No. 159 - Basel 2.5: potential benefits and unintended consequences

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.