Basel Proposes New Rules for Banks

On Thursday, the Basel Committee on Banking Supervision came up with a series of new stringent capital rules for the largest U.S. banks, based on the fundamental review of trading book capital requirements. Basel proposed increased capital holding by banks to align with the risk of heavy losses in the trading market.

As per the newly proposed rules, banks will be restricted beyond an extent in transferring assets between trading and banking books. They need to provide regulators with details related to the selling and buying of securities in their trading books. Moreover, more capital would be required to maintain to avoid the risk of credit crunch.

In trading books, portfolios of securities, which are actively traded by banks, are represented while banking books enclose products that the banks plan to hold to maturity.

Trading activities of the banks would be reduced once the new rules get approved as capital requirements would be enhanced. Moreover, this is expected to reduce the profitability of large financial institutions involved in extensive trading activities such as Barclays PLC ( BCS - Snapshot Report ) , The Goldman Sachs Group Inc. ( GS - Analyst Report ) and Deutsche Bank AG ( DB - Snapshot Report ) .

Before the approval of the proposed rules, the Basel Committee awaits feedback until September 2012. When the review of responses is complete, the committee will declare the amendments to the Basel III framework.

In July 2009, the Basel Committee issued "Basel 2.5," which inculcated modifications to the market risk framework. These amendments significantly enhanced capital requirements for trading activities, mainly for securitizations and planned credit products, based on the losses incurred by the banks during the financial crisis.

The current proposal contains a revised market risk framework that includes the measures to enhance trading book capital requirements. However, Basel 2.5 did not consider the calculation methods in estimating capitals. According to the Committee, the Value at Risk (VAR) measure, which takes into account prospective losses on a portfolio for most situations mainly covering 95% of trading days, was proved to be a poor measure during the financial crisis.

Now, the Basel Committee plans to use “expected losses” while calculating banks’ capital instead of using the VAR measure.

The oversight body of the Basel Committee on Banking Supervision is planning proactive actions to ensure that the world’s largest banks are strengthening their capital and liquidity positions to confront another financial meltdown. The committee is set to carry out on-site assessments of the banks' financial conditions.

Previously, a global agreement, known as Basel III (named after the city of Switzerland), was passed in July 2011. Under the agreement, banking giants throughout the world would have to maintain an extra 1% to 2.5% of capital on their balance sheets in addition to the Basel III mandate of 7% by 2019. The percentage will vary depending on the size of their balance sheets. Based on a particular bank’s importance and position in the overall financial system, the regulators will formulate a method to identify target banks.

A weak capital level is always a threat to the global economy. Needless to say, meeting new rules would act as building blocks of the still unstable world economy, with fewer bank collapses and less involvement of taxpayers’ money for bailing out troubled financial institutions.