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Equity at risk

7 - From the Basel Committee proposals to equity at risk

In Section 2 of this paper, we set out five tests which should be met by a revised international regulatory regime for financial firms. We believe that the approach we have outlined above fully meets the first four of these tests which are

  • 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

This leaves us with the last of our five requirements for a new regulatory capital regime which is:

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

In this context, we need to recognise that there are three aspects to our proposed regime which are not currently addressed by the current Basel Accord or in the current Basel Committee discussion paper. These are

  • a recognition of the role which earnings play in absorbing losses and protecting the capital of the firm; and

  • the use of stress loss measures as the basis for assessing a firm's potential exposure to a systemic shock

  • an explicit focus on liquidity management in assessing the adequacy of risk management practice at individual firms

Whilst we recognise that these proposals may appear to advocate a radical departure from the approach advocated in the June discussion paper, in practice we believe that the transition from the existing regime to the one advocated here could be achieved relatively easily. Indeed, the approach builds on much of the work which has already been undertaken by the Basel Committee in the field of both risk management practice and disclosure. In particular, the estimation of a firm's exposure to stress losses in its market and credit risk portfolios would be a natural extension of the work which has already been undertaken by the Committee in the context of market risk and is currently under way in the field of credit risk modelling. Moreover, the increased regulatory focus on issues of funding and liquidity could easily be absorbed within the second and third pillars of the proposed approach. This could be achieved by making express reference in both these sections to the importance of regulators reviewing firms' liquidity policies and of the importance of firms providing appropriate information to their own liquidity providers as part of their standard disclosure practices.

Further our proposed approach would remove an internal illogicality which exists in the current proposal. This is that the capital requirements set under Pillar 1 are intended to be risk based, whilst at the same time the firm is required to demonstrate under Pillar 2 how it ensures that risk relates to capital through its own capital allocation process. If the regulatory capital regime meets the test set our above it would provide a consistent and self reinforcing basis under each of the three pillars of capital requirements, regulatory review and in particular the disclosure requirements.

The remaining consideration would thus be how to manage a transition from the current balance sheet based capital calculation to the equity at risk calculation. We would suggest that the Committee could adopt a dual track approach which would run in parallel with the work which is currently under way to allow firms to utilise internal credit rating systems and portfolio models for calculating their capital requirements for credit risk. This approach would permit banks which already have demonstrated their ability to calculate their market risk capital requirement using the current VaR methodology and which have the ability to measure their credit exposure and potential credit stress losses using their internal ratings methodologies to calculate in addition their capital requirement using the equity at risk methodology. This should not be difficult for the firms involved, since many of the input elements for the two calculations would be the same. This would then allow a period during which the results of the two approaches could be assessed and the differences analysed and understood, allowing a decision to be made at a later stage whether or not to permit firms to transfer fully to the equity at risk methodology.

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