Bâle 2.5 - Revisions to the Basel II market risk framework

General Information

This document, entitled "Revisions to the Basel II market risk framework," was published in July 2009 by the Basel Committee on Banking Supervision. It is a 35-page regulatory standard (only the first 33 pages were provided) aiming to revise the market risk management framework under Basel II. The scope covers capital requirements for market risks in banks, including standardized methods and the internal models approach, as well as disclosure requirements and the consideration of illiquid positions. The document is set in the post-2007-2008 financial crisis context, focusing on recent periods and international banking practices.

Executive Summary

The document addresses revisions made to the Basel II regulatory framework for market risk, in response to significant losses suffered by banks in their trading portfolios during the financial crisis starting in 2007 (p. 7). The main objective is to correct deficiencies in the existing framework, notably the inability to capture key risks such as default and migration risk in non-securitized credit products held in the trading book. To this end, the Committee introduces an "incremental risk capital charge" (IRCC) covering these additional risks, as well as a "stressed value-at-risk" (sVaR) requirement based on a one-year observation period characterized by significant stress, to reduce the procyclicality of capital requirements (p. 7). The framework distinguishes treatments for securitized products, generally applying banking book capital charges, except for certain so-called "correlation trading" activities where a full internal model may be used under strict stress testing and data quality conditions (p. 8-9). Banks using the internal models approach must meet enhanced qualitative and quantitative criteria, including independent validation, rigorous backtesting, and frequent data updates (p. 15-21). The document also specifies changes to standardized methods, notably for correlation trading exposures and specific capital requirements for credit risks and securitized products (p. 10-14). Implementation of these revisions is planned for December 31, 2010 (p. 9). Furthermore, the framework extends prudent valuation guidance to fair-valued positions, including those in the banking book, with emphasis on managing illiquid positions (p. 32-33). Finally, disclosure requirements are strengthened to better reflect risks and methodologies used, both for the standardized approach and the internal models approach (p. 30-31). These revisions aim to enhance banks' resilience to market risks, improve the quality and consistency of risk measures, and limit regulatory arbitrage between banking and trading books.

Context and Objectives

Since the start of the financial crisis in 2007, losses in trading portfolios revealed that the existing Basel II market risk framework did not capture certain significant risks, notably default and migration risk on non-securitized credit products (p. 7). The Committee therefore undertook to revise this framework to incorporate additional capital covering these risks (incremental risk capital charge) and to introduce a stressed value-at-risk requirement to better reflect market conditions during stress periods and reduce procyclicality of capital requirements (p. 7). These efforts were conducted in cooperation with IOSCO and were subject to public consultations in 2008 and 2009, with about thirty responses from banks, professional associations, and supervisory authorities (p. 8). The scope covers banks and banking groups subject to prudential regulation, with the possibility for national authorities to extend these rules to investment firms or mixed groups (p. 8). The document aims to improve the robustness of the regulatory market risk framework, limit regulatory arbitrage between banking and trading books, and strengthen the quality of internal models and prudent valuation practices.

Summary of Key Points by Theme

Market Risk Framework Revision: The Committee introduces an incremental risk capital charge (IRCC) covering default and migration risk for non-securitized credit products in the trading book, in addition to capital based on value-at-risk (VaR) (p. 7-8). For securitized products, banking book capital charges generally apply, except for certain "correlation trading" activities where a full internal model may be used under strict conditions (p. 8-9). Stressed Value-at-Risk: A stressed VaR requirement is introduced, based on a one-year observation period characterized by significant stress, calculated in addition to the standard VaR, to reduce procyclicality and better reflect risks during crisis periods (p. 7, 19). Standardized Methods: The framework specifies definitions and treatments for "correlation trading" portfolios, including eligibility criteria for positions (exclusion of resecuritizations, existence of a two-way liquid market) (p. 10-11). Specific charges for securitized exposures are detailed according to external ratings and internal approaches, with deduction thresholds for high-risk or unrated exposures (p. 11-14). Internal Models Approach: Banks must obtain supervisory approval, which assesses the quality of the risk management system, staff competence, model validity, and the conduct of rigorous stress tests (p. 15). Models must include all relevant risk factors (interest rates, FX, equities, commodities), capture non-linearities, correlations, and be updated frequently (at least monthly) (p. 17-19). VaR must be calculated at a 99% confidence interval over a 10-day period, with at least one year of history, and a minimum regulatory multiplier of 3, adjusted according to model quality and backtesting results (p. 19-21). Banks must also calculate a stressed VaR according to a stress period approved by the supervisor (p. 19-20). Specific risk management (credit risk, event risk) must be integrated into the model or subject to an additional charge (p. 21-22). Models must be regularly validated, including tests beyond backtesting, to ensure adequacy and robustness (p. 22-23). Supervisory Review and Disclosure: Supervisors must verify model quality and the consideration of specific risks, with the possibility to require removal of certain positions from the model (p. 23). Disclosure requirements are strengthened for both standardized and internal models approaches, including qualitative information on methodologies, stress tests, and quantitative data on VaR, stressed VaR, and additional capital charges (p. 30-31). Prudent Valuation and Illiquid Positions: Prudent valuation guidance is extended to all fair-valued positions, trading or banking book (p. 32). Banks must implement robust systems and controls, favor marking-to-market when possible, and apply prudent model-based marking in absence of reliable market data, with clear and independent governance (p. 32-33).

Main Findings and Lessons Learned

- Established Facts: The previous Basel II framework did not adequately capture certain credit risks in the trading book, notably default and migration, which contributed to losses in the 2007-2008 crisis (p. 7). The introduction of the incremental risk capital charge and stressed VaR aims to fill these gaps (p. 7-8). VaR and stressed VaR calculation requirements are specified with a minimum of one year of history, a 99% confidence interval, and a 10-day horizon (p. 19). Internal models must meet strict qualitative criteria, including an independent control unit, rigorous backtesting, and regular external validation (p. 15-23). - Assumptions: The Committee considers that current methodologies do not yet capture all risks of securitized products, justifying the general application of standardized charges for these products, except for certain correlation trading activities (p. 9). - Interpretations: The implementation of stressed VaR and additional capital for incremental risks should reduce procyclicality and incentives for regulatory arbitrage between banking and trading books (p. 7-8). External validation and enhanced supervision are essential to ensure model reliability (p. 22-23). - Uncertainties: Final calibration of multipliers and action plans will depend on the results of ongoing impact studies (p. 8). The precise definition of stress scenarios for correlation trading activities will be finalized by March 2010 (p. 9).

Conclusions and Author's Recommendations

The Committee recommends implementing the Basel II market risk framework revisions by December 31, 2010, including the introduction of the incremental risk capital charge, stressed VaR, and changes to standardized methods and the internal models approach (p. 9). It emphasizes the importance of rigorous model validation, prudent management of illiquid positions, and transparent disclosure of risks and methodologies (p. 15-33). For securitized products, the Committee maintains the application of standardized charges except for certain correlation trading activities, which must meet strict data quality and stress testing requirements (p. 9). It stresses the need for banks to integrate these requirements into their risk management systems and for supervisors to ensure effective oversight, notably through model review and valuation practices (p. 23, 32). The Committee plans a recalibration of multipliers and capital thresholds following ongoing impact studies (p. 8).