7:57 AM Dec 12, 1995

ADDITIONAL CAPITAL CHARGES ON TRADING BANKS

Geneva 12 Dec (Chakravarthi Raghavan) -- Banks engaged in securities and derivatives trading, effective atleast end-1997, may need to make additional capital provisions to cover market risks arising from their activities in securities and derivatives trading.

The Governors of the Central Banks of the G-10 industrialized countries, at their meeting in Basle Monday, have accepted the proposal of the Basle Committee on Banking Supervision to amend the Basle Capital Accord of 1988 to take account of the market risks that individual banks, and the banking system, face as a result of their involvement in such trading activities, not only on behalf of their clients, but on their own behalf.

A communique issued in Basle Tuesday by the Basle Committee said that a full package of papers incorporating a detailed amendment to the 1988 accord would be released early in January 1996 and the amendment is to take effect latest at end-year 1997.

An analysis of the full effects of the proposed changes would need to await the full package of papers become available and could be studied.

While many banks would find they would need to make additional provision for capital charges to take account of the risks, some may find their capital requirements, judged now on the basis of their "credit risks" may be reduced as a result of different criteria for credit risk and market risk.

Hitherto the market risks involved in trading were absorbed so to say in the credit-risk calculations for capital requirements, but one effect of the latest Basle Committee changes would be to separate them.

The Basle Committee came into being in the wake of the collapse of the Bankhaus I.D. Herstatt and the Franklin National Bank, and this resulted in what became known as the Concordat of September 1975.

Since then the Committee has been regularly revising the provisions and rules for better supervision, including clearly laying down the responsibility of the Central Bank of the home country of the private bank, both for operations on its territory as well as branches abroad, and for cooperation and sharing of information among the home and host central banks.

But from the 1974 Herstatt case -- through the Italian Ambrosiano (which hit the public eye when its head Calvo had a 'suicidal hanging' from a London Bridge, but was widely suspected to be case involved the Italian Mafia and its use of the bank) and the Vatican bank (whose head was practically confined to the Vatican to escape extradition) and the Bank of Credit and Commerce International -- down to the latest Barings and Daiwa bank cases, has always appeared to outsiders to be a case of G10 Central Banks trying to lock the stable after the horse is stolen.

The problem with the G-10 Central banks is perhaps because they are pushing everywhere for privatization and liberalisation concepts, preserving only their own right to issue money and earn seigniorage on it - a preserve that the new smart cards threaten.

At a meeting with foreign correspondents in Switzerland at Basel on 1 December, the General Manager of the Bank of International Settlements (BIS), Mr. Andrew Crocket, sought to play down the fact they are always one step behind the traders bending rules. Crocket said that no set of rules could prevent individual failures, nor could there be guarantees against any failure without encouraging moral hazards for operators. The international supervision, he said, could only focus on systemic risks. Judged by that, the action of the Bank of England in refusing to rescue the Barings, showed there had not been systemic risks.

But these finer points of regulation, deregulation and supervision, and all being attributed to the 'compulsions of globalization' could sit well on experts and central bankers, have not been reassuring to the public at large who are beginning to question globalization itself.

The Basle Committee had published in April, for comments by banks and financial market participants, a package of proposals for applying capital charges to market risks of banks. A revised version of this, in the light of the comments, are to be issued in January. The G10 Central Banks at their meeting Monday have endorsed these revised proposals for amending the Basle Capital Accord of July 1988.

The Basle Committee has accepted the view of the industry that, as an alternative to a standardised measurement framework of the earlier proposals, industry should be allowed to use "proprietary in-house models" for measuring market risks. However, to ensure transparency and consistency of capital requirements across banks, the Basle Committee has defined a number of qualitative and quantitative criteria for banks wishing to use their own proprietary models for capital purposes.

Under these 'qualitative standards', a bank's board of directors and senior management are to be actively involved in the risk control process; the banks have an independent risk control unit; the model by closely integrated into the day-to-day risk management; and that a rigorous programme of stress testing be in place.

Banks, the Basle Committee has said, must have a routine for ensuring compliance with documented internal controls and procedures and must ensure an independent review of both risk management and risk measurement is carried out at regular intervals and, additionally, procedures prescribed for internal and external validation of risk measurement process.

In terms of quantitative standards, the new guidelines require that "value-at-risk" should be computed daily, using a "99 percentile, one-tailed confidence internal" and that a minimum price shock of ten days or holding period be used. The model is also to incorporate a historical observation period of atleast one year.

