Regulation and risk management expert Bozena
Gulija examines how methods and regulatory approaches have
evolved when it comes to this category of
risk
What is market risk?
Although the general risk taxonomy and definitions have been
refined over the years, market risk can be broadly defined as
the risk of financial loss due to movements in market prices
such as interest rates, foreign exchange (currency) rates,
equity prices, credit spreads and commodity prices that can
adversely affect banks’ on and offbalance sheet
positions.
Interest rate risk (IRR) is a form of market risk that is
especially relevant to various on and offbalance sheet items
whose cash flows are sensitive to interest rates (eg loans,
bonds, deposits, interest rate derivatives). IRR can be
analysed as a gap risk (arising from timing differences in
maturity or repricing among a bank’s positions),
basis risk (arising due to different interest rate indices, eg
Libor, Euribor or some future risk free rates) and option risk
(related to option derivative positions or embedded options).
Furthermore, foreign exchange (FX) risk arises from currency
fluctuations, equity risk is the risk of losses due to the
adverse changes in equity prices, credit spread risk is driven
by the changes in the credit quality of a debtor or
counterparty, while commodity risk depends on the movements in
commodity prices (eg grains, metals or oil).
For this purpose, the market risk scope will be aligned with
the definition used for minimum regulatory capital
requirements, which is underpinned by the delineation between
banking and trading book. From the European Banking
Authority’s (EBA) perspective, 'market risk stems
from all the positions included in banks' trading book as well
as from commodity and foreign exchange risk positions in the
whole balance sheet’. Therefore, this overview is
restricted from exploring some (sub)categories, such as
interest rate risk in the banking book (IRRBB), which may be
included in banks’ internal market risk
definitions.
How to measure market risk?
In order to assess market risk, banks use a mix of specific
and comprehensive metrics. Specific measures are targeted at a
particular characteristic of some instruments and each of them
measures the sensitivity to a small change in a given
underlying parameter, while comprehensive measures aim to
calculate the risk exposures across all instruments and can
cover a whole bank’s portfolio of exposures.
The typical specific measures (including some
'greeks’) are:
 delta, which measures linear exposure to a market
factor or a rate of change with respect to a change in the
underlying asset or volatility;
 gamma, which measures the rate of change in delta
(first derivative of delta);
 vega, which measures risk exposure to implied
volatility changes;
 beta, which measures whether an individual investment
is more or less risky than a market as a whole (or a
benchmark);
 duration, which is the weighted average time to payment
weighted by cashflow amounts; or
 convexity, which measures the rate of change in
duration (first derivative of duration).
The most relevant comprehensive measures are as follows:
 Value at risk (VaR) represents the biggest loss (VaR
amount) associated with a certain probability (confidence
level, eg 95%) and a future period (time horizon, eg one
day). Subsequently, VaR can also be interpreted as the best
outcome on the worst (eg five percent) days. A number of
methods are available for calculating VaR, such as
historical simulation, variance/covariance and Monte Carlo
simulation.
 While VaR examines the recent year, stressed VaR (SVaR)
uses the data from a reference period that must include a
period of high market stress – a very bad period
is needed to capture extreme events.
 Conditional VaR (CVaR) or expected shortfall (ES) is
focused on tail risk, as it calculates the average of the
extreme losses beyond the VaR cutoff point. Simply, it is
the average loss on 'VaR break days’.
Regulatory milestones
In the 1980s and 1990s, the market risk concept gradually
gained prominence and was connected to the growing importance
of universal banks, globalisation and increasing complexity of
financial products and markets (including derivatives trading).
Banks, besides specific measures, started using VaR (developed
by JP Morgan) in order to capture market risk in a simple and
comprehensive way.
In 1996, the Basel Committee on Banking Supervision (BCBS)
adopted the Market Risk Amendment (to the Basel I capital
accord) that introduced regulatory capital requirements for
market risk in pillar 1. It allowed the standardised approach
(SA) where positions were allocated into buckets with
predefined risk weights, and the internal models approach (IMA)
based on VaR but subject to some regulatory restrictions (eg
99% confidence level, 10day horizon, regulatory multiplier,
use test, backtesting, validation and prior approval). These
concepts also remained in Basel II from 2004.
The considerable and rapid depreciations in trading
assets’ values were one of the more obvious
initial symptoms of the 2007 financial crisis. The weaknesses
in VaR, used as the main market risk measure at the time, were
considered to be an important part of the problem since VaR was
proven to be inadequate in times of high stress when the normal
distribution could be misleading and could not properly express
tail risk. Additionally, VaR was not able to capture liquidity
risk because it assumed that a bank could exit a trading book
position within a predefined holding period. Also, the
existing rules were not able to capture credit risk in trading
book exposures, and therefore banks’ capital
buffers were insufficient to cover the trading losses driven by
the subprime crisis.
