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Basel 2.5: potential benefits and unintended consequences

Author

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  • Giovanni Pepe

    (Bank of Italy)

Abstract

Since 1996 the Basel risk-weighting regime has been based on the distinction between the trading and the banking book. For a long time credit items have been weighted less strictly if held in the trading book, on the assumption that they are easy to hedge or sell. The Great Financial Crisis made evident that banks declared a trading intent on positions that proved difficult or impossible to sell quickly. The Basel 2.5 package was developed in 2009 to better align trading and banking books� capital treatments. Working on a number of hypothetical portfolios I show that the new rules fell short of reaching their target and instead merely reversed the incentives. A model bank can now achieve a material capital saving by allocating its credit securities to the banking book, irrespective of its real intention or capability of holding them until maturity. The advantage of doing so is particularly pronounced when the incremental investment increases the concentration profile of the trading book, as usually happens for exposures towards banks� home government. Moreover, in these cases trading book requirements are exposed to powerful cliff-edge effects triggered by rating changes.

Suggested Citation

  • Giovanni Pepe, 2013. "Basel 2.5: potential benefits and unintended consequences," Questioni di Economia e Finanza (Occasional Papers) 159, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:opques:qef_159_13
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    File URL: https://www.bancaditalia.it/pubblicazioni/qef/2013-0159/QEF_159.pdf
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    References listed on IDEAS

    as
    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Bernd Engelmann & Robert Rauhmeier (ed.), 2006. "The Basel II Risk Parameters," Springer Books, Springer, number 978-3-540-33087-5, September.
    3. Simone Varotto, 2011. "Liquidity risk, credit risk, market risk and bank capital," International Journal of Managerial Finance, Emerald Group Publishing Limited, vol. 7(2), pages 134-152, April.
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    Cited by:

    1. Dominique Guegan & Bertrand K. Hassani, 2019. "Risk Measurement," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-02119256, HAL.

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    More about this item

    Keywords

    Basel 2.5; trading book; market risk; risk-weighted-assets; capital arbitrage;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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