Basel capital rules for banks’ trading books will shift business models

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The revised approach to the regulation of banks’ trading books – focusing on capturing deep losses during systemic crises and a tougher approach to internal-risk modeling – will limit lucrative arbitrage and trading opportunities.

The Basel Committee on Banking Supervision (BCBS) wants to make banks treat the assets in their trading books more like those in their banking books by forcing them to hold increased capital against assets designated for trading.

Historically, lower capital requirements for trading book assets had encouraged banks to shift assets from the more expensive banking book into the trading book. However, this left many banks with insufficient capital to cover losses when credit markets collapsed during the crisis.

However, the latest BCBS proposals for how banks should calculate risk-based capital requirements at the trading book level, published on October 31, indicate banks are winning the argument that they should continue to be allowed freedom to use their own models to determine how much capital to hold against risky trading activities.

The revised rules represent a substantial U-turn for the BCBS, which had originally proposed in 2012 to force banks to aggregate their trading desk’ risk weighted assets (RWA), according to prescribed correlations.

Fixed correlations were needed, the BCBS suggested, because different banks used different models for calculating risks, which led to an unhelpful fragmentation of oversight approaches among national regulators. All this variation meant that risks were probably being understated and capital reserves were too low.

By and large, the industry seems satisfied with the compromise, which allows banks to rely on their own internal credit risk and correlation models, but also requires them to backstop these with a standardized approach based on credit rating agency ratings.

The revised rules include new suggestions for making banks’ internal models more robust, as well as changes to the standardized approach that will increase its risk-sensitivity, while making it easier for smaller banks to implement.

“It’s tough to be entirely critical of the revised proposals, as it’s clear that some additional level of capital reserve is helpful in a market downturn,” says one market source. “The question is how much is too much.”

The BCBS is undertaking a quantitative impact study to determine how the current proposals will perform under various stressed market scenarios, and intends to report the results at the end of the consultation period in January 2014.

However, some observers argue that even in their watered down form, the new proposals show that regulators are moving beyond the objective of matching rules to market reality, and are seeking to restructure banks’ incentives for engaging in certain trading activities.

Part of the problem, they argue, is regulators are basing the new framework on the idea that a future crisis could be far worse than the one that occurred in 2008.

“A major complaint with the current focus on trading book RWA is that if you look at the experience during the crisis, liquidity didn’t dry up in the way that is being assumed here,” says Simon Gleeson, a partner with law firm Clifford Chance in London.

“However, these proposals aren’t an attempt to correlate with reality, but rather they seek to build a driver into the system – a disincentive to hold trading assets.”

Indeed, the revised trading book RWA proposal is the latest of a raft of reforms, including the liquidity coverage ratio and the credit valuation adjustment charge that seek to decouple banks’ capital reserves from the health of the asset markets they participate in.

“There’s a decent policy reason why regulators should not want banks to hold traded assets that are accounted for on a mark-to-market basis,” says Gleeson. “A market crash translates the mark-to-market moves real time into a reduction in bank capital. If a bank is holding a portfolio of non-mark-to-market assets, such as the loans in its banking book, its capital stock is not exposed.”

Given the mutually reinforcing direction of regulatory capital reforms and OTC derivatives regulation, several banks have already realigned their business models according to the new incentives, with a sharp reduction in fixed-income inventory and position-taking among leading market makers.

Jon Skinner, an independent management consultant based in New York who advises banks on their strategic response to regulatory reforms, says that Basel 2.5 already had a significant impact on market RWA levels and the trading book rules appear to be a refinement of this rather than a major further uptick in RWA.

It will be interesting to see how flow-trading dealers will evolve their market risk management and flow trading in response to the combination of market risk RWA rules (Basel 2.5, trading book review) and the Dodd-Frank SEF mandate in the US.  

“Whilst prop trading is subject to well-publicized regulatory pressures, there is also market risk and hence RWA inherent in pure flow trading. Although the trading book review alone may not place a further burden sufficient to change the trading model, given the SEF trading mandate in the US, dealers may look to optimize market risk RWA in the new environment by adjusting their flow trading business," he says.

Under the new regime, this kind of trading operation is now a dying breed.