Regulators responded very promptly to market risk issues
with a set of interim measures known as Basel II.5, which were
adopted in 2009 and are still part of the current market risk
regulatory framework. This reform added new components to the
existing structure (mainly for internal models), such as SVaR,
incremental risk capital (IRC) and comprehensive risk measure
(CRM). Moreover, regardless of the approach, securitisation
gained a stricter treatment, becoming better aligned with
credit risk. All this has led to a significant increase in
capital charges.

"The ambiguity regarding the
available approaches still contributes to uncertainty
about local implementation"


Generally, the Fundamental Review of the Trading Book (FRTB)
refers to the next generation of market risk approaches that
could be considered a part of the Basel III reform. The Basel
Committee published consultative documents starting from 2012,
and in 2016 they adopted the revised standard for minimum
capital requirements for market risk. Initially, the FRTB was
set to come into force in 2019, but this has been postponed
until 2022. Furthermore after 2016, new consultations were
initiated (most recently in March 2018) and, among other
topics, an introduction of additional simplified alternative to
the standardised approach is being considered.
As regards the FRTB, the key expected changes relate to the
following:
 a revised boundary between trading and banking book
(Instead of 'trading intent’, a new stricter
list of criteria is to be used for assigning an
instrument to trading or banking book.);
 revisions to the standardised approach (and a
possible simplified version) with emphasis on the
sensitivitiesbased method (SBM); and
 revisions to the internal models approach (IMA) based
on expected shortfall (ES).
Capital charges – overview of current
methods
Rules internationally agreed as Basel II.5 form the basis
for the current minimum capital requirements for
banks’ market risk which can be calculated
using the standardised approach (SA) or the internal models
approach (IMA), further depending on a particular
jurisdiction’s application of de minimis rule
and certain discretions in application of the Basel
standard.
Overall, the SA continues to retain a relatively simple
structure and the computation entails adding the charges
for general and specific market risks.
The IMA capital requirement is calculated as the sum of
the following elements:
 VaR;
 SVaR; and
 IRC (incremental risk capital for default and credit
migration risk) and/or CRM (comprehensive risk measure
that also covers default and credit migration risk but is
valid only for certain securitised products primarily
related to correlation trading).
Capital charges – overview of potential
future methods
When the new revised market risk framework (FRTB) comes
into force in 2022, two (or three) more risk sensitive and
complex approaches will be available for pillar 1 minimum
capital requirements for market risk: the revised
standardised approach (revised SA) and the revised internal
models approach (revised IMA), with a possible addition of
the simplified alternative to the standardised approach
(simplified revised SA).
The revised SA capital requirement is the sum of capital
charges calculated as follows:
 SBM – sensitivitiesbased method (main
element that includes delta, vega and curvature
risk);
 DRC – default risk charge (intended to
capture jumptodefaultrisk); and
 RRAO – residual risk addon (capital
requirement for more complex instruments that are not
adequately captured by SBM and DRC).
The revised IMA capital requirement is the sum of capital
charges calculated as follows:
 ES – expected shortfall (main element that
replaces VaR and SVaR; calibration with 97.5%, stressed
conditions, different holding periods);
 NMRF – nonmodellable risk factors (which
represents the capital charge for risks excluded from ES
model); and
 DRC – default risk charge (which replaces
IRC).
The simplified revised SA is proposed as either:
 a reduced form of SBM or
 a recalibrated version of the Basel II standardised
approach.
What are some challenges ahead?
After 20 years of VaR, the FRTB represents a major change
in calculation (and management) of market risk. Although the
final FRTB version is expected in early 2019 (as indicated at
the recent Basel Committee meeting), the ambiguity regarding
the available approaches still contributes to the uncertainty
about local implementations and proportionality available to
regulators and banks. This condition is additionally
complicated by the global regulatory and supervisory
fragmentation, and specifically by the extension of FRTB
finalisation and possible implementation delays, sometimes
also accompanied by national divergences.
Banks are finding it difficult to fulfil the qualitative
and quantitative requirements – from undertaking
strategic, organisational and procedural changes (including
focus on trading desk level) to securing data availability
and significant resources necessary for the development of
new models (including treatment of NMRF), controls and tests
(including profit and loss attribution). Driven by demanding
requirements and complexity of the new IMA, some big banks
have already decided to opt out and use the revised SA.
Finally, it is imperative to consider how these alternative
choices and subsequent modifications will affect
banks’ portfolio and capital optimisation
policies.