PRIMER: market risk – a banking regulation perspective
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PRIMER: market risk – a banking regulation perspective

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Regulation and risk management expert Bozena Gulija examines how methods and regulatory approaches have evolved when it comes to this category of risk

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 off-balance sheet positions.

Interest rate risk (IRR) is a form of market risk that is especially relevant to various on- and off-balance 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 cut-off 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, 10-day 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 pre-defined 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 sub-prime 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 sensitivities-based 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 – sensitivities-based method (main element that includes delta, vega and curvature risk);

  • DRC – default risk charge (intended to capture jump-to-default-risk); and

  • RRAO – residual risk add-on (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 – non-modellable 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.

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