An Ad Hoc Committee, comprised of representatives of five large investment banks, filed a response with the Basel Committee on Banking Supervision of the Bank for International Settlements (“Basel Committee”) and the International Organization of Securities Commissions (“IOSCO”) on a Consultative Document (“the CD”) entitled The Application of Basel II to Trading Activities and the Treatment of Double Default Effects. The Ad Hoc Committee focused primarily on Parts 4 and 5 of the CD that deal with the trading book and unsettled trades.
“While there is much in the CD with which we agree, significant revisions to the proposed capital requirements for both credit risk in the trading book and unsettled trades are warranted,” said Michael Alix, chairman of SIA’s Risk Management Committee, and a senior managing director of Bear Stearns & Co., Inc., who signed the letter on behalf of the Ad Hoc Committee.
“Managing trading risk is absolutely key for investment banks. Consequently, the Ad Hoc Committee believes it essential that the provisions governing the trading book ‘get it right’ so that regulatory capital is proportional to risk, and firms have appropriate incentives to continually improve their risk management practices,” Alix added.
Consistent with the Basel II framers’ goal to better align risk and regulatory capital, the Ad Hoc Committee’s letter makes the following points:
- While some Value at Risk (“VaR”) models may not adequately capture the credit risk of some trading book positions, the Ad Hoc Committee does not believe that all VaR models are inherently incapable of doing so. Pursuant to Pillar 2 of Basel II, supervisors should consult with investment banks and banks to determine whether their VaR models effectively capture the material risks of their business.
- The Ad Hoc Committee strongly disagrees with the CD’s proposed exclusion from the trading book of some positions that would otherwise meet the definition of eligible trading book assets as contained in Basel II.
- If a regulator determines that a VaR model does not adequately capture default risk, an “Incremental Default Risk Capital” charge should be developed that is grounded in risk-based principles.
- The proposal to increase what are already inappropriately conservative standardized risk charges is a mistake. The concept of standardized risk weights should be rethought to ensure that any such charges are appropriately risk-sensitive.
- The proposals for the treatment of unsettled transactions would create a very significant operational burden, and result in punitive capital charges for risks that -- in the experience of investment banks -- have not been material.