Basel Committee consults on removing trading book capital loophole

In its draft proposals (99-page / 557KB PDF) for a fundamental review of 'trading book capital' requirements, the Committee calls for a "more objective boundary" between trading and banking book assets that "materially reduces the scope for regulatory arbitrage". Historically, banks have been able to count assets in their trading books towards regulatory capital requirements.

Under Basel standards, trading and banking assets are regarded as being subject to different levels of risk. Trading books contain those assets that banks plan to actively trade while banking books contain those assets which they intend to hold to maturity. Banks experienced "materially undercapitalised" trading books during the financial crisis due to ineffective risk management and valuation methods, the Committee said, as well as the inclusion of financial instruments exposed to longer-term credit risks in the trading book.

The Committee substantially increased the amount of capital banks have had to hold against securities and structured products on their trading books as part of its 'Basel 2.5' package of revisions to the market risk framework. However, the Committee said that those requirements "largely built on the existing regulatory definitions and framework".

"The recent crisis exposed material weaknesses in the capital treatment of banks' trading activities," it said in the paper. "Some of the most pressing deficiencies of the trading book regime were addressed by the July 2009 revisions to the market risk framework, while others have been dealt with as part of Basel II. However, the Committee has agreed that a number of the market risk framework's fundamental shortcomings remain unaddressed and require further attention."

Any changes will operate separately from the new baseline requirements for capital, leverage and liquidity which will be phased in between 2013 and 2022 under the Basel III international banking agreement. Under Basel III, banks will have to increase both the quantity and quality of capital they hold, while accounting for higher levels of risk-weighted assets.

The consultation proposes a stricter regulatory boundary between banking and trading book assets as opposed to the current "inherently subjective" differentiator of "intent to trade". "Prior to the crisis, it was advantageous for banks to classify an increasing number of instruments as 'held with trading intent' (even if there was no evidence of regular trading of these instruments) in order to benefit from lower trading book capital requirements," the Committee said. Large differences in capital requirements against similar types of risks depending on how an asset was classified meant the framework was "susceptible to arbitrage", it added.

"The fundamental review needs to deliver both an improved boundary which better meets the goals of supervisors and an improved capital requirements regime for those instruments that form part of a revised trading book," it said.

It proposes an enhanced version of the current intent-based boundary, in which banks would have to carry out ongoing evaluation to assess whether they are categorising their assets correctly, or a 'valuation-based boundary' which would take into account the amount of risk attached to that asset rather than its purpose. These assets would be constantly revalued to take into account changes in market prices. The Committee said that a trading book held under this approach would likely be "significantly larger" in many cases and "increase the number of banks subject to market risk capital requirements".

The Committee also proposes changing from a 'value-at-risk' to 'expected shortfall' risk management measure, which is says will better capture the risks banks face from market crashes. It also sets out a new standardised approach to valuation that will act as a more "credible fallback" when banks' own internal calculation models prove inadequate.