Basel is consulting on a fundamental review of trading book capital requirements. Its review focused on several key areas:
- The boundary between the trading book and the banking book: the paper criticises using as a determinant the bank’s intent to trade. However, it feels a boundary is necessary and is consulting on two potential definitions. One is based on trading evidence and the other on valuation. The latter suggestion would be likely to result in a larger regulatory trading book.
- Stressed calibration: Basel believes the capital framework should be calibrated to a period of significant financial stress in both the internal models-based and standardised approaches.
- VaR to expected shortfall: The paper identifies various weaknesses in using the value-at-risk (VaR) for working out capital requirements. It suggests using a method based on the “expected shortfall” beyond a given confidence level. It recognises operational challenges with this approach, but thinks the benefits outweigh them.
- Incorporating the risk of market illiquidity: the paper proposes three elements to factor in market liquidity risk – based on an assessment of market liquidity, incorporating varying liquidity horizons and incorporating certain capital add-ons;
- Aligning more closely the treatment of hedging and diversification.
- Creating a clearer link between the internal models-based and standardised approaches and potentially requiring all banks to use the standardised approach.
- Addressing weaknesses in both the models-based and standardised approaches.
- Ensuring positions subject to credit are treated correctly so the risk is properly measured.
The review does not cover interest rate in the banking book or interaction of market and counterparty risk. Basel asks for comments by 7 September. (Source: Fundamental Review of the Trading Book)