MBS capital charges coming soon in Basel II shake-up

Basel II capital requirements on structured credit products are to be raised as part of a wide-ranging review of risk management practices for financial institutions in G-7 nations, the Financial Stability Forum (FSF) has announced.

Under sweeping new proposals designed to strengthen the resilience of banks in the wake of the credit crisis, the FSF has concluded that capital requirements and supervisory liquidity guidelines need “further improvement”, especially in the areas of securitisation, off-balance sheet activities and the operation infrastructure of over-the-counter derivatives.

In the most remarkable element of the proposals, the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (Iosco) intend to levy additional capital charges on the individual business lines they identify as posing the biggest systemic risk.

- Further reserves will be set aside for structured credit products such as collateralised debt obligations of asset-backed securities (CDOs of ABSs), which the FSF calls “the most serious risk management shortcoming” it has identified.

- Credit exposures in banks' and securities firms' trading books will incur further capital charges to compensate for the credit risk they pose, as opposed to the simple market risk buffer held under current Basel II requirements.

- Capital requirements will also be reviewed on off-balance sheet asset-backed commercial paper conduits. Under Basel II, these vehicles are regarded as senior exposures, so additional capital charges will be considered to reduce regulatory arbitrage incentives.

Monoline insurers will similarly be investigated to ascertain the need both to strengthen their own capital base, and to ensure they are more prudent in the risks they guarantee, in order to bolster their own balance sheet and prevent other counterparties over-leveraging themselves.

All told, the report makes 67 recommendations on issues from new code of conduct rules for credit rating agencies to new plans to strengthen the collective ability of central banks to deal with periods of systemic stress.

Although the report was compiled by the FSF with the assistance of Iosco, the Basel Committee and a further eight supranational regulators, responsibility for strengthening existing Basel II capital requirements will lie with the financial regulators of the G-7 economies.

Supervisors themselves have not escaped the scope of the new guidance, however, as Iosco and the Basel Committee will publish best-practice guidance later in the year, establishing more stringent risk management monitoring processes for regulators. The Committee will also provide supervisors with a consultation paper on sound management of liquidity in July, as part of a wider drive to promote a consistent liquidity approach across jurisdictions.

Thomas Wieser, director-general of the Austrian Ministry of Finance and chairman of the Organisation for Economic Co-operation and Development’s (OECD) financial markets committee, welcomed the FSF’s proposals.

“The OECD believes that fundamental reform of the financial system and its regulation has to be a key focus of the policy debate going forward. It will no longer be possible to assert the view that we have the best of all possible financial systems. The current regulatory framework reflects the 'simple' world before globalisation; the new division of labour has partially led to global imbalances. We need to ensure a co-operative framework for financial markets that takes account of new realities, and enhances stability, while retaining efficiency,” Wieser said.

All of the proposals and guidance outlined in the FSF report will be issued by the BCBS, Iosco, national regulators and other supervisory agencies over the course of 2008 and early 2009.

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