Finadium Research Report

A Primer on Basel II and Risk in Prime Brokerage

Finadium
September 2008

Basel II is creating waves of change in both the brokerage and banking industries. For prime brokers, pieces of Basel II regulations, known in the US as Advanced Risk Management and in Europe as the Capital Adequacy Directive 3, alter the value of clients. Some clients occupy more risk on a balance sheet than others, leading to internal and external discussions on pricing and whether to extend credit. For borrowers, whether hedge funds or corporations, Basel II provides a specific framework for allocating the cost of capital; borrowers using more of a balance sheet will now pay more for that usage.

Basel II is the product of years of work from the Basel Committee on Banking Supervision, a group of international regulators sponsored by the Bank for International Settlements. Basel II is a framework more than prescriptive legislation, offering multiple variations for most regulatory choices and a host of options for banks and regulators alike.. In practice, regulators have adopted variations of Basel II to fit their local circumstances, often leaving aside choices for banks in favor of one fixed set of rules, or a reduced set of options.

At its heart, Basel II is banking regulation, which makes its retrofitting onto the brokerage industry a bit awkward. Yet, this is what is occurring. Most European brokers are owned by banks, hence are directly impacted by Basel II. The largest US brokers not affected by Basel II adopted similar risk management techniques some years ago. Today, as Basel II spreads throughout the rest of the world and is looked to as a guidepost for the broader financial services industry, all of brokerage looks set to follow.

While Basel II is a major step forward in linking capital monitoring to regulatory oversight, it is not the end of the road in maintaining financial stability. Basel II addresses capital adequacy but largely ignores liquidity, the fundamental cause of Bear Stearns’ collapse. Basel II also relies heavily on Value-at-Risk (VaR), a methodology with shortcomings in anticipating and planning for extreme market movements. The Basel Committee is aware of these faults, as are a raft of private sector organizations who have stepped forward to propose additional regulatory solutions.

This report is 34 pages with 11 exhibits.

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TABLE OF CONTENTS
■ Executive Summary
– Key Point Summary
■ Credit Crises, Risk Management and the Impact of Basel II
■ An Introduction to the Three Pillars of Basel II
– Pillar 1: Monitoring Risk and Capital
– Pillar 1: Operational Risk Elements
– Pillar 2: Supervisory Review and Systems Requirements
– Pillar 3: Market Discipline and Disclosure
■ Risk in Securities Lending
– Agent Lender Disclosure
■ Challenges in Regulating Capital and Liquidity Risk
■ What Basel II and Liquidity Guidelines Mean and Don’t Mean for
Brokers
– Basel II as a Driver of US Financial Regulatory Consolidation
■ Glossary of Abbreviations
■ About the Author
■ About Finadium

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