Questions not to ask – sovereign risk edition July 26, 2011 at 9:10 am

Buried in the recent Basel Committee FAQ on the market risk framework – basically a set of answers to questions banks have asked about how to interpret the rules – we find:

Should sovereign bonds be included in the IRC charge?

Yes.

The definition of specific risk in paragraph 709(iii), first sentence, is quite generic. Consequently, it does not scope out any particular securities. When an acceptable IRC model identifies sovereign bonds as subject to migration and default risk, the capital charge should be determined accordingly. Even if certain sovereign bonds are subject to a risk weight of 0% under the standardised approach (cf. paragraph 710), they cannot be considered as free of default and migration risk. Therefore, sovereign risk should be included in the scope of the incremental risk capital charge. Sovereign bonds must therefore be included in the relevant model. A general partial use of the standardised approach for sovereign bonds, ie exclusion of positions subject to a risk weight of 0% under the standardised approach from IRC, will not be granted. Accordingly, they will attract a capital charge under the IRC, except where the output of the model happens not to imply a capital charge for these positions.

Now, to interpret this you need to know that the IRC or incremental risk charge is one of the new trading book capital charges imposed under the Basel 2.5 changes, and due to come into force on both sides of the Atlantic shortly. Most if not all large banks will have IRC models for their trading books. This ‘interpretation’ from Basel will therefore ensure that sovereign risk is properly capitalized in these banks’ trading books. All this does of course is give the banks an even greater incentive to put such bonds in the banking book where they will be subject to the kinder disciplines of the IRB (where my guess is that some banks have the lowest permitted PD for sovereign exposures).

One question though – which idiot asked the Basel Committee to clarify this?

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