Basel 3.5 vs. Basel III: a radical overhaul of the capital requirements pillar. The case of commodity exposures

Abstract

Following the implementation of Basel III, the Basel committee has embarked on a thorough review of its market risk directives and enacted new proposals generically called Basel 3.5. They involve a radical transformation of the standardised approach (SA) into a risk-sensitive method and a complete overhaul of the internal models approach (IMA) through the replacement of VaR for ES, amid stringent validation standards. The study analyses Basel's recent regulations for commodities exposures, finding a substantial rise in capital levels for SA and IMA and the relatively disadvantageous position in which IMA is placed, arising from the higher SA's capital requirements and the tougher evaluation criteria only attained by schemes featuring extremes theory. This, in turn, provokes accuracy disincentives and unnecessary immobilisation of funds. Consequently, the paper introduces a straightforward solution designed to level SA and IMA and provide substantial protection against huge market slumps with more reasonable capital levels and reduced implied costs.