In Focus: Precommitment System For Market-Risk Capital Said to Succeed

An experimental technique for setting capital requirements to cover swings in securities prices has cleared its first hurdle.

Reporting the results from the first quarter of the experiment, Jill Considine, president of New York Clearing House Association, said none of the 10 banks testing the so-called precommitment approach to market risk needed more capital than they set aside for price fluctuations.

"They took a conservative approach," Ms. Considine said. "They didn't want their peer group or their primary regulator to know they went through their capital."

The precommitment approach to market risk requires banks at the start of each quarter to inform regulators of their market risk capital requirements. Banks that underestimate their capital needs are fined.

Ms. Considine declined to reveal which banks are participating. But she said for the first time that they included four members of the clearing house, four other American banks, one European bank, and one Japanese bank.

To set their capital requirements, the 10 banks used a three-step system. First, they employed statistical models to predict how the economy would perform during the next three months. They then ran these predictions past experienced traders to make sure that they made sense. Finally, they vetted their analyses past the chairman of the bank.

"They all took this very seriously," she said. "They saw this as a threat to their reputation."

The Federal Reserve Board first raised the precommitment approach in January 1996 and the New York Clearing House began a trial at the start of the fourth quarter.

"I'm enthusiastic about the results so far," Ms. Considine said during an interview at a recent conference sponsored by the Federal Reserve Bank of Atlanta. "But I cannot say yet for sure that this is the way to go."

The experiment will run for three more quarters, Ms. Considine said. Still to be resolved is how regulators will punish banks that fail to reserve enough capital. Regulators have discussed fining banks, but Ms. Considine said the threat of publicly disclosing the shortfall may work better.

"The penalty of market discipline rather than a financial fine is the biggest deterrent," she said.

The precommitment approach is a possible successor to the internal model rule for market risk, which kicks in Jan. 1 for banks that trade more than $1 billion a year in securities. The rule requires banks to use their own models, subject to certain technical requirements, to set capital levels.

Bankers have complained about these technical requirements, saying they will force them to run one model for internal use and one model for regulatory purposes. The precommitment approach would resolve this complaint by freeing banks to use whatever technique they want to set capital reserves.

Ms. Considine said the clearing house would expect precommitment to replace the internal model rule. If it did not, the group would have to reevaluate its support for precommitment, she said.

Any change to the market risk capital requirements would have to be approved by the Basel Committee, an international group of banking regulators. The clearing house included two foreign banks in the pilot program to head off criticism by other Basel Committee members that the precommitment approach only works for U.S. banks, she said.

"We wanted a global scope so they couldn't say this just works in America," she said.

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