that had been in place since 1996. The overhaul pushed up capital requirements for trading book assets, but was only ever intended to be a stop-gap. In May 2012, the Basel Committee on Banking Supervision launched its Fundamental review of the trading book in an attempt to modernise and streamline the rules, with a second iteration following in October last year. The comment period ended in January.

There is a real fear that the boundary point at which it makes sense to have IMA permission will change

Among its changes, the review proposes switching from VAR to expected shortfall – a measure that is claimed to be better at capturing tail risk losses – and requires this to incorporate five different liquidity horizons, ranging from five days to one year. The horizons are intended to reflect the time it might take to close a position under stressed market conditions, but are applied separately to a range of 24 risk factors, such as large-cap equity prices or investment-grade sovereign credit spreads, rather than to individual products.

In addition, to address fears that differing model choices produce unreliable or inconsistent risk-weighted asset (RWA) numbers from one bank to the next, IMA banks will also be required to calculate and report RWAs using the standardised approach, so analysts and investors can make apples-to-apples comparisons. As a result, the standardised approach has also been revised, making it more complex but also more risk sensitive, and – in theory – creating a credible alternative to modelled capital.

Panellists, though, argued the net result will be a confusing new risk measure, a big jump in workload resulting from the need to run the revamped standardised and IMA approaches in parallel, and – crucially – a further increase in trading book capital.

Lloyds Banking Group's English said regulators "say they have no mandate to increase it, but my fear is that it will increase rather dramatically as a result of the differential liquidity horizons." That could mean new capital levels are "multiples" higher in some cases, he said.

Intesa Sanpaolo's Gnutti said regulators have the levers needed to adjust the resulting burden. She urged the Basel Committee to heed the findings of the quantitative impact studies it is running this year. Early indications are that capital would increase under the current version of the proposals, she said.