This document presents revised standards for minimum capital requirements for market risk, developed by the Basel Committee on Banking Supervision. Key enhancements include a new, more rigorous internal models approach, a revised standardized approach, and a shift from the Value-at-Risk measure to Expected Shortfall. These changes aim to better capture market risks and strengthen banks' resilience during periods of…
This document, published by the Basel Committee on Banking Supervision in 2016, presents the revised standards relating to minimum capital requirements for market risk under Basel III. It covers the methods for calculating regulatory capital for internationally active banks on financial markets, particularly for their trading activities. The scope includes the definition of trading book and banking book instruments, the standardized and internal approaches for capital calculation, as well as the rules for managing internal risk transfers and default risks. The intended application period extends until the final implementation scheduled for January 2019.
The document addresses the revision of the Basel III regulatory framework for calculating minimum capital requirements related to market risk. This revision aims to replace existing rules, notably those from Basel II of 2006, by enhancing risk sensitivity and the robustness of the models used.
Key changes include:
- A strengthened Internal Models Approach (IMA) with a more rigorous approval process, allowing supervisors to withdraw modelling authorization for specific desks, better identification of risk factors, and limits on hedging and diversification effects.
- A thoroughly revamped Standardised Approach (SA), based on a sensitivities method (delta, vega, curvature) to ensure sufficient risk sensitivity and serve as a floor to the IMA.
- Replacement of the Value-at-Risk (VaR) risk measure by Expected Shortfall (ES), more prudent to capture extreme risks under stress.
- Integration of market liquidity risk via variable liquidity horizons, replacing the previously fixed 10-day horizon.
- A more objective definition of the boundary between trading book and banking book, reducing regulatory arbitrage.
The IMA combines ES, a Default Risk Charge (DRC), and a Stressed ES (SES) for non-modellable risks, excluding securitisation exposures from the IMA scope. The standardized approach includes a sensitivities method, a DRC calibrated on credit risk treatment in the banking book, and a Residual Risk Add-on for uncovered risks.
Rules strictly govern instrument transfers between books, prohibiting capital arbitrage, with additional capital imposed if charge reduction occurs following a transfer. Internal risk transfers are subject to precise conditions to be recognized in capital.
Implementation is planned by January 2019, with mandatory reporting by end-2019. The Committee will continue monitoring impacts and adjusting rules, notably in connection with work on securitisations, CVA, and other risks.
This document was developed to address identified shortcomings in the existing regulatory framework on market risk, notably the weaknesses of the VaR measure and possibilities for arbitrage between trading book and banking book. The objective is to strengthen banks' resilience to market risks by improving risk sensitivity, the rigor of internal models, and integrating liquidity risk. The scope covers internationally active banks on capital markets, focusing on financial instruments held in trading book and banking book. Limitations notably include the exclusion of securitisation exposures from the IMA scope and the requirement for national approval to use internal models.
Definition of market risk and scope of application:
- Market risk includes default risk, interest rate risk, credit spread risk, equity, foreign exchange, and commodities for the trading book, and foreign exchange and commodities for the banking book (p. 9).
- Two calculation methods are possible: standardized approach (SA) and internal models approach (IMA), subject to approval (p. 9).
Definition and management of the trading book:
- Trading book instruments: financial instruments, currencies, commodities without legal impediment to sale or hedging, valued at fair value with recognition of variations in P&L (p. 10).
- Inclusion criteria: held for short-term resale, profit from price movements, arbitrage, hedging risks related to these activities (p. 12).
- Instruments excluded from the trading book: unlisted equities, real estate, retail credits, investments in non-transparent funds, derivatives on these assets, etc. (p. 11-12).
- Strict supervision of designations, with supervisor power to reclassify instruments (p. 13).
Management of trading desks:
- Clear definition of desks with strategy, reporting, risk limits, and internal control (p. 13-14).
- Regular reports on inventory, limits, intraday usage, and liquidity (p. 14).
Restrictions on transfers between books:
- Transfers are rare and subject to approval, only in extraordinary events (p. 14).
- Capital arbitrage prohibited, with capital surcharges if charge reduction follows a transfer (p. 14).
- Mandatory documentation and public disclosure (p. 14-15).
Treatment of internal risk transfers:
- No capital recognition for transfers from trading book to banking book (p. 15).
- Possible recognition for transfers from banking book to trading book under strict conditions, notably existence of corresponding external hedge (p. 15-16).
