Wednesday, 15 October 2008

Basel 2: Installing smoke alarms while Rome burns

I have detected a slightly more sarcastic tone than usual in my recent posts and I had resolved to be nicer. But then something like this comes along:
The Basel Committee/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank’s value-at-risk model. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks’ trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. At its meeting in March 2008, the Basel Committee on Banking Supervision (the Committee) decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II Framework.
The details are here and here.

What's wrong with this? Well, at least three things. Firstly we still have VAR as the basis of market risk capital. Until Basel throws that out and comes up with something more prudent, probably based on stress tests, the Basel 2 market risk capital framework will rightly remain a laughing stock.

Secondly, not only have the supervisors kept VAR, they still believe that procyclical, miscalibrated risk models are a good idea, and they want more of them, even though they know banks cannot model the risks they are trying to capture:
Because a consensus does not yet exist with respect to measuring risk for potentially illiquid trading positions, it is anticipated that banks will develop different IRC modelling approaches. For example, a bank could develop a comprehensive asset pricing model incorporating both diffusion and jump processes for price movements over liquidity horizons
Finally, the proposed incremental capital charge is much higher for liquid, trading book assets than for held to maturity assets of the same risk profile in the banking book. That is simply wrong. So, Basel Committee, step away from the rule book: you have lost any credibility you might have had before the Crunch. Let's start again, ideally with a different set of rule makers. Perhaps the white rabbit is free.

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