Macaskill on markets: The mystery of the Basel outlier

Jon Macaskill
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The Basel Committee on Bank Supervision released long-awaited guidance on a new capital regime for market risk in January. It did not, however, solve the mystery of which bank was the outlier in a study of the potential effect of a change in trading risk evaluation.


Prime suspects including JPMorgan, Deutsche Bank, Citi, Goldman Sachs and Morgan Stanley are ruling themselves out, but often on a background basis and with a qualification such as having no reason to believe that they were the nominee for outlier in the trading risk hall of shame.

This underscores the continuing uncertainty about the effect of new risk rules on capital requirements for banks, and the problems investors face in gauging how much risk is embedded in bank trading books.  

The Basel Committee accompanied its release on a new capital framework for market risk with soothing words designed to calm fears that big dealers may face yet another big capital shortfall.

The disastrous start to the trading year has reawakened concern about credit quality in all corners of the markets and a run on Italian bank stocks in January provided a prime example of how a poorly communicated regulatory shift can exacerbate this fear. Confusion over the treatment of non-performing loans contributed to the sell-off in Italian banks and showed how technical regulatory adjustments can hit confidence.

An emollient tone from the Basel Committee on the effect of its new capital requirements for market risk was therefore unsurprising. It stressed that it had reduced the overall capital impact of the new rules from an earlier draft and pointed out that changes were now likely to produce market risk-weighted assets of less than 10% of total risk-weighted assets, compared with around 6% historically.

That is still a large amount, given the size of the modern banking system, and the treatment of market risk looms much larger for big investment banks than it does for commercial banks.

In November, the Basel Committee released a graph showing the potential impact on 44 banks of a move to new capital charges for market risk, using end-of-2014 data. Most banks were in quite a narrow range, with a limited change, but one firm faced an increase of almost 80% for its market risk capital charge as a percentage of its total Basel III minimum capital requirement. This was far higher than the second-most affected bank at just over 20% and contrasted with little net effect for most banks.

In proposing its new framework in January, the Committee used the graph again, though it excluded the outlier bank from some calculations on the overall impact of its changes. 

The Committee declined to identify the outlier bank in its own study of the effect of a change in market risk rules, or to say whether it (or the relevant member supervisor) had pressed for a change in approach at the firm.

Guessing game

That has led to a guessing game about the identity of the bank, which is likely to be an important dealer with a large trading book – including substantial derivatives exposure – and an aggressive approach to modeling its own risk for capital calculation purposes.

JPMorgan, the biggest trading house and historically the firm with the greatest derivatives exposure, is the only bank in this category to publicly rule itself out as the outlier.

“I can tell you that wasn’t us,” JPMorgan’s CFO Marianne Lake said at an investor conference in December. She acknowledged that the new rules increase the need for capital allocated to the firm’s trading businesses during the bank’s quarterly earnings call in January, but said that JPMorgan has not yet made adjustments to reflect this shift. “It would have been premature to have taken any actions in advance of figuring out where this has landed,” Lake said.

Citi CFO John Gerspach took a similar line on his firm’s quarterly earnings call by conceding that there could be a big impact on market risk capital under the new rules, while pointing out that Citi’s current $77 billion of market risk-weighted assets only accounted for 6% of the firm’s balance sheet.

Citi has bucked the approach of many banks in pushing to expand derivatives market share recently, but it has also trimmed its overall notional exposure in the last year and an insider said that it was not the outlier firm in the Basel Committee study.

Deutsche Bank was another pick of some observers for likely status as the outlier, given its history of tensions with regulators such as the Federal Reserve over its capital allocation policies for trading businesses. The bank is indeed likely to add trading book capital inflation to its mountain of woes, which range from enormous litigation exposure to slumping investment bank revenue. A bank insider said that it is not the Basel outlier, however, which is at least a minor consolation in a time of trouble.

That leaves Goldman Sachs and Morgan Stanley as likeliest remaining candidates, in part because of another chart in the Basel Committee’s original November release, which showed that one bank suffered inflation of 700% in its potential market risk charge as a proportion of its current charge due to a shift to the draft trading book rules.

The Committee disclosed that the removal of that bank from the sample resulted in weighted inflation for the group of 44 banks falling to 39% from 74%, indicating that the outlier was a leading trading firm where market exposure has a big bearing on its group risk. By combining the impact on an assumed 10% tier-1 equity ratio of a sharp increase in market risk charges with the percentage of these assets of overall group exposure, some analysts concluded that the outlier must be either Goldman or Morgan Stanley, once JPMorgan is excluded. 

Once again, though, insiders at Goldman and Morgan Stanley said that they did not believe that they were the outlier, though with caveats such as being “confident” that they were not it, or “having no reason to believe” they were the outlier, respectively.

This underscores the uncertainty over the impact of the new Basel market risk rules and a continuing air of suspicion within the industry about risk measurement policies. It seems unlikely and alarming that a leading dealer might be the outlier without realizing that it is. But dealers often make dark, if unspecific, warnings about the assumptions that underlie trading decisions made by their competitors. And sudden changes in attitude towards fixed income trading, where the new market risk rules have the greatest effect, are becoming a dominant trend in banking, with the abrupt reversal of a bid to increase share by Morgan Stanley and a related management purge just the latest shift by a big dealer.

Further changes of tack as the impact of the new rules sinks in would not be a surprise, nor would an eventual forced disclosure from a large dealer about market risk capital inflation – though that could potentially be masked by a general withdrawal from certain business lines.