Market Risk
From the Basel ii framework
Market Risk: The risk measurement framework
Market risk is defined as the risk of losses in on and
off-balance-sheet positions arising from movements in market
prices.
The risks subject to this requirement are:
• The risks pertaining to interest rate related instruments
and equities in the trading book;
• Foreign exchange risk
and commodities risk throughout the bank.
Scope and coverage of the capital charges
The capital charges for interest rate related instruments
and equities will apply to the current trading book items
prudently valued by banks.
The capital charges for
foreign exchange risk and for commodities risk will apply to
banks’ total currency and commodity positions, subject to some
discretion to exclude structural foreign exchange positions.
It is understood that some of these positions will be
reported and hence evaluated at market value, but some may be
reported and evaluated at book value.
In the same way as
for credit risk,
the capital requirements for market risk are to apply on a
worldwide consolidated basis.
Where appropriate, national authorities may permit
banking and financial entities in a group which is running a
global consolidated book and whose capital is being assessed on
a global basis to report short and long positions in exactly the
same instrument (e.g. currencies, commodities, equities or
bonds), on a net basis, no matter where they are booked.
Moreover, the offsetting rules as set out in this section may
also be applied on a consolidated basis.
Nonetheless,
there will be circumstances in which supervisory authorities
demand that the individual positions be taken into the
measurement system without any offsetting or netting against
positions in the remainder of the group.
This may be
needed, for example,
where there are obstacles to the quick repatriation of profits
from a foreign subsidiary or where there are legal and
procedural difficulties in carrying out the timely management of
risks on a consolidated basis.
Moreover, all national authorities will retain the
right to continue to monitor the market risks of individual
entities on a non-consolidated basis to ensure that significant
imbalances within a group do not escape supervision. Supervisory
authorities will be especially vigilant in ensuring that banks
do not pass positions on reporting dates in such a way as to
escape measurement.
A
trading book
consists of positions in financial instruments and commodities
held either with trading intent or in order to hedge other
elements of the trading book.
To be eligible for
trading book capital treatment, financial instruments must
either be free of any restrictive covenants on their tradability
or able to be hedged completely.
In addition,
positions should be frequently and accurately valued, and the
portfolio should be actively managed.
A financial instrument is any contract that gives rise to
both a financial asset of one entity and a financial liability
or equity instrument of another entity.
Financial
instruments include both primary financial instruments (or cash
instruments) and derivative financial instruments.
A
financial asset is any asset that is cash, the right to receive
cash or another financial asset; or the contractual right to
exchange financial assets on potentially favourable terms, or an
equity instrument.
A financial liability is the
contractual obligation to deliver cash or another financial
asset or to exchange financial liabilities under conditions that
are potentially unfavourable.
Positions held with
trading intent are those held intentionally for short-term
resale and/or with the intent of benefiting from actual or
expected short-term price movements or to lock in arbitrage
profits, and may include for example proprietary positions,
positions arising from client servicing (e.g. matched principal
broking) and market making.
Banks must have clearly defined policies and procedures for
determining which exposures to include in, and to exclude from,
the trading book for purposes of calculating their regulatory
capital, to ensure compliance with the criteria for trading book
set forth in this Section and taking into account the bank’s
risk management capabilities and practices.
Compliance with these policies and procedures must be fully
documented and subject to periodic internal audit.
These
policies and procedures should, at a minimum, address the
general considerations listed below. The list below is not
intended to provide a series of tests that a product or group of
related products must pass to be eligible for inclusion in the
trading book.
Rather, the list provides a minimum set of
key points that must be addressed by the policies and procedures
for overall management of a firm’s trading book:
• The
activities the bank considers to be trading and as constituting
part of the trading book for regulatory capital purposes;
• The extent to which an exposure can be marked-to-market
daily by reference to an active, liquid two-way market;
•
For exposures that are marked-to-model, the extent to which the
bank can:
(i) Identify the material risks of the
exposure;
(ii) Hedge the material risks of the exposure
and the extent to which hedging instruments would have an
active, liquid two-way market;
(iii) Derive reliable
estimates for the key assumptions and parameters used in the
model.
