In this paper we have argued that any new regulatory capital regime which is proposed by the Basel Committee at the end of the current consultation period will have to take into account the implications which changing risk management practice at firms carry for the valuation of credit portfolios and the definition of capital as well as the implications of the changing business profiles of financial firms for the character of international systemic risk if it is to prove sufficiently robust to apply for the foreseeable future to all internationally active financial firms. We believe that the implications of these developments are extensive. In particular, they require a better understanding of the difference between expected loss and unexpected and stress loss in managing and controlling risk, in the accounting treatment of financial instruments and in assessing the adequacy of a firm's capital. At the same time they require a broader definition of risk at financial firms which analyses in generic terms the extent to which a firm is vulnerable to a shock to its total earnings stream, taking into account in particular the extent to which liquidity management and capital interact in trading markets.

The central conclusion of the paper is therefore that any system of regulation that is designed to protect against systemic risk in international markets needs to provide a high level of confidence that the firms which are supervised are able to survive any reasonable combination of stress shocks to their earnings with their capital sufficiently intact to ensure that they can continue in business long enough to allow appropriate remedial action to be taken either by the firm itself or by the regulator. Moreover, the approach has to provide a similar level of confidence at all systemically significant firms whatever risks they face and whatever business mix they may have. Our analysis of the current Basel Committee's approach to calculating regulatory capital suggests that it will not be able to fulfil these for two principal reasons. First, the approach, which seeks to derive the capital which a firm requires directly from the components of a its portfolio of assets, does not distinguish between the expected and the unexpected component of risk in the credit portfolio. This means that firms which already provide for the expected loss component of their credit risk will be disadvantaged in terms of the regulatory capital requirement relative to those firms which only realise credit losses as and when they arise. Secondly, because the approach only seeks to measure the extent to which a portfolio could be negatively affected by adverse events, but fails to take into account the important role which earnings play in absorbing losses, it cannot discriminate effectively between those firms which are at risk of a loss and whose capital would indeed be at risk from such an event and those which are well placed to absorb losses out of their normal earnings stream. As a result it is not possible to derive any meaningfully comparable implied regulatory safety margin across different firms from the individual capital requirements which are calculated using this approach.

In view of these limitations, we believe that an alternative approach is now needed which should have two components. First we believe that the regulatory capital regime should seek directly to assess the extent to which a firm's earnings are vulnerable to stress losses of any type - a measure we refer to as regulatory equity at risk - and should then establish a capital requirement which is sufficient to provide a high level of assurance that the firm could survive such a stress event and still remain solvent during a work out period. Secondly we argue that there needs to be much more explicit regulatory oversight of the liquidity management arrangements in place at the firm, since effective liquidity management arrangements rather than capital provide the primary protection against any stress events affecting the firm

We believe that the proposals in this paper not only represent a significant improvement over the current Basel Committee proposals for setting regulatory capital requirements, but would also provide a sound theoretical and practical basis for a broader international regulatory framework for internationally active financial firms over the next ten years. We also believe that an approach of this type, which recognises expressly the role which capital plays in protecting against systemic shocks and large adverse price movements, would establish the basis for addressing the related issues of valuation and provisioning within financial firms. Indeed, although it is largely outside the scope of this paper, we are convinced that the current accounting rules for financial firms which prevent firms from maintaining reserves which can be used to absorb such unexpected shocks, can act as an amplifying factor in periods of market stress. As a result the issue of accounting standards needs to be addressed in parallel with the regulatory capital issue if we are to develop a fully integrated approach to the reduction of systemic risk in international markets.

The benefit of such an integrated approach, if it could be achieved, would be very significant. Indeed, it could provide the basis for resolving one of the most troubling and long lasting problems in finance, which is the challenge of distinguishing between a liquidity and a solvency problem at a financial firm. This issue is essentially a problem of how to value the assets of a financial firm which is in difficulty. It lies at the heart of the regulatory capital debate and is also the principal source of the moral hazard which particularly concerns central banks in their role of lender of last resort to the financial markets. But progress in risk management and risk measurement practices at financial firms in recent years brings with it the prospect that this conundrum could be resolved within the foreseeable future. If this could be achieved it would have very positive benefits for both firms and central banks by allowing them to operate with much greater transparency and certainty than ever before. The equity at risk approach to regulatory capital which we have outlined here would be a significant step in this direction, and we hope that it will receive serious consideration by both the industry and the regulators.

Contact: Mr Tim.shepheard-walwyn