"Computing Capital for Incremental Risk in the Trading Book" and "Revisions to the Basel II market risk framework" - consultative documents issued by the Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision today issued for public comment Guidelines for Computing Capital for Incremental Risk in the Trading Book as well as Proposed Revisions to the Basel II market risk framework.

"Major banking organisations have experienced significant losses over the last 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." The guidelines support one of the key recommendations for strengthening prudential oversight set out in the Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, which was presented to G7 Finance Ministers and Central Bank Governors in April 2008.

These proposals were developed jointly by the Basel Committee and the International Organization of Securities Commissions (IOSCO). Mr Christopher Cox, chairman of IOSCO's Technical Committee and Chairman of the US Securities and Exchange Commission, noted that the proposed requirements will also apply to investment firms. He added: "The market turmoil has had a severe impact on many commercial and investment banks. The incremental risk guidelines and related changes to the Basel II Framework will contribute to a safer and sounder financial system."

In October 2007, the Basel Committee consulted on proposed guidelines for computing capital for incremental default risk, or the risk that is incremental to the default risk already reflected in a bank's value-at-risk (VaR) model. The application of such an incremental default risk charge, however, would not have captured recent losses in CDOs of ABS and other resecuritisations held in the trading book. The losses that materialised during the market turmoil have not arisen from actual defaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity. Given this and other observations from the market turmoil, as well as comments received through the consultative process, the Committee decided to expand the scope of the capital charge. The proposed incremental risk charge (IRC) would capture price changes due to defaults as well as other sources of price risk, such as those reflecting credit migrations and significant moves of credit spreads and equity prices.

The Basel Committee also proposes improvements to the Basel II Framework concerning internal VaR models. It has further aligned the language with respect to prudent valuation for positions subject to market risk with existing accounting guidance. In addition, it has clarified that regulators will retain the ability to require adjustments to current value beyond those required by financial reporting standards, in particular where there is uncertainty around the current realisable value of a position due to illiquidity.

Once the Basel Committee has finalised the revised requirements, it expects firms to comply with them by 1 January 2010. However, firms will be allowed an additional year to incorporate into their IRC models all risks covered by the proposed IRC beyond default and migration risks for positions subject to credit risk. Until the IRC is implemented in 2010 and to ensure that firms hold adequate capital for resecuritisations, an interim treatment will apply. This interim treatment will be specified in a separate proposal that will be issued by the Basel Committee later in 2008. Over a longer term horizon, the Committee also intends to review the VaR approach for the trading book including the specific risk capital charges under the standardised approach.

In conjunction with this proposal, the Basel Committee will conduct a two-stage quantitative impact study of the IRC on firms' capital requirements. In the first stage, the Committee plans to rely largely on data collected in connection with the 2007 incremental default risk proposal to examine the impact of incorporating default and migration risk into the IRC. In stage two, additional data will be collected to examine the impact of incorporating other risks.

The Committee, through its Trading Book Group, will continue to work closely with industry groups and individual firms during and after the comment period to refine the proposed principles and the supporting supervisory guidance for implementing the new capital requirement.

Comments are invited by 15 October 2008 and may be sent via e-mail to baselcommittee@bis.org.

Alternatively, comments may be addressed to:

Basel Committee on Banking Supervision
Bank for International Settlements
Centralbahnplatz 2
CH-4002 Basel
Switzerland