March 26, 2013 - Banks' ability to exploit a regulatory loophole in the Basel III capital adequacy regime by purchasing credits default swaps (CDS) and other instruments to lower the amount of risk on their books, and thereby reduce their capital requirements, will be curbed under new proposals released by the Basel Committee on Banking Supervision.

The group of international regulators, made up of 27 countries with major financial centres, announced its intention to levy hefty charges that would prevent banks from lowering capital charges by using instruments such as CDS to insure themselves against losses while failing to acknowledge the major liabilities they incur from paying for such protection. The move was in response to "continued activity in high cost credit protection transfers", said the Basel Committee.

"The proposed changes are intended to ensure that the costs, and not just the benefits of purchased credit protection are appropriately recognised in regulatory capital," a statement issued by the Committee read. There exists the "potential for capital arbitrage" as banks can book the benefits of such deals without simultaneously booking the associated costs, it added.

The US Federal Reserve has also spoken out against the practice, which it said called "into question the degree of risk transfer of the transaction and may be inconsistent with safety and soundness".

It recently emerged that in 2012 private equity giant Blackstone Group insured Citi against initial losses on a US$1.2bn pool of shipping loans. The regulatory capital trade enabled Citi to reduce the amount set aside to cover defaults by as much as 96%, according to individuals involved in the deal cited by the 'Financial Times', while keeping the loans on its balance sheet.

The Basel Committee said that it would open a consultation period lasting until 21 June to solicit view on the proposed amendments to its capital rules.