In Focus: 5 Years in the Making, New Market Risk Rule Seen Just a

No one is satisfied with the market-risk capital rule adopted by federal regulators last week.

When the Federal Reserve Board approved the new rule Aug. 7, Chairman Alan Greenspan said it "verges on the obsolete."

"This has got to be viewed as only a beginning," Comptroller of the Currency Eugene Ludwig added in an interview last week.

Regulators here and abroad have been working on this rule for more than five years. They estimate a new market-risk rule will be needed in another five years as more sophisticated means of measuring a bank's exposure are developed.

"The problem is when you lock today's risk management models into a regulation, it becomes a challenge to incorporate tomorrow's advances into the regulation's framework," said Mark C. Brickell, managing director at J.P. Morgan.

Despite the rule's shortcomings, observers said a combination of international politics and a lack of viable alternatives gave the regulators little choice but to forge ahead.

Market risk is a bank's exposure to changes in the value of its securities portfolio. The rule requires active trading banks to use an internal model that can calculate the expected loss if its stocks, bonds, and foreign exchange contracts decline in value for 10 straight days. The model produces a value-at-risk figure, which the bank multiplies by three to produce the capital requirement for the upcoming quarter.

Mr. Greenspan conceded that the rule doesn't - and cannot - address every aspect of market risk. The rule need not "be fine-tuned to the point where it captures everything because it won't," Mr. Greenspan said.

So what's the matter with the new rule?

Bankers are complaining that the rule will produce inaccurate capital requirements because it assumes a bank will not change its portfolio during the coming quarter. That's not realistic, because banks often buy and sell securities in their portfolios.

Also, bankers are worried they will have to run two models side by side. As more sophisticated models are developed, banks will be able to peg more accurately the future value of their securities. But these models typically capture only a single day's drop in prices, rather than a 10-day fall as required under the new rule.

That means the new models won't satisfy regulators. Bankers will have to operate one model for capital purposes and another for planning purposes.

Still, bankers emphasize that the new rule is much better than what might have been. The international Basel Committee on Bank Supervision originally wanted to require all banks to use a standardized model to calculate capital reserves. U.S. banks, saying this one-size-fits-all approach was less accurate than their internal models, persuaded federal regulators to bully the Basel Committee into allowing use of either a regulatory or internal model.

U.S. regulators, having fought for this approach, couldn't abandon it. That said, the Fed is field-testing an alternative at some New York banks.

This so-called "precommitment approach" lets banks set capital levels without having regulators poring over their internal models. Banks will be hit with hefty fines if they underestimate how big reserves should be. Officials said this approach is several years away from wholesale adoption.

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