The Basel Committee has finalised its standards (PDF 1.41MB) for the capital treatment of market risk. The Committee has also published (PDF 607KB) a helpful note explaining the gestation of the new market risk framework and the main changes introduced in the final version.
The final standards follow the publication of a revised market risk framework in January 2016, and consultation papers in June 2017 and March 2018 with proposals to revise some elements of the 2016 framework.
The consultation proposals have been adopted, together with some further changes. The main changes to the 2016 market risk framework
Implications for banks
Banks are likely to welcome this final version of the market risk framework, which will generally have a much smaller impact on market risk capital requirements than the 2016 version. There are no major surprises, and the proposals continue to provide an incentive for banks to adopt the IMA.
According to a limited impact study conducted by the Basel Committee using end-2017 data, the final standards are estimated to result in a weighted average increase of 22 percent in market risk capital requirements compared with the currently applied Basel 2.5 standards. Banks that exclusively use the standardised approach will see a 30 percent increase on a weighted average basis, while banks that use the internal models approach will see a 20 percent increase on a weighted average basis.
Overall, the share of market risk risk-weighted exposures as a percentage of banks' total risk-weighted assets increases from 4.4 percent under the current Basel 2.5 market risk framework to 5.3 percent under the final version of the market risk framework. This share would have increased to 7.2 percent under the January 2016 version of the framework.
Banks using the IMA will benefit from the proposed revisions to the PLA framework, whereby less serious failures of the PLA test will not require trading desks to switch from the IMA to the SA, and from the amendments to the NMRF (which the Basel Committee had signalled an earlier unwillingness to introduce). This makes adoption of the IMA a more attractive option for more banks.
Meanwhile, the changes to the standardised approach will reduce slightly the output floor (compared with the impact of the 2016 market risk framework), thereby increasing the potential benefit of using the IMA (if this benefit would otherwise have been constrained by the output floor).
The precise timing of the capital impacts also remains uncertain - pressure from market analysts may in effect require banks to comply with the new requirements ahead of their fully transitioned implementation dates. On the other hand, the January 2022 implementation date could slip further back in the EU if there are delays in introducing amended EU legislation, or if this legislation allows for an EU-specific transition period.
Banks that have focused on foundational aspects first (such as data alignment, data granularity, migration from Monte Carlo to historical simulation etc.) will not have to re-engineer much as a result of these proposals, which is a very positive outcome Those banks that were further ahead, having developed SA models and calculators and / or IMA tactical solutions (including IMA analysis), may require some modifications to their approaches, but this should not require fundamental re-building. Finally, for those banks in 'wait and see' mode the certainty provided by final standards should provide the impetus to begin their implementation programmes.
1. Scope of application
The final standards clarify the approach that banks should take in relation to:
a) financial instruments that could be included in either the trading book or the banking book;
b) the treatment of equity investments in funds (allocated to the trading book where a bank can 'look through' to the underlying assets, or has access to daily price quotes and to the information contained in the mandate of the fund); and
c) the treatment of structural foreign currency positions (revisions to the extent to which banks can exclude foreign currency risk positions entered into or maintained with the intent to completely or partially hedge adverse effects of exchange rate movements on the bank's risk-based capital ratio from foreign exchange capital requirements).
2. Standardised approach
Compared with the 2016 market risk framework, the final standards:
a) reduce the risk weights for general interest rate risk (by 30 percent) and FX risk (by 50 percent), and adjust the risk weights for the credit spread risk of high-yield sovereign bonds and covered bonds;
b) allow banks, subject to supervisory approval, to calculate FX risk with respect to the currency in which they manage their trading business (their 'base currency') rather than with respect to their reporting currency;
c) permit the use of liquid currency pair triangulation, and treat the resulting new FX pair as liquid and therefore subject to lower risk weights (this revision will also apply to the internal models approach);
d) add new 'index' buckets for equity and credit spread risks to provide a simple approach that does not require the identification of each underlying position in an index to calculate the capital requirements for equity and credit indices;
e) revise the treatment of low correlation scenarios in order to address the current overly conservative treatment;
f) amend curvature risk measurement to apply consistent scenarios for non-linear instruments such as options to risk factors defined in the same bucket for credit spread risk, equity and commodity risk classes, and to introduce a floor to address circumstances where the aggregate curvature risk creates a cliff effect.
3. Simplified standardised approach
For banks with relatively small or non-complex trading portfolios the Basel 2.5 standardised approach will be retained as a simplified alternative to the revised standardised approach, subject to the application of specified scalars to ensure a sufficiently conservative calibration of capital requirements for these banks. The scalars are set at:
As the scalars are multiplied by the capital requirement calculated under the Basel 2.5 framework, the scalar of 1.3 for interest rate risk means a 30 percent increase in market risk capital requirements relative to Basel 2.5.
4. Revisions to the internal models approach
(i) Profit and Loss Attribution (PLA)
As proposed in the consultation paper in March 2018, the final standards introduce new PLA test metrics to differentiate more effectively between well-performing and poorly-performing models:
The consequence of failing the test has been revised from a binary pass/fail outcome to a 'traffic light' approach with an intermediate 'amber zone' in which trading desks may continue to use the IMA subject to a capital surcharge. Trading desks that materially fail the test ('red zone') must use the standardised approach.
(ii) Non-Modellable Risk Factors (NMRF)
The quantitative conditions for a risk factor to be eligible for modelling have been amended to include risk factors that have sufficient liquidity but may experience extended periods during which there is limited trading (for example agricultural commodities). For example the requirement of no more than a 30-day gap between real price observations has been replaced by a requirement of a minimum of four real price observations in a 90-day period. Where a risk factor fails this risk factor eligibility test, it may still be considered eligible for modelling if there are a minimum of 100 real price observations in the previous 12 months. In both cases banks are permitted to count only one real price observation per day.
The calculation of the stressed loss for each NMRF has been simplified to reduce the operational burden. The final standards allows banks to use a common stress period for all risk factors relevant to a particular risk class. The period over which the loss should be calculated has been amended to be the same as the liquidity horizon specified for the expected shortfall (ES) measure, with a floor of 20 days.
The aggregation approach to calculating the overall NMRF capital requirement incorporates additional, but limited, diversification benefits.
The amended framework clarifies the qualitative conditions for eligible risk factors to be considered modellable, introducing a set of principles that banks must apply to the data used to model risk factors that have passed the risk factor eligibility test.
5. Trading desk requirements
The final standards provide greater flexibility in relation to trading desk structure, subject to local supervisory approval.
6. Implementation Timetable
The final standards are to be applied from 1 January 2022, to align with the other elements (credit risk, operational risk, and the phasing in of the output floor) of the final Basel package. There is, however, one transitional arrangement, under which the outcomes of the PLA test under the IMA will be used for Pillar 2 purposes beginning 1 January 2022, with the Pillar 1 capital requirement consequences of trading desks falling into the amber or red zones applying from 1 January 2023.