The Application of Basel II to Trading Activities and the Treatment of Double Default Effects

Note: This document has been incorporated in the comprehensive version of International Convergence of Capital Measurement and Capital Standards: A Revised Framework, including the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process and the 1996 Amendment to the Capital Accord to Incorporate Market Risks.

Introduction

The efforts of the Basel Committee on Banking Supervision (BCBS) to revise the standards governing the capital adequacy of internationally active banks achieved a critical milestone in the publication of an agreed text in June 2004. The International Convergence of Capital Measurement and Capital Standards: a Revised Framework2 describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities represented on the BCBS are now working to implement through domestic rule-making and adoption procedures.

The "Basel II" framework, or Revised Framework, as the new standard is frequently called, seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Revised Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, the Revised Framework is intended to be more flexible and better able to evolve with advances in markets and risk management practices.

In releasing the Revised Framework last summer, the BCBS re-iterated its intention to maintain its active dialogue with the industry to ensure that the new framework keeps pace with, and can be applied to, ongoing developments in the financial services sector. Two areas that the BCBS identified where immediate work should be done concerned (1) finding a prudentially sound treatment under the Revised Framework for exposures to "double default," where the risk of both a borrower and a guarantor defaulting on the same obligation may be substantially lower than the risk of only one of the parties defaulting; and (2) applying the Revised Framework to certain exposures arising from trading activities.

Given the interest of both banks and securities firms in the potential solutions to these particular issues, the BCBS has worked jointly with the International Organization of Securities Commissions (IOSCO) to consult with industry representatives and other supervisors on these matters. This paper describes a proposal to address five specific issues related to double default and trading activities prior to the implementation of the Revised Framework. These issues consist of the following:

1. the treatment of counterparty credit risk for over-the-counter derivatives, repo-style and securities financing transactions; and the treatment of cross-product netting arrangements;
2. the treatment of double-default effects for covered transactions;
3. the short-term maturity adjustment, in the internal ratings-based approach;
4. improvements to the current trading book regime, especially with respect to the treatment of specific risk; and
5. the design of a specific capital treatment for failed transactions and transactions that are not settled through a delivery-versus-payment framework (non-DvP).

While this work was undertaken jointly by working groups from the BCBS and IOSCO, the resulting proposal represents an effort by the BCBS to find prudential treatments for certain exposures held by banks under the new capital standards outlined in the Revised Framework. Consequently, this text frequently refers to rules for "banks", banking groups, and other firms subject to prudential banking regulations. The BCBS recognises that, in some cases, national authorities may decide to apply these rules not just to banks and banking groups, but also to investment firms or to combined groups of banks and investment firms. In such cases, national authorities may additionally wish to apply the treatments specified in this proposal to investment firms, to groups of investment firms, and to combined groups of banks and investment firms that are subject to prudential banking or securities regulation.

The BCBS released a first version of this proposal in April 2005, for consultation purposes. Thirty-seven comments have been provided by banks, investment firms, industry associations, supervisory authorities, and other interested institutions. The BCBS and IOSCO wish to thank representatives of the industry for their fruitful comments. The BCBS and IOSCO worked diligently, in close cooperation with representatives of the industry, to reflect their comments in the present paper.