The publication of the Basel Committee's paper proposing revised capital adequacy framework for banks is a significant event in the development of international financial regulation. The existing 1988 Accord which first established a common capital adequacy framework for banks has become the international standard by which banks are assessed in terms of their capitalisation, and within the EU has also become the standard for capital adequacy for securities firms. However, as the Basel Committee recognises, the 1988 approach has become significantly outdated as a result of market developments and consequently the Committee has initiated a consultation process with a view to updating the framework.

The approach which the Committee is proposing has three elements:

• an updated capital adequacy framework which seeks to relate minimum capital requirements more accurately to the risks which banks face

• an enhanced process for supervisory review of banks; and

• improved market discipline through better public disclosure

While much of the detail of the proposed new regime has yet to be determined, the overall direction of the review has been broadly welcomed on the grounds that it will address the most pressing concerns about the inadequacies of the existing regime. In particular, it should help to address the most obvious types of regulatory arbitrage and disincentives to good practice in credit risk management which are associated with the 1988 Accord.

We share these sentiments, and welcome the Basle Committee's initiative in inviting a debate about the future framework for regulatory capital. However, in view of the fact that the framework which is agreed upon at the end of the current consultation period will almost certainly establish the foundations for capital regulation for the next ten years not just for commercial banks but for all internationally active financial firms, we believe that it is important to consider whether the underlying theoretical basis for the Basel Committee's capital is appropriate for the firms to which it will apply in the future.

In this context it is important to recognise that the Basel Committee approach is based on a traditional banking view of the world, where the core risk which a firm faces is the credit risk in its lending portfolio. Moreover, the approach is based on the fundamental assumption that credit losses are essentially random events which are only realised and passed through the p&l account as and when they arise. As a result, within this approach capital is viewed as the primary buffer against the credit losses which are inherent in the balance sheet and regulatory capital is a primary tool to protect against the systemic risk associated with a rise in realised credit losses.

In the future, we believe that it is highly questionable whether this approach to setting regulatory capital will remain appropriate for the internationally active financial firms to which the Accord will in practice apply either directly, because they are regulated as banks, or indirectly because they are subject to the Capital Adequacy Directive within the EU. We believe that these firms will no longer manage their credit exposure on a buy and hold basis using traditional accrual accounting and default based loss recognition. Instead they will adopt an active portfolio management approach to managing their credit risk and will account for their credit exposure on a mark to market or fair value basis with anticipated credit losses being appropriately reserved or passed through the P&L account on a continuing basis. In this environment it is clear that income rather than capital acts as the primary buffer against loss, whether from credit related events or from other sources of risk.

Moreover, as recent events have demonstrated, systemic risk in the modern international financial market, which is increasingly characterised by securities and trading activities rather than by traditional commercial lending, is itself of a significantly different nature. This raises the question as to whether the Basel Committee proposals, which explicitly state that regulatory capital requirements remain the primary regulatory tool to protect against systemic risk remain valid. In particular, we believe that any effective regulatory framework needs to recognise the critical importance of effective liquidity management within firms as a primary protection against systemic risk, together with the link between capital and funding.

In view of these considerations, and the strategic importance of this issue to the future shape of international finance we believe that it is essential for there to be a full discussion about the best way to devise an appropriate regulatory capital framework for internationally active financial firms. This should build on the considerable work that the Basel Committee has already undertaken in seeking to modernise its approach and make it more sensitive to the actual risk which banks face, but should also explicitly recognise that the framework which is agreed at the end of the consultation period needs to be applicable in an even handed way to all systemically significant firms. In particular, we believe that to be robust the regime needs to meet the following five requirements:

• it meets the core regulatory requirement of protecting against systemic risk

• it can be applied to all systemically significant financial firms;

• it is consistent with the way that the firms manage risk and capital internally;

• it avoids perverse incentives and market distortions; and

• it can build on the existing Basel Committee approach in an incremental manner

In the rest of this paper we examine in more detail the factors which are driving the need for a new approach to setting regulatory capital requirements, and outline our proposal for an alternative approach based on the calculation of a firm's potential exposure to loss in the event of certain stress loss events which we refer to as 'regulatory equity at risk'.