one of the most important meetings of the Basel Committee on Banking Supervision since the group came out with risk-based capital standards in 1988. At issue is market risk - the danger banks face from sharp price shifts in the stock, bond, currency, and derivatives markets. The Basel Committee tried to factor these risks into the capital standards set in 1988, but couldn't agree on how to do it. Now, with derivatives and other trading activities making up an ever- bigger chunk of money-center banks' business, Basel Committee Chairman Tommaso Padoa-Schioppo of Italy has said he wants the group to complete market-risk capital rules by the end of this year. The rules proposed by the Basel Committee in April would give banks the option of following a standardized regulatory formula to determine how much capital they must set aside for trading risk, or using their own internal models - subject to checking by regulators - to provide an appropriate capital cushion. Using banks' internal models to set capital requirements is a major innovation for regulators. Though the market-risk rules will apply to only about 25 big U.S. banks and a few smaller ones with big trading portfolios, the reliance on banks' own models could set a precedent that eventually will affect much more of the industry. "It is new territory for us in capital regulation," said Susan Krause, senior deputy comptroller for bank supervision policy, who will be one of the Office of the Comptroller of the Currency's representatives at the two- day Basel Committee meeting. "It's very promising, and it is an approach we ought to consider for other areas of capital regulation." Banks have reacted favorably to the idea, though they've been extremely critical of some of the particulars of the Basel Committee proposal. For instance, while the proposed standards would let banks use internal models to determine their market risk, it calls on regulators to multiply those estimates by a factor of three to compensate for anticipated low estimates by individual institutions. The capital requirement would be derived from the higher figure. The biggest U.S. banks, which dominate the global over-the-counter derivatives business, have been far more enthusiastic about a tentative proposal floated over the summer by the Federal Reserve Board. The Fed's "precommitment approach" would let banks decide for themselves how much capital to set aside for their trading activities, then face penalties if their trading losses exceed that amount. Three big-bank trade groups - the New York Clearing House Association, the Bankers Roundtable, and the International Swaps and Derivatives Association - have urged the Fed to start testing the precommitment approach. In a recent speech in New York, J.P. Morgan & Co. managing director Mark Brickell, a leading derivatives industry spokesman, said he hoped the Basel Committee would "keep the door open for the use of precommitment - perhaps as an 'advanced' version of the internal models proposal." That isn't likely to happen, Ms. Krause said. "The market-risk proposal is well 'in train,' as the Europeans say. It's not taking any detours because of the Fed proposal." A Federal Reserve official said his agency doesn't expect any detours either. "There won't be any attempt to make this a third alternative at this point within the Basel framework," he said, "although we would hope the Basel group would leave room for it." But there may be a hitch. "The precommitment approach is on its face problematic from the European perspective because the Europeans are committed by law to take a different approach," said Barbara Matthews, an associate with the law firm of Morrison & Foerster in Washington, who specializes in derivatives regulation. That European approach is something called the Capital Adequacy Directive, approved by the European Parliament in 1993. The directive, modeled on the standardized portion of the Basel market-risk proposal, goes into effect for European banks in January. U.S. banks and their regulators have been less comfortable with standardized market-risk measures than their European counterparts. But the United States, though it is represented on the Basel Committee by officials from the Comptroller's office, the Federal Reserve Board, the Federal Reserve Bank of New York, and the Federal Deposit Insurance Corp., gets only one vote; European Community members have seven.
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