WASHINGTON — While the cursed Basel II capital proposal has stolen the spotlight, a separate plan to better assess a bank's market risks is cruising toward completion.
The plan would force a large bank to move more of its trading positions to its banking book, which in turn would drive up capital requirements.
The trading book, which holds financial instruments banks expect to trade quickly, requires much less capital than the banking book, which will be governed by Basel II's rules on credit risk capital.
Comments on the market risk rule are due to regulators by Jan. 23 and industry representatives are already claiming the cost of business will soar if banks are forced to transfer many positions to the banking book.
"It is clear banks will have higher costs with this. It will cause some shifts in their portfolios," said Robert Strand, an economist at the American Bankers Association.
The market risk proposal would apply to roughly 20 banks whose trading activity is either 10% of assets or exceeds $1 billion.
The plan was prompted by the international Basel Committee on Banking Supervision's 2004 adoption of rules to prevent banks from hiding on their trading book those items that actually belong on the banking book.
U.S. regulators first moved in this direction in 1996, requiring banks to hold capital against such risks as changes in interest rates, credit spreads, or foreign exchange rates. The new proposal updates that rule and covers thrifts for the first time.
Regulators now plan to force banks to hold more capital against sudden market events and high concentrations either by asset category or geographic area. They also want banks to consider the entire so-called specific-risk portfolio when developing models to calculate capital requirements. Banks without such a system in place by 2010 would have to use a formula designed by regulators.
Banks also will face new capital charges for incremental default risks, such as credit swaps. Regulators are worried that some of the positions that will remain on the trading book could still be risky enough to warrant additional capital. These calls would be left to a bank's examiner.
Most observers expect the market risk proposal to lead to higher regulatory capital levels.
"The regulators are trying to buy some insurance against what they don't know," said Christopher Whalen, the managing director of Lord, Whalen LLC's Institutional Risk Analytics.
"I would expect for most banks, these rules would be a net capital cost," said Karen Shaw Petrou, managing partner of Federal Financial Analytics Inc. "It ends arbitrage, and to the degree that things are moved to the banking book, there's no offsetting benefit."
Mr. Whalen sees the proposal as a means for regulators to ensure capital increases even if Basel II collapses. "I've had a number of regulators tell me point-blank that if they don't have Basel II, they'll approach issues piecemeal," he said.
Other coming changes may not require more capital but could be hard to implement, industry representatives say. For instance, under the market risk proposal banks would have to develop policies and procedures on what should be included in their trading books and to comply with beefed-up disclosure rules.
Mr. Strand said bankers reviewing the plan are frustrated.
"They're finding it much like Basel II - overly restrictive and proscriptive," he said. "Banks are supposed to develop their process as long as it's the right process for the bank. This, on the other hand, goes beyond that and specifies how it should be done."
Regulators are clearly writing this rule with an eye toward moving more items to the banking book.
"The agencies are concerned … that a bank could craft its hedging strategies in order to bring nontrading positions that are more appropriately treated under the credit risk capital rules into the bank's covered positions," according to the proposal. "The agencies will scrutinize a bank's hedging strategies to ensure that they are not being manipulated in this manner."
Regulators did not provide a list of acceptable positions that may be held on the trading book. Instead, banks would have to justify why each position belongs there, leaving the possibility that examiners could force banks to transfer certain items to the banking book.
Most of the 20 banks subject to the market risk proposal are expected to adopt Basel II, but a few will have the option to use Basel IA. Since that proposed rule is expected to be voluntary, a few banks might even remain on Basel I.
Each version of Basel treats the banking book's credit risk differently, so a bank's overall capital level could depend on which rule it follows.
"That's a unique difference between the U.S. and international approach," Ms. Petrou said. "No one else has all these choices."
That could create more competitive problems if U.S. banks are operating under capital standards that banks in other countries are not facing. Bankers are already in a row with regulators over whether to require the advanced version of Basel II in the United States, arguing that it would create a competitive disadvantage.
Pam Martin, the regulatory affairs director at the Risk Management Association, said that if the U.S. version of the market risk proposal "is very different from what's being implemented in the EU, then we're going to have a very big problem."
To make matters even more complicated, Basel IA and Basel II will not be in place when the market risk rule is slated to take effect, Jan. 1, 2008. That means banks will initially use Basel I to determine capital for the banking book before making the transition to Basel IA or Basel II.
Given the roadblocks that have delayed Basel II, some observers doubt the market risk rule will be implemented on schedule.
"I think that in and of itself is an impossibility," Ms. Martin said.
But regulators seem determined to move forward. Earlier this month the Federal Deposit Insurance Corp. approved a 90-day extension for comments on Basel IA and Basel II but refused to do so for the market risk plan.
