The Basel Committee on Banking Supervision is set to move ahead with proposals to introduce a new capital charge for interest rate risk in the banking book, defying warnings from lenders that have lobbied heavily against such a move.
A consultation will be launched in the coming weeks, according to a source close to the Basel Committee, amid concerns that banks are arbitraging the current framework by switching assets from the trading book to the banking book.
The proposed charge would cover “expected losses” on assets intended to be held to maturity, including loans and deposits. That may include loss of interest income or value lost through changes in interest rates.
A new capital charge would be a fundamental departure from existing Basel capital charges, which focus on “unexpected losses”, measured using value at risk models. Expected losses have to date been assumed to be outside the remit of the Basel Committee, and covered by reserves and provisions held on the balance sheet.
A example of a potential exposure would be a floating rate loan sold at Libor plus 100bp three years ago, now under water because an equivalent loan would price at Libor plus 200bp.
Under the existing Basel framework, the loan would be subject to credit risk capital charges protecting against default, but the interest would not be.
Interest rate risk in the banking book is currently covered by Pillar 2 of Basel II, which is concerned with internal risk management. However, changes in interest rates, as in the recent sell-off, can have a significant impact on bank profitability.
“There is fair amount of logical consistency in the Committee’s thinking,” said Mark Nicolaides, a partner at law firm Latham & Watkins. “Pillar I capital covers unexpected losses, whereas expected losses are covered by income at present. If banks are expected to hold capital against loan principal then it makes economic sense they should also hold capital against the income.”
“Of course, it’s safe to assume banks are not going to like it,” he added.
Banking trade bodies, including the European Banking Association, have lobbied against a capital charge for interest rates risk in the banking book, claiming the risk is difficult to calculate and would be better overseen via a supervisory reporting framework incorporating early warning indicators.
