Banks face tougher capital requirements on swaps, bonds, and other securities that they intend to trade, as global regulators tighten market-risk rules for the second time since the financial crisis.
The Basel Committee on Banking Supervision, whose members include the U.S. Federal Reserve and the People's Bank of China, said updated rules published on Thursday will result in a weighted mean increase of about 40 percent in trading-book capital charges. The revised framework boosts the share of banks' risk-weighted assets produced by market risk to nearly 10 percent, from about 6 percent under existing rules, the Basel group said in a statement.
The overall capital burden on banks imposed by the Fundamental Review of the Trading Book, which takes effect in 2019, is nevertheless lower than was produced by earlier proposals, the Basel Committee said. The impact on specific asset classes and business lines is likely to be uneven and could hit some banks harder than others, even making some trading desks unviable.
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"The purpose of the revised market-risk framework is to ensure that the standardized and internal-model approaches to market risk deliver credible capital outcomes and promote consistent implementation of the standards across jurisdictions," the Basel Committee said.
The regulator said its overhaul was needed to "improve the overall design and coherence of the capital standard for market risk, drawing on the experience of 'what went wrong' in the buildup to the crisis." The overhaul started in 2012 after a first set of tweaks to trading rules was introduced in 2009, seeking to close loopholes banks had used to understate the riskiness of their trading assets.
The International Swaps and Derivatives Association (ISDA) said in an emailed statement on Thursday that while the Basel Committee had amended "several areas of concern identified by the industry," its estimate of a 40 percent increase in market-risk capital requirements "would impose a considerable burden on banks on top of the increases already introduced following the crisis, as part of Basel 2.5."
A report last year by ISDA and other industry groups estimated the capital requirement using Basel's new standardized approach would be 4.2 times the total market-risk capital the firms currently have.
Bank of England Expects Basel Effects to Be 'Quite Modest'
Mark Carney, governor of the Bank of England, said in December that some institutions had "taken extreme versions of the previous consultation and read that as that's what's going to come," and that "we see it as quite modest in terms of its overall impact in the U.K."
Marianne Lake, chief financial officer of JPMorgan Chase & Co., said the final market-risk rules showed "meaningful improvement" on earlier drafts, though "it's clear that net-net, despite the committee's stated intention wasn't necessarily to increase market-risk capital across the industry, it will be higher." Banks will have to "sift through" the "very technical" new framework to determine how much higher, she said.
ISDA similarly said that a number of changes had been made in the final rules compared with earlier proposals "to both the standard rules and internal models," including "multipliers, liquidity horizons, risk weights, and correlation matrices. It is therefore very difficult to comment on the overall capital impact at this stage," the group said.
The rules limit banks' ability to shift assets between the trading and the banking books, where they hold assets to maturity and aren't forced to write them down if market prices fall. They come with a list of default designations—unlisted shares go in the banking book, listed shares in the trading book, for example—putting the onus on banks to explain if they want to deviate. Regulators can prescribe a switch if they think it's necessary.
For gauging the potential losses on trading assets, the review replaces the "value-at-risk" model with "exposure shortfall," a measure deemed to better capture rare but substantial risks. The revised rules also try to better predict the risks of sudden stops of market liquidity as they occurred in the financial crisis.
Basel's new framework restricts the benefit of strategies meant to reduce losses by simultaneously holding assets whose prices normally go in opposite directions, and give less favorable treatment to diversified investments, based on the analysis that hedging and diversification didn't work as advertised in the crisis.
'Pre-Crisis Framework' Relied on Bank Models to Determine Capital Needs
"The deficiencies in the pre-crisis framework included an inadequate definition of the regulatory boundary between the banking book and trading book, which proved to be a key source of weakness in the design of the trading-book regime," the committee said. In addition, "the models-based capital framework for market risk relied (and still relies) heavily on risk drivers determined by banks, which has not always led to sufficient capital for the banking system as a whole."
The Basel group completed the market-risk rules after four impact studies over two years. The final study was based on end-June 2015 data. Compared with existing rules, the new framework "is likely to result in an approximate median (weighted average) increase of 22 percent (40 percent) in total market-risk capital requirements," including securitization and non-securitization exposures, the regulator said.
The review is part of a broader project to limit the use of banks' own models for calculating their capital needs. The regulator is giving standardized models greater importance compared with internal models, while at the same time prescribing internal models in more detail than before.
–With assistance from John Glover, Silla Brush, Rebecca Christie, and Yalman Onaran.
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