Global financial institutions will have to hold much more capital behind trading books — up to three times as much — when a market risk rule adopted by the Basel Committee on Banking Supervision takes effect by yearend 2010.
The group of international regulators released a report Thursday illustrating the rule's impact, and the results make it clear that the margins on investment banking will be squeezed.
In fact, once in effect, the requirements could force some large banks to back away from the business, even though it has been such a huge contributor to recent earnings.
"This is confirmation of the fact that the new trading book regime will be very, very stringent," said Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc. "This will force a strategic rethink of large diversified banks."
The Basel Committee toughened rules governing trading books in July as part of a makeover of global capital rules. But like the rest of Basel II, the U.S. lags one step behind. American regulators have not finalized the rules here but have said they are working on the effort. The Obama administration has already said it supports stricter market-risk rules.
Among other things, the revisions are designed to strengthen value-at-risk models and force banks to set aside more capital for incremental risk.
Studying data from 43 banks in 10 countries, the Basel Committee said those changes will raise the overall trading book capital requirements by an average of 223.7%. One unnamed bank that participated in the study saw its trading book capital charge rise by 1,112.8%.
Digging into the specific components, the study found that value-at-risk capital will rise by an average of 110.8%. All banks reported at least some increase in required capital, from as little as a 7.2% bump to a 694.5% increase.
Before the Basel Committee finalized the changes, executives from Bank of America Corp. criticized the rule for simply raising capital requirements without adequately adjusting the value-at-risk model.
"Some of the proposed changes in the framework would effectively just scale up capital requirements in current VaR models," Mark Linsz, BofA's corporate treasurer, and J. Chandler Martin, the enterprise credit and market risk executive, wrote in a comment letter to the Basel Committee in March. "These kinds of changes are not consistent with the direction in which the framework should be moving, and in some cases, represent a significant step backward."
Incremental risk charges, which require banks to hold capital for possible downgrades or defaults in their holdings, rise by an average of 156% under six-month horizons. For individual institutions, the increases range from 5% to 613%.
"One thing that's worrying when you see such large increases is the implication that if this is where we think minimum regulatory capital requirements need to be, then gosh, some firms are pretty undercapitalized now," said Robin Lumsdaine, a former associate director in the Fed's banking regulation and supervision department who is now a professor at American University's Kogid School of Business.
American regulators began the process of revising the market-risk rules several years ago but faced resistance from the industry and were later distracted by the financial crisis. Industry representatives said institutions would likely try to find ways around the new requirements but acknowledged they do not have much room to fight regulators right now.
"Banks would find a way to deal with the capital requirements by transferring activities outside of them into the subsidiary if that could be done," said Rob Strand, a senior economist at the American Bankers Association. "But we don't expect favorable treatment here in the U.S. We don't expect a lot of wiggle room."