On January 14, 2016, the Basel Committee on Banking Supervision (BCBS) issued the revised minimum capital requirements for market risk.

The revised framework for market risk capital requirements, known as the Fundamental Review of the Trading Book (FRTB) during the consultative phase, seeks in our view to remove weaknesses pertaining to risk evaluation within “Basel 2.5” by addressing the undercapitalisation of the trading book.  The new rules will take effect in 2019.  The Basel Committee expects national supervisors to finalize implementation of the revised market risk standards by January 1, 2019, and to require their banks to report under the new standards by December 31, 2019.

Key Enhancements

The revised market risk framework comes as a continuation and strengthening of the set of revisions to the market risk framework introduced in July 2009 as part of the “Basel 2.5” package of reforms and consists of the following key enhancements as stated in the recently published Basel Committee on Banking Supervision (BCBS) document on capital requirements for market risk:1

  • “A revised internal models-approach (IMA). The new approach introduces a more rigorous model approval process that enables supervisors to remove internal modelling permission for individual trading desks, more consistent identification and capitalisation of material risk factors across banks, and constraints on the capital-reducing effects of hedging and diversification.”
  • “A revised standardised approach (SA). The revisions fundamentally overhaul the standardised approach to make it sufficiently risk-sensitive to serve as a credible fallback for, as well as a floor to, the IMA, while still providing an appropriate standard for banks that do not require a sophisticated treatment for market risk.”
  • “A shift from Value-at-Risk (VaR) to an Expected Shortfall (ES) measure of risk under stress. Use of ES will help to ensure a more prudent capture of “tail risk” and capital adequacy during periods of significant financial market stress.”
  • “Incorporation of the risk of market illiquidity. Varying liquidity horizons are incorporated into the revised SA and IMA to mitigate the risk of a sudden and severe impairment of market liquidity across asset markets. These replace the static 10-day horizon assumed for all traded instruments under VaR in the current framework.”
  • “A revised boundary between the trading book and banking book. Establishment of a more objective boundary will serve to reduce incentives to arbitrage between the regulatory banking and trading books, while still being aligned with banks’ risk management practices.”

Revised Framework for Minimum Capital Requirements for Market Risk

Key regulatory requirements include:

 Areas Key components
A. Trading Book and Banking Book Boundary

 

The new market risk framework set out in the final rules maintains the relationship between the regulatory trading books and instruments “held for trading” by the bank. However, the rules have been formulated to address the gap in the trading book and banking book boundary which was not addressed in the previous framework. This gap was used to exploit the regulatory arbitrage opportunities between these two regulatory books of the bank.

Some of the key points covered in the regulation are:2

  • Covered Instruments: The rules clearly specify the instruments included as part of the trading book within the new framework. Any instrument held for short-term resales, profiting from price movements, arbitrage opportunity or that hedges the risks from these strategies, is considered to be a part of the trading book.
  • Trading Desk: Trading desks have been defined as a group of traders or accounts which implement a trading/business strategy for that particular group and that have a dedicated risk management function for monitoring risk within the desk.
  • Moving Instruments between Regulatory Books: Switching instruments for regulatory arbitrage is now strictly prohibited. Banks are now required to calculate the capital charge before and after the switch and if it is reduced because of the movement, then the difference is imposed on the bank as a Pillar 1 capital surcharge.
  •  Internal Risk Transfers: There is no recognition of regulatory capital for internal risk transfer from trading book to banking book. For risk transfer from the banking book to trading book, regulatory capital recognition will be provided only if the trading book executes a hedge with external counterparty and the value of the hedge completely matches that of the internal risk transfer.
B. Standardized Approach The BCBS has put greater importance on the use of standardized model for calculating capital requirements for market risk. As per published rules, all banks are responsible for calculating their capital requirement using the standardized approach and report to the supervisor on a monthly basis. The standardized approach is the aggregate of the risk charges used in sensitivities based method, the default risk charge and the residual risk add-on. Specifically: 3

  • Sensitivities Based Method: The risk charges from sensitivities based method are calculated by adding the Delta, Vega and Curvature risk measures. There must be no diversification benefit recognized between individual risk classes.
  • Coverage of Instruments: Each instrument with optionality value is subject to Vega and Curvature risks. Tranches of securitized instruments may be subject to an embedded prepayment option and as such will attract a residual risk add-on charge.
  • Default Risk Charge (DRC): The default risk charge is intended to capture a portfolio’s exposure to Jump-To-Default (JTD) risk. The rules have provided a detailed description of the methodology to be used for calculating the DRC.
  • Residual Risk Add-On: The residual risk add-on has to be calculated for all instruments bearing residual risk independently and is an additional charge to the capital charge calculated for other components under the standard approach. The rule also specifies that “The residual risk add-on is the simple sum of gross notional amounts of the instruments bearing residual risks, multiplied by a risk weight of 1.0% for instruments with an exotic underlying and a risk weight of 0.1% for instruments bearing other residual risks.”
C. Internal Model Approach The specific rule in the capital requirements for market risk standards document states that the “use of an internal model for the purposes of regulatory capital determination will be conditional upon the explicit approval of the bank’s supervisory authority.” Under the revised set of rules published by the BCBS the difference between the Standardized Approach (SA) and Internal Model Approach (IMA) has been reduced significantly. More specifically:4

