Tuesday, 24 February 2009

Changes to Basel II Would Require Banks to Hold More Capital Against Trading Risk. Too Late?

The Basel Committee's proposed changes to Basel II for financial institutions worldwide would require banks to hold more capital than they do now against their trading books. Standard and Poor's says the changes will be more consistent with underlying market risks. S&P analyst Thierry Grunspan says the proposed regulatory capital requirements for market risk are likely to be less procyclical than current rules. But, are these changes coming too late, or not?

Yes. But evidence shows that market participants tend to forget lessons from previous crises during liquidity boom periods. So, better to prevent than regret -- as the old Colombian idiom says. In general, market participants see the proposed changes as positive because they will force banks to engage into more prudent risk management, improve dealing with specific risks about complex markets like derivatives and structured finance, treat illiquidity risk more carefully. The reckless days of disgruntled risk management for extreme market movement risk, which was underestimated in the current regulatory framework according to Grunspan, might be over. ''Due to the underweighted regulatory capital requirements for the trading book under current rules, returns on equity on banks' trading activities were artificially high,´´ he says, adding this ''may have given some banks an incentive to develop their trading books excessively.´´

Thus, if changes to Basel II are implemented, the new regulation should discourage banks from taking on risk in a benign market environment by accumulating large trading positions that turn out to be hard to manage when market conditions deteriorate. The changes would be effective Jan. 1, 2011 if implemented. They feature three major changes to Basel II's Pillar 1, some recommendations for Pillar 2, as well as expanded requirements for public disclosures by financial institutions under Pillar 3, according to S&P.

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