Correlation desks win relief from Basel trading book rules

Correlation traders have been given a reprieve after final rules on the regulatory capital treatment of trading book positions, published by the Basel Committee on Banking Supervision on July 13, eased the rules for securitisation positions.

The change is part of a final package of measures published by the Basel Committee, which includes revisions to the market risk framework and changes to Pillars I, II and III of the framework.

Central to the new rules is the introduction of an incremental risk charge (IRC). Meant to reduce the scope for regulatory arbitrage between trading and banking books, the IRC guidelines confirm banks must measure losses in the trading book due to default and migrations at a 99.9% confidence level over a one-year capital horizon, taking into account the liquidity horizons of individual positions or sets of positions.

In the previous draft of the rules, published in January, the Basel Committee specified that securitisation positions would be excluded from IRC models and subjected to a harsher banking book charge based on credit ratings. As a result of the loose definition of securitisation exposures under Basel II, there were concerns that a wide array of products, including liquid credit derivatives indexes tranches, would be subject to punitive charges – a move that dealers said could have made correlation trading uneconomical.

While the stricter general rules for securitisation positions remain, correlation trading has been offered a lifeline. Rather than employing the more punitive charge, banks will be able to apply to use their own internal approach for calculating capital charges for correlation books, covering specific and incremental risk. This model must consider the cumulative risk of multiple defaults, credit spread risk, volatility in implied correlations, basis risk and recovery rate volatility, for example, and should be calculated at least once a week.

For a bank to apply this exception, it must apply a set of predetermined stresses to its portfolio, including default rates, recovery rates, credit spreads and correlations. The exact nature of these, which would be calculated weekly and reported to supervisors quarterly, is expected to be determined in consultation with the industry by March 2010. Any instances in which the stress tests indicate a material shortfall of the internal risk measure would have to be reported to supervisors in a timely manner.

To make use of this approach, banks would also be required to have sufficient market data to ensure they fully capture risks of these exposures and demonstrate their risk measures can explain the historical price variations of the products covered. In addition, they would have to make sure they can separate positions for which they have approval to model internally from other exposures in the trading book. The Basel Committee expects to come up with a minimum floor for the new internally modelled charge by 2010.

Higher capital requirements for securitisations come alongside a more targeted crackdown on resecuritisations such as collateralised debt obligations of asset-backed securities – an instrument seen as a key culprit for market disarray. Similarly, securitisation warehouses and liquidity facilities for off-balance-sheet vehicles will also attract increased regulatory capital charges.

Meanwhile, the Basel Committee reaffirmed a new trading book capital charge will be introduced based specifically on stressed market conditions – something intended to make the framework less pro-cyclical. The 10-day stressed value-at-risk measure will be measured at a 99% confidence interval, employing data from a one-year period of market dislocation. The proposals cite periods encompassing the 2007–2008 credit crisis, although other time periods relevant to specific portfolios must also be considered.

Over the coming months, the Basel Committee expects to review impact studies collected by national regulators to determine the effect the new rules will have on bank capital. The results of this review will dictate the final calibration of the market-based capital requirements. The Committee will also consider what should be the minimum assumed liquidity horizon prescribed by the IRC, which is currently set at three months.

The increased capital requirements, along with enhanced disclosures for securitisations, off-balance-sheet exposures and trading activities, are due for implementation by the end of 2010. The updated framework also includes extra guidance for supervisors on raising standards in governance and risk management, as well as principles on sound compensation practices published by the former Financial Stability Forum in April. These revisions, which fall under Pillar II of the Accord, will be implemented immediately.

According to the Committee, the trading book changes are part of a broader initiative to strengthen Basel II. Among its aims are the build-up of greater capital buffers to be drawn down in periods of market stress, a strengthening of the quality of bank capital and the introduction of a leverage ratio to act as a backstop for the Basel II regime. It anticipates making a consultative proposal in line with these broader themes by the first quarter of 2010.

See also: Basel changes could "kill off correlation trading”
Q&A: Basel Committee's Walter outlines Basel II reform agenda
Risk Europe: Walter sets out programme for Basel II changes
Basel Committee improves market risk framework