Basel Committee releases incremental risk charge proposal

The Basel Committee on Banking Supervision today released revised proposals for the charging of capital for incremental risk in the trading book. The new rules, developed in conjunction with the International Organisation of Securities Commissions, are in response to the global credit crisis, which saw banks rack up billions of dollars in losses in illiquid structured credit products, and follows on the back of a missive in April, in which the committee warned it would modify aspects of the Basel II framework.

The rules replace previous proposals on an incremental default risk charge, first introduced in July 2005 and expanded upon in a consultation paper released last October. However, the scope of rules has changed to encompass a broader range of risks beyond default – in particular, credit rating migration, spread widening and equity prices. This follows a realisation that the majority of losses experienced by banks in recent months were not the result of actual defaults, but were instead caused by credit migrations, widening spreads and a lack of liquidity. As such, these would not have been captured by an incremental default risk charge.

“Major banking institutions have experienced significant losses over the past year, most of which were sustained in banks’ trading books,” stated Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank. “Against this backdrop, the Basel Committee’s incremental risk proposal will better align regulatory capital requirements with the risk exposure of banks’ trading book positions.”

Similar to the October 2007 proposals, the committee allows banks to use their own models and proposes the incremental risk charge (IRC) be measured at a 99.9% confidence interval over a one-year capital horizon. However, the IRC must encompass all positions except those whose valuations depend solely on commodity prices, foreign exchange rates or the term structure of default-free interest rates – for instance, debt securities, equities, securitisations, collateralised debt obligations and other structured credit products. The charge must also capture default risk, credit migration risk, credit spread risk and equity price risk.

The new rules also put a lot more emphasis on the liquidity horizons (the time required to sell a position or hedge all material risks in a stressed market) of individual positions. The minimum liquidity horizon is set with a floor equal to: one month for equities traded on a recognised exchange, exposures to broad equity market indexes or benchmark interest rate spreads traded in liquid markets. This horizon is set at one year for re-securitisations and three months for all other IRC covered positions; or the time it takes for bank to actually rebalance or hedge similar positions during stressed market conditions – whichever is greater.

Banks are required to calculate the IRC at least weekly – a change from the October 2007 consultation paper, in which it stated banks should calculate a default risk measurement daily.

Financial institutions must comply with the new rules by January 1, 2010, although firms will be allowed an extra year to incorporate those risks other than default into their models. Until the IRC is implemented in 2010, an interim rule will be introduced to ensure banks hold enough capital for re-securitisations. This will be published some time later this year. The proposals are open to consultation until October 15, 2008.

The Basel Committee simultaneously released proposed revisions to the Basel II market risk framework. Under the new guidelines, banks must update their data sets for value-at-risk calculations every month and have processes in place to update data sets more frequently if market prices are volatile. The committee also clarified that banks can use a weighting scheme for historical data, so long as the resulting figure is at least as conservative as that generated using the existing methodology, which requires banks to calculate VAR using an effective observation period of at least one year.

In another tweak to existing rules, the Basel Committee emphasises that banks must use observable market prices for valuation purposes whenever possible. Actual market prices should be used even when the market is less liquid, unless those prices are the result of a forced liquidation or fire-sale, the committee said. Banks can only use mark-to-model when marking-to-market is not possible.

See also: Proposed revisions to the Basel II market risk framework
Guidelines for computing capital for incremental risk in the trading book
Compliance by default