Basel Committee’s fundamental review of the trading book: A commentary

In July 2009, the Basel Committee on Banking Supervision (BCBS) issued revisions to the market risk framework. At the same time, the BCBS initiated a fundamental review of the trading book. The review’s intent was to evaluate comprehensively the overall design of the market risk amendment of 2004 and the update of 2009 including an assessment of the risk-quantification techniques adopted within Basel’s internal models-based and standardised approaches. The resulting document provides commentary on weaknesses identified in the prevailing Value-at-Risk (VaR) based capital adequacy regime, concluding that shortcomings resulted in materially undercapitalised trading book exposures prior to the crisis. As a consequence of the review, the BCBS is proposing that VaR be replaced by the Expected Shortfall methodology, thereby increasing the sensitivity of the risk regime to accommodate extreme events or ‘tail risk’. Given the nature and extent of the weaknesses reported in their paper, the wisdom of building on an evidently flawed regime in an incremental way is questionable. In this commentary on the BCBS’s proposals, the authors suggest that more fundamental revisions should be considered with a view to reinstating accounting in place of financial modelling, as the foundation on which capital adequacy should be determined and administered.