• The extent to which the bank can and is required
to generate valuations for the exposure that can be validated
externally in a consistent manner;
• The extent to which
legal restrictions or other operational requirements would
impede the bank’s ability to effect an immediate liquidation of
the exposure;
• The extent to which the bank is required
to, and can, actively risk manage the exposure within its
trading operations; and
• The extent to which the bank
may transfer risk or exposures between the banking and the
trading books and criteria for such transfers.
The
following will be the basic requirements for positions eligible
to receive trading book capital treatment.
• Clearly
documented trading strategy for the position/instrument or
portfolios, approved by senior management (which would include
expected holding horizon).
• Clearly defined policies and
procedures for the active management of the position, which must
include:
– positions are managed on a trading desk;
– position limits are set and monitored for appropriateness;
– dealers have the autonomy to enter into/manage the
position within agreed limits and according to the agreed
strategy;
– positions are marked to market at least daily
and when marking to model the parameters must be assessed on a
daily basis;
– positions are reported to senior
management as an integral part of the institution’s risk
management process; and
– positions are actively
monitored with reference to market information sources
(assessment should be made of the market liquidity or the
ability to hedge positions or the portfolio risk profiles).
This would include assessing the quality and availability
of market inputs to the valuation process, level of market
turnover, sizes of positions traded in the market, etc.
•
Clearly defined policy and procedures to monitor the positions
against the bank’s trading strategy including the monitoring of
turnover and stale positions in the bank’s trading book.
Revisions to the Basel II market risk
framework
July 2009
A
main contributing factor
was that the current capital
framework for market risk, based on the 1996 Amendment to the
Capital Accord to incorporate market risks, does not capture
some key risks.
In response,
the Basel Committee on Banking
Supervision (the Committee) supplements the current
value-at-risk based trading book framework with an incremental
risk capital charge, which includes default risk as well as
migration risk, for unsecuritised credit products.
For securitised products, the
capital charges of the banking book will apply with a limited
exception for certain so-called correlation trading activities,
where banks may be allowed by their supervisor to calculate a
comprehensive risk capital charge subject to strict qualitative
minimum requirements as well as stress testing requirements.
These measures will reduce the incentive for regulatory
arbitrage between the banking and trading books.
An
additional response to the crisis is
the introduction of a stressed
value-at-risk requirement.
Losses in most banks’ trading books during the financial
crisis have been significantly higher than the minimum capital
requirements under the former Pillar 1 market risk rules.
The Committee therefore requires banks to calculate a
stressed value-at-risk taking into account a one-year
observation period relating to significant losses, which must be
calculated in addition to the value-at-risk based on the most
recent one-year observation period.
The
additional stressed value-at-risk
requirement will also help reduce the procyclicality of the
minimum capital requirements for market risk.
Background
and objectives
The
Basel Committee/IOSCO Agreement reached in July 2005 contained
several improvements to the capital regime for trading book
positions.
Among the revisions was a new requirement for
banks that model specific risk to measure and hold capital
against default risk that is incremental to any default risk
captured in the bank’s value-at-risk model.
The
incremental default risk charge was incorporated into the
trading book capital regime in response to the increasing amount
of exposure in banks’ trading books to credit-risk related and
often illiquid products whose risk is not reflected in
value-at-risk.
At its meeting in March 2008,
the Committee decided to expand the
scope of the capital charge, to improve the internal
value-at-risk models for market risk and to update the prudent
valuation guidance for positions accounted for at fair value.
Given the interest of both banks and securities firms in the
potential solutions to these particular issues, the Committee
has worked jointly with the International Organization of
Securities Commissions (IOSCO) to consult with industry
representatives and other supervisors on these matters.
While this work was undertaken jointly by a working group from
the Committee and IOSCO, the resulting proposal represents an
effort by the Committee to find prudential treatments for
certain exposures held by banks under the Basel II Framework.
Consequently,
this text frequently refers to rules
for banks, banking groups, and other firms subject to prudential
banking regulations.
The Committee recognises
that, in some cases, national authorities may decide to apply
these rules not just to banks and banking groups, but also to
investment firms, to groups of investment firms and to combined
groups of banks and investment firms that are subject to
prudential banking or securities firms’ regulation.
