Ahead of the Fundamental Review of the Trading Book Summit taking place April 19-20, the Center for Financial Professionals have reviewed the Finalisation paper for the revised capital standard for market risk. Presenters and panelists will be presenting their findings of the paper and amending sessions in line with the changes.
With the Basel III capital framework for trading activities weaknesses being highlighted, resulting in undercapitalized trading book exposures ahead of the 2007-8 financial crisis, The Basel Committee have proposed and finalized a set of revised standards to the market risk framework, most specifically focusing on the boundary between banking and trading book, revised standardized approach and internal models approach. The changes are looking to address the deficiencies in the pre-crisis framework across the three areas.
The first area highlighted in the reform is the revised boundary between regulatory banking and trading books to work alongside and support banks risk management practices, ensuring a harmonization between the two.
The reform has provided principles for what may be in the trading book, and more specifically a list of instruments presumed to be in the trading book. The reform within the book boundaries also looks to reduce the ability to arbitrage the boundary, with stricter limits put on the movement of instruments between the books, reduced charges will be incurred as a fixed, additional Pillar 1 charge. Closely related under the book boundaries is switching instruments from one book to the other if deemed improperly designated, this falls on supervisors who will be given a full report on boundary determination. The majority of changes under the market risk reform are around clarification of definitions of terms under the act. Whether this be across book boundaries, ensuring a clear definition as to instruments that should clearly fall under each book, and clear documentation for better informed decision making if a transfer is required.
Another area of focus within the revised capital standard for market risk is the the revised standardized approach, acting as a fallback for internal models that are not approved, under the standardized approach the method for calculating capital requirements for banks with a level of trading activity is far less complex, requiring no sophisticated measurement of market risk. The approach must also ensure comparable reporting of market risk across banks and jurisdictions so must therefore be accessible and accomplishable. Improvements seen within the internal model approach have also been incorporated within the standardized approach to align calibration between model and standardized approaches. The standardized bucket risk weights under the standardized approach have been calibrated using expected shortfall methodology. Under the revised standardized approach there is a greater reliance put upon risk sensitivities as input into capital charge calculations, this requires an alignment between risk data infrastructure, further supporting the requirement for alignment between internal and standardized models to ensure a fallback. The methodology further expands upon requirements around the capturing of sensitivities, and extends the use of sensitivities to a much broader set of risk factors. Further amendments within the standardized approach is the standardized default risk charge which looks at credit risk treatment in the banking book and alleviating the potential discrepancy in capital requirements for risk exposure across the banking book and trading book. Finally the revised standardized approach includes a residual risk add on, designed to capture any risks beyond those in the sensitivities based approach or standardized default risk charge above. It looks to ensure a more consistent treatment of more complex instruments or exotic underliers that would not be captured under the other two components.
Finally the changes look to address the revision of the internal models approach, and ensuring a better, more comprehensive capture of risks that better account for tail risks and market illiquidity, an enhanced model approval process and constraints put down against effects of hedging and portfolio diversification. The enhanced risk capture makes a significant change from the measurement of VaR to Expected Shortfall, this provides a single metric to measure riskiness of position. Under Expected Shortfall positions can be determined by measuring the size and the likelihood of losses above certain confidence levels. Under the current VaR methodology, tail risk is not effectively accounted for, this was a big shortcoming of the methodology. Finally under the revision of the internal models approach is the more granular model approval process, breaking the approvals down to the level of the trading desk, approval for the models can be though the bank supervisor, unlike previously when this was at a bank wide level. New model validation criteria must be complied with to qualify as a model eligible desk, if not approved the desk will capitalize under the standardized approach; this is determined on meeting the validation criteria under P&L attribution and backtesting. If the trading desk model is approved, it is then incumbent upon a bank to determine modellable and unmodellable risk factors to ensure that risk factors are modelled with adequate data. Constraints have also been imposed on the capital reducing benefits of hedging and portfolio diversification, under expected shortfall.
The capital framework for trading activities provides a comprehensive layout of the expectations and rationale around the changes to be made, with further improvements placed around the approval process for internal models, and mitigating the risk with standardized approaches acting as a fallback to limit the impact.
The Center for Financial Professionals have conducted research prior to the release of the finalization paper, we have conducted further research around the changes and further challenges posed with implementation of the final guidance to address at Fundamental Review of the Trading Book Summit, April 19-20, 2016.
Senior Market Risk professionals will address the challenges with implementation and discuss best practice moving forward, providing a platform for industry discussion and review.
For full information visit www.cefpro.com/frtb