U.S. Fed Chair Janet Yellen said last month that she expects to raise interest rates this year if the economy meets her forecasts, with a gradual pace of tightening to follow.

“One reason interest-rate risk is so grave a concern now is that the combination of accommodative monetary policy and post-crisis regulation leads to large holdings of long-dated, low-rate obligations,” Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., said by email.

Existing international standards on banks' resilience to interest-rate changes have been applied differently across nations, meaning the amount of capital required “varies considerably,” the Basel group said.

While the Basel group is weighing different options for change, it made clear that the status quo is not an option, saying a “strengthened framework” is needed.

The Basel proposal concerns possible losses on assets that banks intend to hold to maturity, a part of their inventory known as the banking book.

Current international standards in this area date back to 2004 and are limited to a system whereby banks regularly report to their national supervisors on risk levels. These supervisors then take decisions on whether more capital, or a reduction in the size of the position, is needed.

Capital Requirements

The plans published for consultation by the committee today set out two options for strengthening this banking book regime. The regulator seeks views on the plans until Sept. 11.

The first would toughen the current supervisor-led approach, including by boosting the amount of information that banks have to disclose.

The second, more radical option would see this system replaced by minimum capital requirements set centrally by the Basel committee, which nations would be expected to make binding on their banks.

These requirements would include a methodology for “shock scenarios” against which banks should pit themselves and detailed rules on how to calculate capital requirements.

Change is necessary to remove incentives for banks deliberatively to shift assets between their banking book and trading book to exploit differences in capital rules, the regulator said.

Such “capital arbitrage” could arise because the Basel committee already sets binding capital charges for assets banks intend to trade.

Capital is a measure of banks' financial strength, in other words of a firm's ability to take a hit without failing. Capital requirements dictate how far banks must fund themselves through equity and other sources that can absorb unforeseen losses.

Types of interest-rate risk in the banking book include a change in rates that leaves a bank locked into receiving a relatively low interest rate on long-term investments such as mortgages, while being under competitive pressure to offer higher rates to depositors. Others include banks being caught out by changes in the relationship between interest rates on short- and long-term debt.

There are limits to how far supervisory rules can shield banks from such perils, Petrou said.

Two Approaches

“Supervisory guidance now can slap some risks, but it does nothing to address structural risk drivers, especially those the regulators themselves have inadvertently created,” she said.

The Basel committee brings together regulators from 30 nations to set bank capital requirements. In addition to the ECB and the Fed, its members include the Bank of England, the Bank of Japan, and the Swiss National Bank.

The two different approaches being assessed by the Basel committee reflect a split in the committee between European and U.S. regulators over how far to go beyond current measures.

Many European Basel members are keen to move toward tighter global standards on risk measurement and on the amount of capital required. This has put them at loggerheads with the U.S., which wants to stay closer to the current approach.

There are pros and cons of each path, the committee said in its consultation paper.

While the more rigid international approach is best suited for delivering consistency, discretion for supervisors can “accommodate differing market conditions and risk management practices across jurisdictions,” the regulator said.

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