Basel reforms highlight flaws

Tuesday July 29

Basel II has been nearly a decade in the making and has only just begun to be implemented across the globe.  Last week, the Basel Committee on Banking Supervision and International Organization of Securities Commissions proposed a series of ad hoc fixes to the ambitious regulations.  The key proposed amendments have focused on making regulatory capital requirements a more realistic reflection of trading book risks in light of the lessons learned during the credit crisis. However, the fact that such fixes were necessary in the first place has dealt a blow to the credibility of the controversial regulations.

Incremental risk charge. This additional amount of risk capital that banks must hold was originally proposed in October 2007 to cover the default risk associated with the increasing amounts of credit risk-related instruments residing on trading books. However, in the interim, the Committee received numerous comments highlighting the fact that taking into account default risk alone was inadequate:

• In the latest proposals, the incremental risk charge (IRC) covers other kinds of risk not captured in the conventional measure of market risk -- specifically known as value-at-risk (VaR).

• In addition to default risk, credit rating migration risk, credit spread widening risk and the risk posed by significant moves in equity prices should also be reflected in the IRC.

Problems. There are two significant problems associated with the recent proposals and related regulatory moves:

• The IRC is incomplete as it omits other significant risk factors.

• Basel II's patchy implementation and increasing complexity is creating an uneven, potentially unfair and uncertain regulatory landscape.

Non-IRC market risks. Trading book positions whose value depends solely on commodity prices, foreign exchange rates and the shape of the forward curve of interest rates are other sources of price risk not included in the IRC. The Committee stated that it is cognisant of the potential for these non-IRC market risks to create large trading book risks. However, it stated that it will be difficult for most banks to meet the operational and modelling requirements entailed by its current limited-scope IRC proposal.

Flawed regulation. This suggests the Committee is aware that its regulatory framework and fixes are flawed. However, it also suggests the Committee believes that some action is better than none. Indeed, the current proposals seek to address many of the risks that have been laid bare during the credit crisis. Nonetheless, the Committee's decision to delay addressing non-IRC factors currently suggests it is not grasping the scope of banking risks as firmly as it should.