Friday, 24 October 2008

Basel 3

I have sniped, perhaps too much, at Basel 2. So it only seems reasonable to outline some alternative proposals, particularly as Lord Turner is apparently open to significant change. Here goes.

Scope. Capital charges should apply to assets, derivatives, and to asset/liability mismatch. In particular funding mismatch and the heavy use of confidence sensitive short term funding like repo should generate a capital charge.

Risk types. There should be capital for market risk, credit risk, counterparty risk and funding liquidity risk. If there is a need for an operational risk charge, it should be a simple expenditure-based requirement.

Models. Given the spectacularly bad performance of risk models, these should be banned for regulatory capital purposes. In particular no diversification benefit should be given. Total capital requirements should be derived by adding up the capital requirements for each risk type.

Asset Liquidity. This should be explicitly included in capital requirements, with market risk capitals being scaled by root t for assets whose liquidation horizon is longer than typical. (Implicitly the current horizon is ten days, so this is a good start.)

Haircuts. These should reflect a prudent move across the cycle. For equity indices, for instance, a reasonable capital charge would be the biggest loss resulting from an 8% move up or down in the index. [For any reg. junkies out there, what I am envisioning here is rather similar to the CAD 1 approach used before the 1996 market risk amendment.]

Anti-cyclicality. There should be a capital buffer over and above the calculated minimum, varying from 25% or more at the good points in the cycle to essentially nothing in a crisis. The availability and cost of leverage, volatility measures, and market returns should be used to determine where we are in the cycle.

Credit risk in the banking book. The revised standardised approach in Basel 2 is not too bad for corporate risk, but it is far too generous for retail and mortgage risk. It's badly designed for securitisations. Revisions will be needed to these capital charges.

Credit instruments in the trading book. These charges need to be completely redesigned.

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Blogger Charles Butler said...

Executive remuneration might be dealt with, if it's within their scope. No more compensating short and paying for it long.

7:29 pm  

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