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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.
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Allan D. Grody is a founding board member of the Journal of Risk Management in Financial Institutions, founding professor (retired) of New York University’s graduate course in risk management systems, and founding partner (retired) of Coopers & Lybrand’s financial services consulting practice. He began his business career in General Electric’s finance business and later went on to hold increasingly responsible positions in investment management, the securities industry and international banking. He is President of Financial InterGroup Advisors and Financial InterGroup Holdings Ltd, and an advisory board member of ARC Best Practices Ltd.
Kiran J. Fernandes is the Research Director, Professor of Operations Management and Head of the Operations Management Group at the York Management School. He holds a PhD in operations management and systems from the University of Warwick; a master’s (MS) from the James Worth Bagley College of Engineering at Mississippi State University (MSU); and a bachelor of engineering (Hons.) degree in production from Waltech.
Peter J. Hughes is a chartered accountant and managing director of the UK risk software and consulting firm, ARC Best Practices Limited. He was formerly a banker with JP Morgan Chase, where he held country and area management positions in Europe and South America encompassing audit, operations, finance and risk management.
J. Steven Toms is Chair in Accounting at Leeds University Business School. He has led a number of research projects sponsored by professional accounting bodies, including a recent project entitled ‘Accounting Based Risk Measurement’, funded by the Institute of Chartered Accountants in Scotland. He is a chartered accountant and was awarded his PhD in 1996 from the University of Nottingham.
CitationGrody, Allan D., Fernandes, Kiran J., Hughes, Peter J. and Steven Toms, J. (2013, January 1). Basel Committee’s fundamental review of the trading book: A commentary. In the Journal of Risk Management in Financial Institutions, Volume 6, Issue 1.