| |
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.
1. 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
1. Since the financial crisis began in mid-2007,
an important source of losses and of the build up of leverage
occurred in the trading book.
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-riskbased
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.
2. 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
3. The Basel Committee/IOSCO Agreement reached in July 20051
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.
4. 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.
5. 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.
6. 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.
30 comment letters have been
provided by banks, industry associations, supervisory
authorities and other interested
institutions in the most
recent consultation. Most of them are available on the
Committee’s website. The Committee and IOSCO wish to thank
representatives of the industry for their fruitful comments. 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.
7. 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.
8. 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”).
9. 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.
10. 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.
11. 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.
12. 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.
This review will include the multipliers mc and ms to the
current and stressed value-at-risk numbers as defined in the
revised paragraph 718(Lxxvi) (k) of the Basel II Framework, the
1.0 scaling factor to the incremental risk measure and the 1.0
scaling factor to the comprehensive risk measure defined in the
revised paragraph 718(XCiv) of the Basel II Framework, and the
floor to the liquidity horizon specified in the Guidelines.
Implementation date
13. Banks are expected to comply with the revised requirements
by 31 December 2010.
This also applies to
portfolios and products for which a bank has already received or
applied for approval for using internal models for the
calculation of market risk capital or specific risk model
recognition before the implementation of these changes
Free
E-book: 100 Job Descriptions in Risk and Compliance Management
|
|
Join the International Association of
Risk and Compliance Professionals (IARCP). Membership is Free
www.risk-compliance-association.com/How_to_become_member.htm
Benefits for Members:
www.risk-compliance-association.com/Member_Benefits.htm
Reading Room
www.risk-compliance-association.com/Reading_Room.htm
Certified Risk and Compliance
Management Professional (CRCMP)
www.risk-compliance-association.com/Distance_Learning_and_Certification.htm
Certified Information Systems Risk and
Compliance Professional (CISRCP)
www.risk-compliance-association.com/CISRCP_Distance_Learning_and_Certification.htm
Privacy and Compliance with the Federal
Trade Commission Fair, the California Online Privacy Protection Act,
the Children Online Privacy Protection Act, the Privacy Alliance,
the Controlling the Assault of Non-Solicited Pornography and
Marketing Act
www.risk-compliance-association.com/Privacy.htm
Become a member of the International
Association of Risk and Compliance Professionals (IARCP). Membership
is Free. You will receive a monthly newsletter with risk and
compliance management news, alerts and opportunities. You can
register below:
Distance Learning and
Online Certification programs
from the International Association of Risk
and Compliance Professionals (IARCP)
www.risk-compliance-association.com/Distance_Learning_and_Certification.htm
The
Cost:
US$
297
What is included in this
price:
A. The
official presentations
we use in our
instructor-led classes
B. Up to
3 Online Exams
C.
Personalized Membership Certificate printed in full colour.
Processing, printing,
packing and posting to
your office or home
Certified Risk and Compliance Management Professional (CRCMP) -
Distance
Learning and Online Certification Program
Certified Information Systems
Risk and Compliance Professional (CISRCP) -
Distance
Learning and Online Certification Program
To
learn more:
www.risk-compliance-association.com/Distance_Learning_and_Certification.htm
| |