- Internal transfers between trading desks recognized under conditions (p. 16).
Internal Models Approach (IMA):
- Required capital aggregates Expected Shortfall (ES), Default Risk Charge (DRC), and an add-on for non-modellable risks (SES) (p. 6).
- Exclusion of securitisation exposures from the IMA scope (p. 6).
Standardized Approach (SA):
- Composed of three elements: sensitivities method (delta, vega, curvature), Default Risk Charge, and Residual Risk Add-on (p. 18).
- Sensitivities method extends use of sensitivities for better risk sensitivity (p. 7, 18).
- Default Risk Charge aligned with credit risk treatment in banking book, with limited recognition of hedges (p. 7, 22).
- Residual Risk Add-on covers risks not captured by other components, with risk weights of 1% or 0.1% depending on instrument nature (p. 23-24).
Risk measures and aggregation:
- Shift from VaR to Expected Shortfall to better capture extreme risks (p. 5).
- Aggregation of delta, vega, and curvature risks according to precise formulas with correlations adjusted under three scenarios (high, medium, low) to account for correlation variability under stress (p. 19-22).
- Detailed definitions of risk factors for each class (interest rate, credit spread, equity, commodities, foreign exchange) (p. 24-27).
Treatment of counterparty risk in the trading book:
- Separate capital calculation for counterparty risk on OTC derivatives, repos, etc., applying the same weights as for the banking book (p. 16-17).
Implementation and monitoring:
- Schedule set with final implementation on January 1, 2019, and mandatory reporting by end-2019 (p. 17).
- Continuous monitoring by the Basel Committee of impacts, calibrations, and regulatory trade-offs (p. 8).
- Ongoing work on securitisations, CVA, sovereign risk, and interest rate risk in the banking book likely to affect the framework (p. 8).
Transparency and documentation:
- Obligations to document policies, procedures, and practices for instrument designation and risk management (p. 13, 20).
- Requirements for regular reporting and internal audit (p. 20).
In summary, the framework aims to strengthen risk sensitivity, model rigor, coherence between trading book and banking book, and better integrate liquidity and default risks.
Established facts:
- The revised framework replaces Basel II market risk capital requirements and introduces more prudent and risk-sensitive methods, notably Expected Shortfall (p. 5).
- The IMA combines ES, DRC, and SES, excluding securitisation exposures, with a rigorous model approval process (p. 6).
- The standardized approach is structured around a sensitivities method (delta, vega, curvature), a DRC aligned with the banking book, and a Residual Risk Add-on for uncovered risks (p. 18-24).
- The boundary between trading book and banking book is clarified with strict rules to limit arbitrage and instrument transfers (p. 9-15).
- Counterparty risk is calculated separately in the trading book with rules consistent with the banking book (p. 16-17).
Assumptions:
- Internal models used by banks are assumed to provide adequate bases for sensitivity calculations (p. 19).
- Correlations between risk factors may vary under stress, justifying calculation under three scenarios (p. 21).
Interpretations:
- The shift to ES improves capture of extreme risks compared to VaR, enhancing framework prudence (p. 5).
- Integration of liquidity risk via variable horizons responds to the need to better reflect real market conditions (p. 5).
- Strengthened controls on internal and inter-book transfers aim to reduce regulatory arbitrage practices (p. 14).
Uncertainties:
- The final impact of ongoing work on securitisations, CVA, sovereign risk, and banking book interest rate risk remains to be determined (p. 8).
- Precise calibration of P&L attribution tests for the IMA is being refined (p. 8).
- The effectiveness of new rules in practice will depend on national implementation and ongoing supervision.
The Basel Committee concludes that the revised market risk framework brings significant improvement in risk sensitivity, model rigor, and regulatory consistency. It recommends:
- Full implementation of the framework by January 2019, with mandatory reporting by end-2019 (p. 44).
- Ongoing monitoring of impacts, calibrations, and arbitrage risks, with possible adjustments according to ongoing work (p. 8).
- Strict application of instrument designation and inter-book transfer rules, with required documentation and approval (p. 14-15).
- Continued quantitative assessments, notably on P&L attribution tests for the IMA, to ensure model robustness (p. 8).
- Separate publication of transparency requirements (Pillar 3) related to market risk.
The Committee emphasizes that these standards must be integrated into national legislation and that supervisors must have the necessary tools to ensure consistent and effective application.
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