Bank Capital and New Regulatory Requirements for Risks in Trading Portfolios

Abstract

This article examines the impact of the new supervisory standards of Basel 2.5 and Basel III for bank trading portfolios with regards to the additional capital requirements developed to mitigate liquidity risk and credit risk. Using the incremental risk charge (IRC), the authors estimate risk measures in several alternate contexts. They find a potentially material increase in capital requirements above and beyond that concluded in the far-ranging impact studies conducted by the international supervisors. This effect is accentuated for financial or sovereign sectors as compared with industrial sectors, and regulatory capital is larger than economic capital. They compare credit risk models and find that the multivariate model reveals larger capital estimates for the financial and sovereign sectors by orders of magnitude versus the industrial sector or the Basel II model. Finally, in a Bayesian experiment, they find that the new requirements may introduce added uncertainty into risk measures as compared with existing approaches.