Banks are set to face tougher international rules on the capitalthey must have on hand to cope with a change in interest rates,amid regulators' concerns that current standards may be too flimsyto fully capture the risks.

The Basel Committee on Banking Supervision, a group bringingtogether regulators such as the U.S. Federal Reserve and theEuropean Central Bank (ECB), proposed overhauling its current rulesfor interest-rate risk, including possible binding standards on howbanks should measure their resilience to shock rate changes, and onthe capital they should have to cover potential losses.

The work “is particularly important in the light of the currentexceptionally low interest-rate environment in many jurisdictions,”the Basel committee said June 8 in a statement on its website. Thecommittee wants to ensure that “banks have appropriate capital tocover potential losses from exposures to changes in interestrates.”

Global central banks have pushed interest rates to historic lowsin a bid to counter the worst financial crisis since the GreatDepression. The ECB, as well as monetary policy chiefs in Denmarkand Switzerland, are among those to have pushed some rates belowzero in a bid to spur bank lending and stimulate economicgrowth.

U.S. Fed Chair Janet Yellen said last month that she expects toraise interest rates this year if the economy meets her forecasts,with a gradual pace of tightening to follow.

“One reason interest-rate risk is so grave a concern now is thatthe combination of accommodative monetary policy and post-crisisregulation leads to large holdings of long-dated, low-rateobligations,” Karen Shaw Petrou, managing partner ofWashington-based research firm Federal Financial Analytics Inc.,said by email.

Existing international standards on banks' resilience tointerest-rate changes have been applied differently across nations,meaning the amount of capital required “varies considerably,” theBasel group said.

While the Basel group is weighing different options for change,it made clear that the status quo is not an option, saying a“strengthened framework” is needed.

The Basel proposal concerns possible losses on assets that banksintend to hold to maturity, a part of their inventory known as thebanking book.

Current international standards in this area date back to 2004and are limited to a system whereby banks regularly report to theirnational supervisors on risk levels. These supervisors then takedecisions on whether more capital, or a reduction in the size ofthe position, is needed.

Capital Requirements

The plans published for consultation by the committee today setout two options for strengthening this banking book regime. Theregulator seeks views on the plans until Sept. 11.

The first would toughen the current supervisor-led approach,including by boosting the amount of information that banks have todisclose.

The second, more radical option would see this system replacedby minimum capital requirements set centrally by the Baselcommittee, which nations would be expected to make binding on theirbanks.

These requirements would include a methodology for “shockscenarios” against which banks should pit themselves and detailedrules on how to calculate capital requirements.

Change is necessary to remove incentives for banksdeliberatively to shift assets between their banking book andtrading book to exploit differences in capital rules, the regulatorsaid.

Such “capital arbitrage” could arise because the Basel committeealready sets binding capital charges for assets banks intend totrade.

Capital is a measure of banks' financial strength, in otherwords of a firm's ability to take a hit without failing. Capitalrequirements dictate how far banks must fund themselves throughequity and other sources that can absorb unforeseen losses.

Types of interest-rate risk in the banking book include a changein rates that leaves a bank locked into receiving a relatively lowinterest rate on long-term investments such as mortgages, whilebeing under competitive pressure to offer higher rates todepositors. Others include banks being caught out by changes in therelationship between interest rates on short- and long-termdebt.

There are limits to how far supervisory rules can shield banksfrom such perils, Petrou said.

Two Approaches

“Supervisory guidance now can slap some risks, but it doesnothing to address structural risk drivers, especially those theregulators themselves have inadvertently created,” she said.

The Basel committee brings together regulators from 30 nationsto set bank capital requirements. In addition to the ECB and theFed, its members include the Bank of England, the Bank of Japan,and the Swiss National Bank.

The two different approaches being assessed by the Baselcommittee reflect a split in the committee between European andU.S. regulators over how far to go beyond current measures.

Many European Basel members are keen to move toward tighterglobal standards on risk measurement and on the amount of capitalrequired. This has put them at loggerheads with the U.S., whichwants to stay closer to the current approach.

There are pros and cons of each path, the committee said in itsconsultation paper.

While the more rigid international approach is best suited fordelivering consistency, discretion for supervisors can “accommodatediffering market conditions and risk management practices acrossjurisdictions,” the regulator said.

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