  • Qualitative Standards: An independent risk control unit of the bank should produce and analyze the daily reports on the output of the Internal Model.  There should be regular backtesting and P&L attribution checks on the risk measure computed.
  • Quantitative Standards: “Expected Shortfall” (ES) is the metric which is to be measured on a daily basis for bank-wide internal model for regulatory capital. Each trading desk also needs to compute the ES on a daily basis (which the bank needs to include within the scope of the IMA). Banks must meet the capital requirements on a daily basis. This is calculated as the higher of the previous day market risk capital charge, or the daily average, or the market risk charge for the previous 60 business days.
  • Liquidity Horizons: This is the time period required to exit or hedge a risk position without materially affecting market prices in times of stress. Liquidity horizons are used to scale ES measure. There are 5 distinct liquidity horizons specified in the rules which map to different asset classes.
  • Market Risk Factors: These are utilized for valuation of instruments and should be used as risk factors in the internal model. All risk factors corresponding to the regulatory risk factors detailed in the SA should be included in the calculation for ES.
  • Default Risk: A separate model must be used to calculate the default risk position for the trading book. The default risk is measured using a VaR model. The calculation must be based on historical correlations using 10 years of data, including stress prices, and over a one-year liquidity horizons. The default risk capital requirement is the greater of: (1) the average of the default risk charge over the previous 12 weeks; or (2) the most recent default risk.
  • Risk Factor Analysis: “For a risk factor to be classified as modellable by a bank, there must be continuously available “real” prices for a sufficient set of representative transactions.” To be considered to have continuously available “real” prices, a risk factor must have at least 24 observable “real” prices per year… with a maximum period of one month between two consecutive observations.”
D. Expected Shortfall – The New Market Risk Measure Expected shortfall is the new measure proposed in the rules to calculate market risk. The regulations also specify the standards for computing the ES.5

  • Computation: ES is to be calculated daily for the bank and individual trading desks in scope for IMA. 97.5% one tailed confidence interval is to be used for calculating ES. No particular methodology is prescribed by the rules as long as the ES calculation captures all the material risks run by the bank.
  • Stressed Expected Shortfall (SES): “The expected shortfall measure must be calibrated to a period of stress. Specifically, the measure must replicate an expected shortfall charge that would be generated on the bank’s current portfolio if the relevant risk factors were experiencing a period of stress.”
E. Approval Process Supervisory authorities will have to provide approval for the use of an Internal Model Approach by the banks. They will have to meet the criteria set for using an IMA to capitalize the market risk of their trading book. The process is shown below:6

  • Internal Model Approval Process: Approval for the internal model is granted by the supervisory authority if:
    • They are satisfied that the bank’s risk management systems are conceptually sound and implemented with integrity.
    • The bank has sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit and back office areas.
    • The bank’s models have a proven track record of reasonable accuracy in measuring risk.
    • The bank regularly conducts stress tests as required by the rules.
    • The positions included in the internal model for regulatory capital determination are held in approved trading desks.

Additionally, supervisory authorities may insist on a period of initial monitoring and live testing of a bank’s internal model before approving it. This includes:7

  • P&L (Profit and Loss) Attribution: “P&L attribution requirements are based on two metrics: mean unexplained daily P&L (i.e. risk-theoretical P&L minus hypothetical P&L) over the standard deviation of hypothetical daily P&L and the ratio of variances of unexplained daily P&L and hypothetical daily P&L.”
  • Backtesting: “Backtesting requirements are based on comparing each desk’s 1-day static value-at-risk measure … at both the 97.5th percentile and the 99th percentile, using at least one year of current observations of the desk’s one-day P&L.”
  • Eligible Trading Activities: To determine the eligibility of trading activities for the internal models-based approach, the following three-step approach should be used:

i. The bank’s organizational infrastructure and its firm-wide internal risk capital model should be assessed.

ii. The second step involves evaluating each of the regulatory trading desk which are in scope for model approval.

iii. The third step is the risk factor analysis where the risk factors are identified and categorized as Modelable and Non-Modelable based on the criteria specified in the rules and summarized in the section for Internal Model Approach.

Key Take-aways

The Impacts on a Bank’s Capital Framework

The new rules for capital requirements for market risk pose in our view a significant challenge for financial institutions as they revise their methods for calculating market risk measures. The exact impact of the rules will need to be analyzed by each bank but the capital charges rate are set to go up for all the market participants significantly.

According to BIS estimates during the interim impact analysis phase, with the adoption of the new rules, the capital requirements for banks is expected to increase by 41% on an average, with the median bank’s increase expected to be somewhere around 18%.8

Accenture has developed a framework for helping firms analyze the impact of the new market risk rules to the bank’s trading book, capital calculations and regulatory reports areas. The figure below illustrates the areas where the new market risk rules are expected to have the some of the highest impact.

View the image.
View the image.

References:

  1. “Minimum capital requirements for market risk,” Basel Committee on Banking Supervision, January 2016. Access at: http://www.bis.org/bcbs/publ/d352.htm
  2. Ibid
  3. Ibid
  4. Ibid
  5. Ibid
  6. Ibid
  7. Ibid
  8. “Fundamental review of the trading book – interim impact analysis,” Bank for International Settlements, November 2015. Access at: http://www.bis.org/bcbs/publ/d346.htm

Newsletter Authors: Amit Gupta, Rahim Inoussa and Gaurav Kapoor

Newsletter Contact Person: Craig Unterseher

Disclaimer

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