The Basel III Endgame: FDIC Director McKernan’s Insights
Federal Deposit Insurance Corporation (FDIC) Director Jonathan McKernan recently provided valuable insights on the interplay between the Fundamental Review of the Trading Book (FRTB) and the US Basel III Endgame proposal at the ISDA Conference on Trading Book Capital. In his remarks, Director McKernan highlighted three significant weaknesses in the trading book framework and discussed the potential for aligning capital requirements with underlying market risks.
Lessons from the Financial Crisis
One lesson learned from the financial crisis was that the value-at-risk (VaR) measure, designed to measure short-term fluctuations in market prices, failed to adequately account for low probability tail events, market liquidity risk, credit risk, and significant stress periods. This highlighted the need for a more robust risk measurement framework.
Another lesson was the absence of a credible option for regulators to withdraw approval of internal market risk models. This was partly due to the lack of a credible backstop provided by the standardized approaches and the fact that model approval was done at the banking organization-level rather than at more granular levels like the trading desk. This raised concerns about the reliability of risk measurement models.
A third lesson was the presence of capital arbitrage opportunities created by the boundary between the trading and banking books. Banks were incentivized to classify instruments as “held with trading intent” even when regular trading activities were absent, in order to benefit from reduced capital requirements on the trading book. This highlighted the need for tighter regulations to prevent such arbitrage.
The Basel III Endgame Proposal
Director McKernan expressed his view that the Basel III Endgame proposal falls short in addressing these weaknesses. He had previously voiced his concerns in July regarding the design decisions made by the Basel Committee, which were also reflected in the US proposal. However, he suggested that the Endgame debate need not be binary but instead should be approached in a phased manner.
According to Director McKernan, efforts to enhance the regulatory capital framework should be supported, but higher capital requirements should not be reverse engineered without considering the costs, benefits, and the underlying calibration framework. He proposed finalizing the less contested aspects of the Endgame market risk reforms and then addressing the remaining issues through future notice-and-comment rulemakings that can rationalize the US implementations.
Phased Approach for Progress
Director McKernan’s suggestion of taking a phased approach to the Basel III Endgame proposal may offer a potential path forward. With bipartisan pushback on the proposal, this approach could allow for the finalization of certain aspects of the Endgame market risk reforms while leaving room for further discussions and refinements.
By focusing on the less controversial parts of the proposal initially, progress can be made without compromising a comprehensive and well-considered approach to addressing the weaknesses in the trading book framework. This approach acknowledges the need for further analysis and refinement to ensure the costs and benefits of higher capital requirements are adequately evaluated.
Frequently Asked Questions
What is the Basel III Endgame proposal?
The Basel III Endgame proposal is a set of reforms aimed at addressing weaknesses in the trading book framework and aligning capital requirements with underlying market risks. It aims to enhance the regulatory capital framework while preventing capital arbitrage opportunities and improving risk measurement.
What are the weaknesses in the trading book framework?
The weaknesses in the trading book framework identified by FDIC Director McKernan include the inadequate capitalization of low probability tail events, market liquidity risk, and credit risk by the value-at-risk (VaR) measure. The absence of a credible option for regulators to withdraw approval of internal market risk models and the potential for capital arbitrage due to the boundary between the trading and banking books are also concerns.
Why is a phased approach suggested for the Basel III Endgame proposal?
A phased approach allows for progress to be made by finalizing the less contested aspects of the Endgame market risk reforms initially. This approach acknowledges the concerns raised about the proposal while recognizing the need for further analysis and refinement. It provides an opportunity to address the weaknesses in the trading book framework without compromising a comprehensive and well-calibrated regulatory framework.
For more information about banking regulations and risk management, visit visbanking.com. If you need information about pricing or would like to request a demo, please visit visbanking.com/pricing or visbanking.com/request-demo.
