Basel Committee raises flag over new interest rate capital charge

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A surprising Basel Committee proposal – a new capital charge for interest-rate risk held in the banking book – is set to challenge banks’ business models and will limit arbitrage opportunities. Bankers will be caught off-guard by this costly proposal, which some say ignores the fundamental difference between banks’ trading and banking books.

Bankers have barely been able to draw breath in recent years, after sweeping reforms of global capital and liquidity rules under Basel III. Too bad. In a speech in March, Stefan Ingves, the chairman of the Basel Committee on Banking Supervision, caught global markets off-guard with a new proposal – a new capital charge for interest rate risk held in the banking book – which suggests the tightening of the regulatory noose has some way to run. This proposal, in contrast to interest rate risk on securities intended for trading, has previously been omitted from the Basel capital framework. The changes were described by Ingves, governor of the Sveriges Riksbank, as one of the “last pieces in what has essentially been a complete overhaul of the regulatory framework since the financial crisis”. The impact of the new rules, should they come into effect, will be significant, expanding the pool of securities faced with a capital charge, including floating rate loans, bonds, derivatives and deposits. The governor did not go into details of the rationale behind the new initiative but dropped a heavy hint when he spoke of his desire to “limit arbitrage opportunities” between banks’ trading and banking books. “The market place showed some instances where banks have moved interest rate assets between the trading book and the banking book, with the aim of maximizing capital efficiencies,” says Erik de Boer, a director in the risk services division of Deloitte, based in Amsterdam. “What that means is that there can potentially be an imbalance in the banking book, where firms are sitting on material losses which are not yet realized.” A typical example of a negative interest rate exposure in the banking book would be a floating rate loan sold at Libor plus 100 basis points three years ago, which is now under water because an equivalent loan would price at Libor plus 200bp. Under the existing Basel framework, such a loan held in the banking book would be subject to credit risk capital charges, essentially protecting against the chance the loan is not repaid. However, that loan would not attract charges, for the risk that changes in the interest rate environment would reduce its real value. “There are banks holding assets in the banking book which because of interest rate fluctuations may not be sold without a loss,” says De Boer. “From that perspective, it makes sense to ask that capital is held to cover that risk.” On the face of it, requiring banks to hold capital against unrealized losses seems fair, but according to some it ignores the fundamental difference between the trading and banking books, and two very different models of banking. The first is a traditional buy-and-hold approach, whereby banks lend money and expect to be repaid on maturity. The second strikes at the heart of the investment-banking philosophy in which the bank’s whole balance sheet is considered fair game to be traded. “The proposals are interesting but in my view are not entirely correct, because they are contrary to the philosophy and operation of the banking book, which is that assets placed there are held to maturity,” says Mark Nicolaides, a London-based partner at Latham & Watkins. “Changes in market prices do not cause actual losses to banks unless they sell prior to maturity, which is something most banks do not do and is in any event within their control. “Capital for principal losses in the banking book is different because losses can be incurred upon an obligor default, which is outside the control of the bank. For those reasons, the proposals should not be progressed by the regulators.” In addition to legal concerns, there are technical challenges that must be addressed before any legislation is considered. “There is a wide range of views over how to measure interest rate risk in the banking book and there are considerable complexities around interest rate modelling that need to be considered before any specific proposal could be put forward,” says Bill Coen, deputy secretary general of the Basel Committee. “But at least conceptually it is no more difficult to model than, say, operational risk, which is already part of the framework. And Australia already has a hard-wired charge for interest rate risk in the banking book, so it’s not unprecedented.” Interest rate risk in the banking book is covered by Pillar 2 of Basel II, which is concerned with internal risk management and the supervisory framework for risks not expressly included in the capital provisions under Pillar 1. Under Pillar 2, banks are required to maintain economic capital and internal systems of management over interest rate risks, and the rules provide sets of qualitative principles to be applied, including stress testing, risk limitation and internal audit. Pillar 2 also gives supervisors the powers to evaluate systems and monitor compliance. In addition, under Pillar 3 banks are required to comply with disclosure requirements in respect of interest rate risk. According to its own reports published in 2004, the Basel Committee in early drafts of Basel II had considered including interest rate risk under Pillar 1, but eventually it was decided against on the basis there were considerable differences between banks in terms of the nature of underlying interest rate exposure as well as monitoring and controlling processes. The Basel Committee chairman’s recent speech suggests those misgivings have come to an end. “When such a senior guy mentions something like this you can bet it’s serious,” say Deloitte’s De Boer. “Banks need to continue to develop their policies around management of interest rate risk and consider responses for the consultation we are likely to see later this year.” Rest in peace: geared and tradable bank balance-sheets.

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