Eyeing the Basel III Finish Line

An effective regulatory capital framework relies on multiple ingredients, from appropriate drafting to rigorous testing and consultation. Even minor calibration distortions can inflate capital requirements, which could negatively affect the capacity of banks to support deep and liquid markets, with negative consequences for the economy. As the Basel III framework has evolved over the years, ISDA has never lost its focus on making sure the rules in every country are appropriate and risk sensitive. With the US moving to finalize the Basel III endgame package, we've conducted thorough testing and analysis that shows US policymakers have made good progress and clarifies the steps that are now needed.

When the original Basel III endgame proposal was published nearly three years ago, ISDA and the Securities Industry and Financial Markets Association carried out a quantitative impact study (QIS) that showed the market risk component of the package, known as the Fundamental Review of the Trading Book (FRTB), would lead to a substantial rise in market risk capital of between 73% and 101%, depending on the extent to which banks use internal models. We have now run the same exercise on the revised proposal that was published on March 19, with input from the eight US global systemically important banks. The picture has improved materially. Under the FRTB standardized approach, the projected increase falls from 101% to 89%; under the internal models approach, it drops from 73% to 30%.

This is a great step forward. US policymakers have engaged constructively with the industry and improved the risk sensitivity of the proposal, while also increasing the viability of internal models. Now it's time to build on this progress and make the final changes that are needed to achieve a fully fit-for-purpose capital framework. As we set out in our response to the US consultation today, there are still some components of the package that are not fully aligned with economic risk, and these must be addressed in the final rule.

One of the most critical outstanding issues is cross-product netting under the standardized approach for counterparty credit risk. The latest proposal recognizes offsets across derivatives and repos, but applies a conservative methodology that lacks risk sensitivity and would overstate capital requirements. ISDA has recommended a hedge coverage ratio that would calibrate the netting benefit according to how well the repos in a portfolio actually hedge the derivatives, avoiding overstatement of risk in well-hedged portfolios.

Other components of the framework that still require some fine-tuning include the FRTB default risk charge, which would overstate the risk of short-dated equity derivatives that hedge longer-dated equity exposures, and the credit valuation adjustment risk capital requirement, which should distinguish between regulated and non-regulated financial counterparties to improve risk sensitivity. ISDA has set out the remedies we believe should now be applied to the framework to address these outstanding issues.

After many years of drafting, consulting and refining the US Basel III framework, the end is now in sight. Thanks to the willingness of regulators to listen to industry concerns, we have a credible framework that will allow banks to use internal models to calculate market risk capital - something that simply wouldn't have been possible in the original proposal. This was a key objective for ISDA and will allow banks to closely align capital with economic risk, a vital foundation for effective prudential regulation. Having come so far, we mustn't lose focus. With some further adjustments as set out in our response, we can achieve a highly effective capital framework that will stand the test of time.