TWN Info Service on Finance and Development (May12/01)
14 May 2012
Third World Network

BCBS proposes beefing up trading book capital standards
Published in SUNS #7366 dated 9 May 2012

Geneva, 8 May (Kanaga Raja) -- The Basel Committee on Banking Supervision (BCBS) has presented some initial policy proposals relating to trading book capital requirements, which it has said will strengthen capital standards for market risk, thereby contributing to a more resilient banking sector.

These proposals are in a consultative document on the fundamental review of trading book capital requirements. The document was issued late last week by the BCBS, whose secretariat is based at the Bank for International Settlements in Basel.

In a press release, the Basel Committee said that the consultative document sets out a revised market risk framework and proposes a number of specific measures to improve trading book capital requirements. These proposals reflect the Committee's increased focus on achieving a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions, it added.

According to the press release, key elements of the proposals include:

-- A more objective boundary between the trading book and the banking book that materially reduces the scope for regulatory arbitrage;

-- Moving from value-at-risk to expected shortfall, a risk measure that better captures "tail risk";

-- Calibrating the revised framework in both the standardised and internal models-based approaches to a period of significant financial stress, consistent with the stressed value-at-risk approach adopted in Basel 2.5;

-- Comprehensively incorporating the risk of market illiquidity, again consistent with the direction taken in Basel 2.5;

-- Measures to reduce model risk in the internal models-based approach, including a more granular models approval process and constraints on diversification; and

-- A revised standardised approach that is intended to be more risk-sensitive and act as a credible fallback to internal models.

The Committee, the press release further said, is also proposing to strengthen the relationship between the models-based and standardised approaches by establishing a closer link between the calibration of the two approaches, requiring mandatory calculation of the standardised approach by all banks, and considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.

(The proposed new approach is expected to have, at least in the short-term, greater impact on European banks with large fixed income desks that would need to raise additional equity capital. They have been using the internal models-based approach of Basel-II, unlike US banks that have been using the standardised approach.)

According to the BCBS consultative document, the financial crisis exposed material weaknesses in the overall design of the framework for capitalising trading activities and the level of capital requirements for trading activities proved insufficient to absorb losses.

The document noted that as an important response to the crisis, the Committee introduced a set of revisions to the market risk framework in July 2009 (part of the "Basel 2.5" rules). These sought to reduce the cyclicality of the market risk framework and increase the overall level of capital, with particular focus on instruments exposed to credit risk (including securitisations), where the previous regime had been found especially lacking.

However, the Committee said it recognised at the time that the Basel 2.5 revisions did not fully address the shortcomings of the framework. As a result, the Committee initiated a fundamental review of the trading book regime, beginning with an assessment of "what went wrong".

"The fundamental review seeks to address shortcomings in the overall design of the regime as well as weaknesses in risk measurement under both the internal models-based and standardised approaches."

According to the Committee, the consultative document sets out the direction the Committee intends to take in tackling the structural weaknesses of the regime, in order to solicit stakeholders' comments before proposing more concrete revisions to the market risk capital framework.

The Committee has set a deadline of 7 September 2012 for comments to be submitted on the consultative document.

According to the document, the Committee has focused on the following key areas in its review: the trading book/banking book boundary; stressed calibration; moving from value-at-risk to expected shortfall; a comprehensive incorporation of the risk of market illiquidity; treatment of hedging and diversification; relationship between internal models-based and standardised approaches; revised models-based approach; revised standardised approach; and the appropriate treatment of credit.

With respect to the trading book/banking book boundary, the Committee said it believes that its definition of the regulatory boundary has been a source of weakness in the design of the current regime.

"A key determinant of the boundary is banks' intent to trade, an inherently subjective criterion that has proved difficult to police and insufficiently restrictive from a prudential perspective in some jurisdictions. Coupled with large differences in capital requirements against similar types of risk on either side of the boundary, the overall capital framework proved susceptible to arbitrage."

While the Committee considered the possibility of removing the boundary altogether, it concluded that a boundary will likely have to be retained for practical reasons.

According to the document, the Committee has now put forth for consideration two alternative boundary definitions:

(1) "Trading evidence"-based boundary: Under this approach, the boundary would be defined not only by banks' intent, but also by evidence of their ability to trade and risk manage the instrument on a trading desk. Any item included in the regulatory trading book would need to be marked to market daily with changes in fair value recognised in earnings. Stricter, more objective requirements would be used to ensure robust and consistent enforcement. Tight limits to banks' ability to shift instruments across the boundary following initial classification would also be introduced.

Fundamental to this proposal is a view that a bank's intention to trade - backed up by evidence of this intent and a regulatory requirement to keep items in the regulatory trading book once they are placed there - is the relevant characteristic for determining capital requirements.

(2) Valuation-based boundary: This proposal would move away from the concept of "trading intent" and construct a boundary that seeks to align the design and structure of regulatory capital requirements with the risks posed to a bank's regulatory capital resources.

