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.
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:
|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
|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
|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
|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
|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
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
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.
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.
- “Minimum capital requirements for market risk,” Basel Committee on Banking Supervision, January 2016. Access at: http://www.bis.org/bcbs/publ/d352.htm
- “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 Contact Person: Craig Unterseher
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