Basel fatigue? We’ve got it, and bet you do too. But, saddle up. The first of the U.S. rules to implement the global framework comes out next Tuesday. This isn’t Basel III – that’s to come. This is one piece of what many call Basel II.5: new standards to impose better risk-based capital requirements on market risk held in a bank’s trading book. Taken in tandem with the Volcker Rule, the standards spell big trouble for large U.S. banks with big capital-market operations.

Clients with the strength for it may find a market-risk capital assessment in the FedFin Archive (see FSM Report CAPITAL152), sent out on August 25, 2009. It details the various ways global regulators regretted the initial market-risk rules issued in tandem with the rest of Basel II. U.S. banks are – believe it or not – still under the 1996 Basel I market-risk rules, standards which exemplified the confidence once devoted to value-at-risk (VaR) judgment. Not only did regulators mandate VaR for trading books, but the FRB even toyed with a VaR methodology for a rewrite of the overall risk-based capital regime. Basel II ultimately didn’t go that way, but the market-risk rewrite issued along with the credit- and operational-risk rules did exemplify not only the still-strong trust in VaR, but also supervisory confidence in banks to know it when they saw it.

That was then. Now, of course, bank regulators don’t exactly trust banks when it comes to internal models. They’ve also learned the hard way – as have we all – that assets held in the trading book can not only lose money the old-fashioned way – less market demand that leads to lower prices – but also through default on the assets that underlie a traded security. The 1996 market-risk rules were almost exclusively focused on traditional trading instruments. The 2005 rewrite didn’t change much, despite the profound market shift towards asset-backed securities in the intervening decade. Trading risk in a debt or equity instrument isn’t the same as that in ABS, but the initial Basel II standards barely dealt with it despite the hundreds of billions then heading into ABS, much of which has now come right back out again in the debris of failed banks around the world.

Now, the capital rules are catching up to this, as well as other hard lessons of the financial crisis. In-depth analyses to come will go through the new U.S. proposals and detail their strategic impact. Suffice it to say now that the standards will, like the rest of Basel’s offerings, force significant rethinking of key profit drivers. Coming as these do in concert with the Volcker Rule, U.S. banks will be under a particularly heavy burden to structure profitable capital-markets operations out of what’s left of their proprietary-trading shops. This may seem like reasonable regulatory vengeance for sins of the past, but it will fuel shadow banking in the future – a very dangerous precursor to a new crisis unless these tough new standards are balanced with broad reform yet even to be seriously discussed by Basel.