Minimum Capital Requirements

The Basel Committee has stated that the new framework should "at least maintain the current overall level of capital in the system." ISDA believes that this objective is inconsistent with the laudable goal of trying to make international capital rules more risk sensitive. The Association urges regulators to consider carefully whether minimum capital requirements are the appropriate tool against all the forms of risk under consideration, even if the overall level of credit risk capital is reduced. Only credit risk is seen to warrant a minimum capital charge in the banking book.

If regulators want to keep the banking system from reducing capital levels, minimum standards are not the appropriate tool, given that banks in most countries already operate above of the minimum level of required capital. Regulators should review the consistency of banks' capital levels with the amount of risk embedded in their activities as part of the supervisory review, as outlined in Pillar II of the proposed framework.

Capital Charge for Operational Risk

The Basel Committee should in particular refrain from imposing capital charges for operational risk or other risk types as a means of maintaining existing capital levels. It is ISDA's view that minimum capital requirements are not the appropriate form of protection against all forms of risk, and particularly not against operational risk. ISDA does not believe that charging against operational risk is sensible, since this risk should normally be addressed by adopting proper systems and controls. Establishing a minimum capital charge against operational risk could lead to arbitrage, and runs the risk of discouraging the development of adequate controls, in particular if the charge applied bears little relation with the underlying risk. All the current evidence indicates that such a charge would be poorly specified and would introduce distortions into the world's financial system, just when these are being reduced in the area of credit risk. Instead, through the concerted and thorough development of Pillar II of the supervisory framework, involving extensive dialogue with the industry now and in the future, supervisors should support and promote the continuous and harmonized improvement of practice, consistent with the goal of the identification and containment of operational risks. Capital should be used to reinforce this goal only where a bank does not meet minimum control standards.

Internal Ratings

The Basel Committee has proposed basing credit risk capital treatment on banks' internal ratings. ISDA strongly welcomes this move. Developing an internal ratings based approach for setting banks' credit risk capital requirements should ensure that regulatory capital charges more closely reflect the banks' risk profile and contribute to greater alignment of regulatory and economic capital.

While the Basel Committee has proposed basing capital requirements on internal ratings only for "sophisticated banks," ISDA believes that most G-10 international banks have ratings systems in place, and that regulators should review these systems regardless of whether the bank falls or not within this ambiguously defined category. The relative degree of sophistication of eligible ratings systems could be reflected as part of the supervisory review. ISDA has identified qualitative and quantitative criteria which regulators may use in their assessment of the robustness of banks' internal rating systems.

Common Metric

In order to be able to translate banks' internal ratings into capital requirements, regulators will first have to translate them into a common metric. Since a majority of the ratings conceptually relate to default probabilities over a given time horizon, ISDA would suggest that these form the basis upon which the Basel Committee builds the future capital requirements.

Risk Weights and the ISDA Index

Testing conducted by a small set of ISDA members has shown that the risk weights proposed by the Basel Committee would result in a significant divergence between banks' regulatory and economic capital. The revised risk weights would continue to foster incentives to arbitrage regulatory capital by holding lower quality assets and, at the margin, to discourage banks from incurring exposure to certain investment grade assets. ISDA believes this would be an undesirable outcome to the extraordinary opportunity the Committee has created to modify the Accord.

ISDA suggests an alternative to the revised risk weights in the form of an index table from which regulatory capital could be calculated by reference to a benchmark asset. The index table has default probability buckets on its vertical axis and maturity buckets on its horizontal axis. The amount of capital suggested for the benchmark asset is based on the average economic capital calculated by the banks involved in the exercise for a three-year asset with a yearly default probability in the range of 0.17% to0.25%.

Significantly, the index was created by a small set of banks using their internal models on typical portfolios of corporate bonds and loans, reflecting the banks' large size, geographic reach, and multiple business lines. The index therefore takes account of diversification, as measured by banks in relation to corporate portfolios.

Portfolio Credit Risk Modeling

ISDA would note that ratings of individual assets only give an indication of the expected default rate or loss attached to these exposures. Basing credit risk capital requirements on ratings implies assuming a set level of diversification across banks' portfolios. ISDA believes that greater accuracy can be attained by using portfolio credit risk models, which are currently the best available risk management tool for detecting and measuring credit risk diversification at bank portfolio level. We would urge supervisors to include the possibility of using them for setting banks' minimum capital requirements in their final proposals, even if only at a future date. In the meantime, model reviews should be included as part of the supervisory assessment of banks. Pillar II of the review offers scope for penalizing excessive credit risk concentration.

The difficulties perceived by the regulators in validating models can be addressed for certain types of portfolios, notably retail, mortgages and project finance. ISDA believes that early recognition of portfolio modeling should be obtained for these asset categories, and that the supervisory review of banks' ratings systems will help allay some of the concerns expressed by the Basel Committee regarding the quality of the data input into the models.

Credit Risk Mitigation Techniques

The need to review the 1988 Capital Accord stems partly from the recognition that it does not adequately capture credit risk mitigation techniques, thereby increasing the gap between regulatory and economic capital. ISDA believes that capital relief should be obtained in proportion to the extent to which credit risk is reduced by the use of risk mitigation tools. ISDA is encouraged by the fact that the Basel Committee has offered to expand the scope of eligible collateral to include all financial instruments, and to expand the scope of on-balance sheet netting to include all assets and liabilities in the banking book. The ISDA response contains concrete proposals for an improved treatment of maturity mismatches, contingent market and credit risks and CLO/CBOs.

Disclosure Requirements

The introduction of disclosure requirements regarding key indicators of regulated institutions' credit quality will support the exercise of supervision. ISDA recognizes that the precise shape of these requirements is currently being discussed and would recommend that supervisors keep in mind the distinction between regulatory reporting and the disclosure of information to investors

The Association's response to the Basel Committee's proposal to amend the 1988 Capital Accord is available as a pdf file (732KB)