The Federal Reserve Board on Wednesday adopted a rule requiring large domestic banks to increase their capital as a cushion against trading losses.
The Fed estimated each of 15 affected institutions will have to set aside an additional $100 million to $200 million.
While the rule only applies to the biggest U.S. banking institutions that are active in securities trading, it is seen as an important advance in regulators' campaign to align capital requirements with risk levels.
The rule also breaks new ground in allowing the banks to use their internal modeling systems as the basis for making the capital calculation.
"This represents a substantial step forward," Clinton Lively, managing director for global risk management at Bankers Trust Co., said after the central bank issued its rule. "This is a tremendous achievement in rationalizing bank capital standards."
Bankers Trust is one of the 15 companies that come under the rule, with trading assets and liabilities exceeding 10% of total assets or $1 billion. These institutions, not named by the Fed, account for 97% of securities trading by banks.
Effective Jan. 1, 1998 - or a year earlier if they wish to opt in - the banks will rely on internal models to determine how much they could lose if their securities portfolios dropped in value over 10 days. The amount that has to be added to capital is derived from that risk value.
The trading-capital rule, also being adopted by the other banking regulators, is the agencies' third major risk-management initiative in the past year. They started risk-based examinations last winter and approved rules earlier this summer governing how banks should protect against swings in interest rates.
There may be still more to come on market risks. Federal Reserve Chairman Alan Greenspan said the securities markets are evolving so rapidly that the current approach will be outdated within five years.
"Every single procedure we employ is a transitional one," Mr. Greenspan said during the Fed's open meeting Wednesday. "The date we promulgate the rule, it verges on the obsolete."
The Fed is moving forward with a replacement system, he said. Known as the "precommitment approach," it would allow a bank to set its own capital requirements. But banks that did not set aside sufficient reserves would pay hefty fines.
For the time being, all the agencies have agreed to rely on banks' internal models. The Office of the Comptroller of the Currency approved the rule late Tuesday, and the Federal Deposit Insurance Corp. is expected to act next week.
The Fed said banks can meet the trading-risk standards by issuing a new form of capital, Tier III. It would consist of short-term securities that owners could not cash in at maturity if the bank were undercapitalized.
Regulatory officials said they expect U.S. banks will have plenty of conventional options to raise the additional capital. They said some foreign markets are more likely to see Tier III capital materialize.
Regulators currently don't require banks to hold capital specifically against potential swings in the value of their securities portfolios. But the Basel Committee on Banking Supervision, an organization of regulators from major industrialized countries, approved a resolution in 1993 requiring market risk rules by Jan. 1, 1998. The Basel Committee amended that draft in April 1995, proposing that banks use either their own models or a standard regulatory model.
The U.S. rule departs from the 1995 proposal by not including the regulatory model. The bank models must be able to accurately specify 99 times out of 100 how much an institution could lose from the equivalent of a 10-day drop in the value of its portfolio.
This equation produces a "value-at-risk" figure, which reflects the amount a bank could lose on a single day. The bank multiplies the value-at- risk by three to produce the market-risk capital requirement.
Banks must back-test these models quarterly to ensure they work. The rule permits the model to fail up to four times per year. But examiners can impose penalties for additional failures by increasing the number the value-at-risk figure is multiplied by, thereby increasing the capital reserve. More than 10 failures would reflect an more systemic problem with the model, regulators said.
The rule also requires examiners to judge whether a bank's risk-control unit is independent of its trading unit, whether senior officials set risk management strategy, and whether the bank subjects its model to stress testing.
The market-risk rules do not eliminate a bank's capital requirements for covering credit, or default, risks. But the credit-risk requirements are lower on assets covered by the new market-risk rules.