In
June 2006, the Committee published a comprehensive version of
the Basel II Framework which includes the June 2004 Basel II
Framework, the elements of the 1988 Accord that were not revised
during the Basel II process, the 1996 Amendment to the Capital
Accord to incorporate market risks, and the July 2005 paper on
The application of Basel II to trading activities and the
treatment of double default effects.
Unless stated
otherwise, paragraph numbers in this document refer to
paragraphs in the comprehensive version of the Basel II
Framework.
The Committee released consultative documents
on the
revisions to the Basel II market risk
framework and the guidelines for computing capital for
incremental risk in the trading book in July 2008 and more
recently in January 2009.
The Committee and IOSCO
worked diligently, in close cooperation with representatives of
the industry, to reflect their comments in the present paper and
the Guidelines.
According to the proposed changes to the
Basel II market risk framework outlined below, the trading book
capital charge for a bank using the internal models approach for
market risk will be subject to a general market risk capital
charge (and a specific risk capital charge to the extent that
the bank has approval to model specific risk) measured using a
10-day value-at-risk at the 99 percent confidence level and a
stressed value-at-risk.
A bank that has approval to model
specific risk will also be subject to an incremental risk
capital charge.
The
scope and implementation requirements for general market risk
will remain unchanged from the current market risk regime.
For a bank that has approval to model specific risk, the
10-day value-at-risk estimate will be subject to the same
multiplier as for general market risk.
The separate
surcharge for specific risk under the current framework5 will be
eliminated.
The Committee has decided that the incremental
risk capital charge should capture not only default risk but
also migration risk.
This decision is reflected in the
proposed revisions to the Basel II market risk framework.
Additional guidance on the incremental risk capital charge
is provided in a separate document, the Guidelines for computing
capital for incremental risk in the trading book (referred to as
“the Guidelines”).
The Committee as a whole has not yet
agreed that currently existing methodologies used by banks
adequately capture incremental risks of all securitised
products.
Until the Committee can be satisfied that a
methodology adequately captures incremental risks for all
securitised products, the capital charges of the standardised
measurement method will in general be applied to these products.
However, there will be
a limited exception for certain correlation trading activities,
where banks may be allowed by their supervisor to calculate a
comprehensive risk capital charge subject to strict minimum
requirements.
In particular, for a bank to
apply this exception it must regularly apply a set of specific,
predetermined stress scenarios to the portfolio that receives
internal model regulatory capital treatment.
The
precise number and composition of
stress scenarios to be applied will be determined by the
Committee in consultation with the industry by March 2010.
Furthermore, the Committee will
evaluate a floor for the comprehensive risk capital charge which
could be expressed as a percentage of the charge applicable
under the standardised measurement method.
This
evaluation will be based on a quantitative impact study to be
conducted by 2010.
The
improvements in the Basel II
Framework concerning internal value-at-risk models in particular
require banks to justify any factors used in pricing which are
left out in the calculation of value-at-risk.
They will also be required to
use hypothetical backtesting at least for validation, to update
market data at least monthly and to be in a position to update
it in a more timely fashion if deemed necessary.
Furthermore, the Committee clarifies that it is permissible to
use a weighting scheme for historical data that is not fully
consistent with the requirement that the “effective” observation
period must be at least one year, as long as that method results
in a capital charge at least as conservative as that calculated
with an “effective” observation period of at least one year.
To complement the incremental risk capital framework, the
Committee extends the scope of the prudent valuation guidance to
all positions subject to fair value accounting and make the
language more consistent with existing accounting guidance.
The Committee clarifies that
regulators retain the ability to
require adjustments to current value beyond those required by
financial reporting standards, in particular where there is
uncertainty around the current realisable value of a position
due to illiquidity.
This guidance focuses on the
current valuation of the position and is a separate concern from
the risk that market conditions and/or variables will change
before the position is liquidated (or closed out) causing a loss
of value to positions held.
The Committee has already
conducted a preliminary analysis of the impact of an incremental
risk capital charge only including default and migration risk,
largely relying on the data collected from its quantitative
impact study on incremental default risk in late 2007.
It has collected additional data in 2009 to assess the impact of
changes to the trading book
capital framework. In the coming
months, the Committee will review the calibration of the market
risk framework in light of the results of this impact
assessment.
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