The Committee said that fundamental to this proposal is a view that capital requirements for market risk should apply when changes in the fair value of financial instruments, whether recognised in earnings or flowing directly to equity, pose risks to the regulatory and accounting solvency of banks. This definition of the boundary would likely result in a larger regulatory trading book, but not necessarily in a much wider scope of application for market risk models or necessarily lower capital requirements.

On stressed calibration, the Committee said it recognises the importance of ensuring that regulatory capital is sufficient in periods of significant market stress. As the crisis showed, it is precisely during stress periods that capital is most critical to absorb losses. Furthermore, a reduction in the cyclicality of market risk capital charges remains a key objective of the Committee.

Consistent with the direction taken in Basel 2.5, the Committee said it intends to address both issues by moving to a capital framework that is calibrated to a period of significant financial stress in both the internal models-based and standardised approaches.

The Committee also said that a number of weaknesses have been identified with using value-at-risk (VaR) for determining regulatory capital requirements, including its inability to capture "tail risk".

For this reason, the Committee said it has considered alternative risk metrics, in particular expected shortfall (ES). ES measures the riskiness of a position by considering both the size and the likelihood of losses above a certain confidence level. In other words, it is the expected value of those losses beyond a given confidence level.

"The Committee recognises that moving to ES could entail certain operational challenges; nonetheless it believes that these are outweighed by the benefits of replacing VaR with a measure that better captures tail risk. Accordingly, the Committee is proposing the use of ES for the internal models-based approach and also intends to determine risk weights for the standardised approach using an ES methodology."

The Committee further said it recognises the importance of incorporating the risk of market illiquidity as a key consideration in banks' regulatory capital requirements for trading portfolios. Before the introduction of the Basel 2.5 changes, the entire market risk framework was based on an assumption that trading book risk positions were liquid, i. e. that banks could exit or hedge these positions over a 10-day horizon.

"The recent crisis proved this assumption to be false," said the Committee, adding that as liquidity conditions deteriorated during the crisis, banks were forced to hold risk positions for much longer than originally expected and incurred large losses due to fluctuations in liquidity premia and associated changes in market prices.

Basel 2.5 partly incorporated the risk of market illiquidity into modelling requirements for default and credit migration risk through the incremental risk charge (IRC) and the comprehensive risk measure (CRM).

According to the consultative document, the Committee's proposed approach to factor in market liquidity risk comprehensively in the revised market risk regime consists of three elements:

-- First, operationalising an assessment of market liquidity for regulatory capital purposes. The Committee proposes that this assessment be based on the concept of "liquidity horizons", defined as the time required to exit or hedge a risk position in a stressed market environment without materially affecting market prices. Banks' exposures would be assigned into five liquidity horizon categories, ranging from 10 days to one year.

-- Second, incorporating varying liquidity horizons in the regulatory market risk metric to capitalise the risk that banks might be unable to exit or hedge risk positions over a short time period (the assumption embedded in the 10-day VaR treatment for market risk).

-- Third, incorporating capital add-ons for jumps in liquidity premia, which would apply only if certain criteria were met. These criteria would seek to identify the set of instruments that could become particularly illiquid, but where the market risk metric, even with extended liquidity horizons, would not sufficiently capture the risk to solvency from large fluctuations in liquidity premia.

Additionally, the Committee said it is consulting on two possible options for incorporating the "endogenous" aspect of market liquidity. Endogenous liquidity is the component that relates to bank-specific portfolio characteristics, such as particularly large or concentrated exposures relative to the market.

The main approach under consideration by the Committee to incorporate this risk would be further extension of liquidity horizons; an alternative could be application of prudent valuation adjustments specifically targeted to account for endogenous liquidity.

"Hedging and diversification are intrinsic to the active management of trading portfolios. Hedging, while generally risk reducing, also gives rise to basis risk that must be measured and capitalised. In addition, portfolio diversification benefits, whilst seemingly risk-reducing, can disappear in times of stress," said the document.

Currently, it noted, banks using the internal models-based approach are allowed large latitude to recognise the risk-reducing benefits of hedging and diversification, while recognition of such benefits is strictly limited under the standardised approach.

The Committee is proposing to more closely align the treatment of hedging and diversification between the two approaches. In part, this will be achieved by constraining diversification benefits in the internal models-based approach to address the Committee's concerns that such models may significantly overestimate portfolio diversification benefits that do not materialise in times of stress.

The Committee also considers the current regulatory capital framework for the trading book to have become too reliant on banks' internal models that reflect a private view of risk.

To strengthen the relationship between the models-based and standardised approaches, the Committee said it is consulting on three proposals: first, establishing a closer link between the calibration of the two approaches; second, requiring mandatory calculation of the standardised approach by all banks; and third, considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.

According to the document, the Committee has identified a number of weaknesses with risk measurement under the models-based approach.

In seeking to address these problems, the Committee intends to (i) strengthen requirements for defining the scope of portfolios that will be eligible for internal models treatment; and (ii) strengthen the internal model standards to ensure that the output of such models reflects the full extent of trading book risk that is relevant from a regulatory capital perspective.