The Basle Committee communique suggests that as a result of the changes from its April 1995 proposal, banks will have more flexibility in specifying model parameters, including possibility of recognising correlation effects across as well as within broad risk factor categories.

While recognising that use of proprietary in-house models to measure market risk for supervisory capital purposes would be a "significant innovation" in supervisory methods, the Basle Committee has taken a conservative approach in choice of parameters, pending full experience, and the supervisors have reserved the right to require banks wishing to use internal methods to perform testing exercise and provide other information need to check validity of the models.

But the capital charge for a bank using a proprietary model is to be the higher of the previous day's value-at-risk and three times the average of the daily value-at-risk of the preceding 60 business days.

Though the banks, in their comments, have questioned the size of the multiplication factor, the Basle Committee has considered it prudent to retain its April proposal.

While a bank's internal model could provide a valuable starting point for risk measurement of a bank's trading portfolio, the Basle Committee feels this daily value-at-risk estimate should be translated into a capital charge that would provide a sufficient cushion for cumulative losses arising from adverse market conditions over an extended period of time.

The multiplication factor, the Committee adds, is designed to account for potential weaknesses in the modelling due to:

* market price movements displaying patterns that differ from statistical simplifications used in modelling,

* the past is not always a good approximation of the future,

* value-at-risk estimates are typically based on end-of-day positions and generally don't take account of intra-day trading risk,

* models cannot adequately capture event risk arising from exceptional market circumstances, and

* many models rely on simplifying assumptions to value positions in the portfolio, particularly in the case of complex instruments such as options.

The Basle Committee said (under the modified guidelines) banks would be required to add to the multiplication factor of 3, a "plus" directly related to ex-post performance of the model.

The Committee also reaffirmed the appropriateness of requiring banks to calculate the value-at-risk based on an instantaneous shock equivalent to a 10-day-move-in-prices.

Other elements of the Committee recommendations, relating to banks adopting in-house models, include treatment of correlation effects within broad risk factor categories (interest rates, exchange rates, equity prices and commodity prices) and assessment of specific risks like events risk or default risk that might not be captured by the models.

The Committee also referred to its on-going collaborative work with the Technical Committee of the International Organization of Securities Commissions on various initiatives, including risk management standards, supervisory reporting and public disclosure of trading and derivatives activities and on other important issues and said the Basle committee would make every effort to ensure that this joint work is carried forward with positive results. It was also collaborating with the IOSCO for a better understanding of relative implications of value-at-risk models for banks and securities firms and the extent to which there is scope for further collaboration in this area.

Whether the new Basle guidelines and requirements would make any difference to trading activities of banks in the derivatives market, and the consequences to the banks, to the international banking system and securities and derivatives trading, and the public dealing with them, remains to be seen.

But an expert observer in an international organization closely following the banking and derivatives trading scene and the work of the Basle Committee said that on paper the new guidelines look good.

"But it all presupposes an environment of effective functioning of tightened internal controls within the enterprise, of external auditors and their responsibilities, and the functioning of the bank supervisors at the Central Banks," the expert said.

"Such an environment of internal controls within the banks and of uniform bank supervision around the global markets by Central Banks (some of whom have very limited 'bodies' to engage in supervision) is lacking."

Other experts noted that supervision based on assumptions about what gentleman will or will not do cannot be adequate in an era of 'greed' for maximising earnings and profits.

The Barings and Dawa cases suggest that in an environment where banks and their traders are primarily motivated by need to earn more and more 'profits', traders would continue to seek advantages not merely in terms of arbitrages based on differing interest rates for example, but even the approach of the supervisory authorities (of banks or security exchanges) towards administration of the rules.

Generally, while the supervisory authorities in the US (the leading financial centre in the world) are known for their strict enforcement approach, others like the Bank of England and the British security exchange regulators (London is the second largest financial centre so far) have been adopting a 'gentlemanly' approach.

For all the requirements of sharing of information among supervisors, in the Barings case for example, Nick Leeson (because of a conviction) would never have been able to be trader in London, but when he was sent to Singapore to do trading for Barings, the Singapore International Monetary Exchange (SIMEX) authorities were not advised of this.

As the Singapore SIMEX report on Barings has brought out, if they had known, they would never have allowed Lesson to trade on behalf of Barings, and could well have demanded more supervision and information on Barings from the Bank of England.