The Difficulties of Applying Basel II to Advanced Trading Strategies

In March this year, the Federal Reserve announced that American banks would be required to comply with the advanced methods of Basel II, and not only its basic principles. With this, the debate over the Basel II accord and the amount and kind of guidance it offers to implementers has reopened. Within the accord, there are some items on which the regulators have not commented, and other items on which the regulators have expressed differing opinions, creating a myriad of views as to how and when banks will be required to follow the regulations. Basel II was much easier to stomach when it looked as if few American banks would be required to adhere to the regulation.

This uncertainty is not necessarily a negative development. The result could be better regulations that catch more of the nuances in the market. The down side could be, at worst, regulations that simply waste resources and do not improve risk control. In either case, with such opacity it is more likely that there will be a further delay in the implementation dates.

The point to remember in dealing with the Basel II accord is that large sections simply provide guidance. The regulations are not absolute cookbook methods to compute economic capital. Different methods can be used and have been accepted by regulators provided they are well documented and are a reasonable implementation of an accepted methodology.

The need for internal models has created a land grab on risk management talent. In the past few months there has been a large movement of risk professionals from regulators and ratings agencies to hedge funds, portable alpha departments and banks. The intricacies of the regulations, and the ability to create internal models that must be ratified by regulators, has increased the demand for qualified staff.

While this is good news for the career prospects of risk professionals, it has caused friction with the trading groups. Basel II, by its very nature, should cause friction. The regulations take their starting point to be commercial banking activities. An unintended friction is caused when these regulations are then applied to structured products and other advanced trading strategies, and it is important to note that Basel II discussions started before the explosive growth in derivatives, structured products and hedge funds.

If you look at the annual reports of global banks you will see that a large proportion of their profit comes from derivatives and structured products. These instruments are going to remain important to the banks, who will continue to innovate at a rapid pace because this is where the margin lies. It is because of this momentum that the pace of regulation is always going to lag behind innovation in the markets.

Therefore, the guidance within the regulations must permit a realistic treatment of the advanced trading strategies. Risk control staff should take an overview of profitable trading strategies and their requirements and not treat a diverse portfolio as if it were a list of homogenous loans to a single industry. The initiative in the European Insurance markets, Solvency II, is attempting to pick up where Basel II ended. It would be useful for Basel II to incorporate some of the developments in Solvency II.

The goal of Basel II is to provide a method to ensure that there are adequate Economic Capital (EC) reserves within a bank to handle defaults by their clients. The EC is, in a simplified description, calculated by determining Probability of Default (PD) for each client and then multiplying it by the Loss Given Default (LGD) for each client. The LGD takes into account recovery rates and costs associated with the recovery. At a complete loss, the LGD could go above the full Exposure at Default (EAD) to each client when legal and management costs are included. LGD is usually lower than EAD due to collateral and recovery after default.

Basel II is driven by the PD and LGD numbers. Data to create the PD and LGD require, as per the regulations, three years of data with a further two-to-three years as verification backup and the problem with this requirement is that not all instruments that are actively traded in the market have existed for three years. Without three years of data, risk management groups are using tight bounds on new instruments.

A further complication is that a bank may not have enough activity in a line of business to create meaningful PD and LGD numbers. A small department may do one or two deals a month as part of full-service banking, and even with three years of data, the low sample size would make the PD and LGD numbers meaningless. There is so far no central data repository to create industry PD and LGD numbers for complex instruments.

Risk groups are using, in the absence of adequate data sets, restrictive PD and LGD numbers. This is causing problems, as if there were not already more than enough, between the trading groups and the risk management groups.

The first thought is that this is a good and prudent action. However, the tight bounds specified for new instruments raises the risk contribution in internal calculations for instruments that were designed to lower overall risk. A structured product that sells off the higher risk tranches and retains the AAA rated tranches should lower firm risk.

We have seen several cases where the trading group has received a charge against their risk budget when they sell off the risky tranches. The risk group is assigning a high PD and LGD for new instruments that do not have large data histories and this is a double hit to the trading group. They created the structured product to improve their risk profile, and the tranches that were sold had both higher return and higher risk. This lowered the expected return to the trading group. Since the risk group increased their risk charge, the trading group realized a large drop in risk adjusted return.

When computing the economic capital numbers, Basel II methods do not take into account correlation of the exposures. Traders of structured products, as do all desks working with portfolios of instruments, use the correlation of the instruments. The trading desk will use correlation to create efficient trading strategies. The fact that the risk group does not use correlation is another area of friction between the risk and trading groups. Traders are using the diversification of the portfolio to reduce risk and this is not reflected in the economic capital numbers.

Structured products do not have well recognized Probability of Default (PD) or Loss Given Default (LGD) numbers. Basel II permits a bank to create internal models for both of these numbers. We again run into the problem of the need for historical data to create these measures. In addition, these two measures do not take into account the correlation of the exposures or the tails of the distributions. This limitation is not noticeable for simple loan portfolios.

The correlations and diversification are also not utilized by the Basel II asymptotic single risk factor model. This model was originally a table of values developed in the early days of Basel II. The Federal Reserve later created an equation that closely mapped this table. The original numbers for the table were created from the assumption that the average holding at a bank would be three-year loans. The model then adopted that same assumption.

The use of a single factor model makes other computations easier and tractable. It is a shame that the assumptions are so narrow. In the interest of computation simplicity, the capital charge for risk does not take into account diversification. The single factor model assumes the idiosyncratic risk has been reduced. Therefore, an actual portfolio, with diversification and lower actual idiosyncratic risk, receives the same capital charge as a portfolio that is not diversified. This causes a higher charge to the diversified portfolio – or it can mean too low a charge to the non-diversified portfolio. It also adds another area of contention between risk and trading groups.

We have looked at some of the areas in which Basel II is too restrictive when trading structured products. It is important for the risk management groups in banks to look beyond the basic Basel II standards and utilize the guidelines in the advanced methods. With adequate backup and data sets, the regulators can approve modifications. Seeking regulatory approval is worth the effort in capital release to areas of the bank with superior returns.