Basel changes could "kill off correlation trading”

Proposed changes to the Basel II Accord’s trading book regime, due in early July, will make correlation trading uneconomical unless a compromise can be found, say dealers.

The proposals include the long-awaited incremental risk charge (IRC), which is an explicit capital charge for risks including default and ratings migration in bank trading books. In addition to the existing value-at-risk market risk capital charge, they also incorporate a new VAR-based charge that will use data from a period of market turbulence, or stressed VAR.

In the latest draft of the changes – published by the Basel Committee on Banking Supervision in January – securitisations were excluded from the IRC charge. The Basel Committee said this reflected its view that risk modelling for securitisations was not reliable enough to merit their inclusion in the IRC. Instead, they will be subject to standard banking book charges based on credit ratings.

Under existing Basel II rules, any layered credit exposure to a pool of underlying assets is considered a securitisation. This would mean a range of products, including liquid credit derivatives index tranches and nth-to-default baskets, being potentially caught by the charge, according to bankers. The banking book charge would be particularly harsh in its treatment of unrated tranches and buyers of credit protection, while offering limited capital offsets for hedged positions. This would have “significant implications” for correlation trading, said risk managers.

The proposals are expected to be rubber-stamped by the full Basel Committee at a meeting from July 8–9. If the changes go through unamended, the new rules “would basically kill off correlation trading”, according to Ed Duncan, New York-based head of risk and reporting at the International Swaps and Derivatives Association. “Minimum regulatory capital requirements for the trading book could blow up,” he said.

Yesterday, Isda, the Institute of International Finance (IIF) and the London Investment Banking Association (Liba) submitted an urgent letter to Nout Wellink, the chairman of the Basel Committee and president of the Netherlands Bank, expressing serious concerns about the proposals. The results of studies by banks into the impact of the changes on bank capital, which have recently been conducted at the request of national regulators, were “sufficiently disturbing to provide a strong reason to consider amendments to the guidelines”, said the letter.

Before the changes are finalised, the results of the studies should be taken into account, the letter said. “The emerging results are sufficiently grave in their implications for the revival of markets and the availability of securitisation as a source of credit to merit the Basel Committee’s close attention,” it added.

The full results are not expected to be made available to the full Basel Committee until after the July meeting.

The proposals mean the capital charge for specific risk on actively managed tranches referencing liquid single-name corporate credits could increase by at least 25 times, according to a survey of eight leading correlation dealers, said Isda, the International Banking Federation, IIF and Liba in a joint submission to the Basel Committee in March.

Elsewhere, more traditional securitisation business is also expected to be hit – something that could lead to banks attempting to dump securitised paper into the market en masse, bankers fear. “This is ridiculous. Many banks will just decide not to hold securitised paper, because the cost will be unbearably high,” said one London-based risk manager at a major British bank.

Overall, one risk manager at a European dealer told Risk, the exclusion of securitisations from the IRC would increase bank trading book capital by more than 10 times. This would make up around half the total effect of the January changes, which also included the IRC and the stressed VAR charge, he said.

Intensive discussions are under way within the Basel Committee to attempt to address the industry’s concerns on correlation trading, said one European supervisor on the Committee’s trading book group. “One option would be to change something in the standardised approach so you have better recognition of hedging. Another would be to single some products out of the standardised approach so you can have some kind of IRC modelling again,” he suggested.

Nonetheless, given the political impetus behind moves to raise bank capital, observers question whether there is enough time for a compromise.

The January proposals will also involve tighter rules for re-securitisations, including collateralised debt obligations of asset-backed securities. These are singled out for a set of higher banking book charges than other securitised products, reflecting their role in precipitating the recent credit meltdown.

If agreed upon, the increased capital requirements would take effect from December 2010.

See also: Q&A: Basel Committee's Walter outlines Basel II reform agenda
Risk Europe: Walter sets out programme for Basel II changes
Risk Europe: Wave of capital legislation to hit Europe
Basel Committee improves market risk framework