To strengthen the criteria that banks must meet before regulatory capital can be calculated using internal models, the Committee said it is proposing to break the model approval process into smaller, more discrete steps, including at the trading desk level.

The Committee explained that this will allow model approval to be "turned-off" more easily than at present for specific trading desks that do not meet the requirements. At the trading desk level, where the bank naturally has an internal profit and loss (P&L) available, model performance can be verified more robustly.

The Committee said it is considering two quantitative tools to measure the performance of models. First, a P&L attribution process that provides an assessment of how well a desk's risk management model captures risk factors that drive its P&L. Second, an enhanced daily back-testing framework for reconciling forecasted losses from the market risk metric with actual losses.

"Although the market risk regime has always required back-testing of model performance, the Committee is proposing to apply it at a more granular trading desk level in the future. Where a trading desk does not achieve acceptable P&L attribution or back-testing results, the bank would be required to calculate capital requirements for that desk using the standardised approach."

The Committee has also identified a number of important shortcomings with the current standardised approach.

According to the consultative document, a standardised approach serves two main purposes. Firstly, it provides a method for calculating capital requirements for banks with business models that do not require sophisticated measurement of market risk. This is especially relevant to smaller banks with limited trading activities.

Secondly, it provides a fallback in the event that a bank's internal market risk model is deemed inadequate as a whole or for specific trading desks or risk factors. This second purpose is of particular importance for larger or more systemically important banks.

The Committee said it has adopted the following principles for the design of the revised standardised approach: simplicity, transparency and consistency, as well as improved risk sensitivity; a credible calibration; limited model reliance; and a credible fallback to internal models.

In seeking to meet these objectives, the Committee proposes a "partial risk factor" approach as a revised standardised approach. The Committee also invites feedback on a "fuller risk factor" approach as an alternative.

The consultative document states more specifically:

-- Partial risk factor approach: Instruments that exhibit similar risk characteristics would be grouped in buckets and Committee-specified risk weights would be applied to their market value. The number of buckets would be approximately 20 across five broad classes of instruments, though the exact number would be determined empirically.

The Committee said that hedging and diversification benefits would be better captured than at present by using regulatory correlation parameters. To improve risk sensitivity, instruments exposed to "cross-cutting" risk factors that are pervasive across the trading book (e. g. FX and interest rate risk) would be assigned to more than one bucket. For example, a foreign-currency equity would be assigned to the appropriate equity bucket and to a cross-cutting FX bucket.

-- Fuller risk factor approach: This alternative approach would map instruments to a set of prescribed regulatory risk factors to which shocks would be applied to calculate a capital charge for the individual risk factors. The bank would have to use a pricing model (likely its own) to determine the size of the risk positions for each instrument with respect to the applicable risk factors. Hedging would be recognised for more "systematic" risk factors at the risk factor level. The capital charge would be generated by subjecting the overall risk positions to a simplified regulatory aggregation algorithm.

According to the consultative document, a particular area of Committee focus has been the treatment of positions subject to credit risk in the trading book. Credit risk has continuous (credit spread) and discrete (default and migration) components. This has implications for the types of models that are appropriate for capturing credit risk.

In practice, including default and migration risk within an integrated market risk framework introduces particular challenges and potentially makes consistent capital charges for credit risk in the banking and trading books more difficult to achieve.

The Committee is therefore considering whether, under a future framework, there should continue to be a separate model for default and migration risk in the trading book.

"The Committee thinks it is important to note that there are two particular areas that it has considered, but are not subject to any detailed proposals in this consultative document."

According to the consultative document, one is interest rate risk in the banking book. Although the Committee has determined that removing the boundary between the banking book and the trading book may be impractical, it is concerned about the possibility of arbitrage across the banking book/trading book boundary.

A major contributor to arbitrage opportunities are different capital treatments for the same risks on either side of the boundary. One example is interest rate risk, which is explicitly captured in the trading book under a Pillar 1 capital regime, but subject to Pillar 2 requirements in the banking book, it said.

The Committee said it has therefore undertaken some preliminary work on the key issues that would be associated with applying a Pillar 1 capital charge for interest rate risk in the banking book. It intends to consider the timing and scope of further work in this area later in 2012.

On the other area of interaction of market and counter-party risk, it said that Basel III introduced a new set of capital charges to capture the risk of changes to credit valuation adjustments (CVA). This is known as the CVA risk capital charge and will be implemented as a "stand alone" capital charge under Basel III, with a coordinated start date of 1 January 2013.

"The Committee is aware that some industry participants believe that CVA risk, as the market component of credit risk, should be captured in an integrated fashion with other forms of market risk within the market risk framework. The Committee has agreed to consider this question, but remains cautious of the degree to which these risks can be effectively captured in a single integrated modelling approach. It observes that there is no clear market standard for the treatment of CVA risk in banks' internal capital."

For the time being, the Committee said it anticipates that open questions regarding the practicality of integrated modelling of CVA and market risk could constrain moving towards such integration.

In the meantime, the industry should focus on ensuring a high-quality implementation of the new stand-alone charge on 1 January 2013, it added. +