Fundamental Review of the Trading Book – The Revised Market Risk Regime

Clarification of the planned regulatory standards for the calculation of capital requirements for market price risks in the trading book

On 31 October 2013, based on an initial draft issued in May 2012, the Basel Committee on Banking Supervision published a second consultative document entitled: "Fundamental Review of the Trading Book: A revised market risk framework", October 2013). 

In the current revised form, the guidelines regulate the following core issues and areas: 

  • The definition of the boundary between the Banking Book and the Trading Book
  • The revised standardised approach 
    (in future, this calculation will also be mandatory for institutions that have an authorised internal market price risk model)
  • Internal market price risk model with new regulations for stressed scenario calibration
  • Determination of market liquidity risks and default risks

Although, in the second consultative paper, too, the inability of VaR to capture tail risks is seen as a major problem. Consequently, for internal models, the basis for measuring risk will be switched from VaR to the ES (Expected Shortfall) risk metric with a confidence level of 97.5 per cent. In the revised standardised approach, ES also has to be used by the supervisor for determining risk weights.

Approval and validation of internal models will be at the trading desk level and will be based on three quantitative eligibility criteria:

  1. P&L attribution analysis
  2. Daily backtesting
    (1-day VaR, for both the 97.5 per cent and 99 per cent confidence levels)
  3. Risk assessment tool

The risk assessment tool serves to identify those trading desks with especially illiquid and complex instruments whose capital backing (according to the internal model-based approach) for potential liquidity shortages, e.g. during a stress period, has to be deemed to be insufficient. Internal ES models have to be geared towards historical stress periods. Therefore, in the future, the frequently criticised double counting of risks, which results from the addition of the current VaR to the stressed VaR, will be eliminated. In order to determine a stress period, the regulator has proposed using the so-called indirect method. In the course of this, while complying with regulatory requirements, an institution may restrict itself to a sufficient subset of significant risk factors.

The current assumption of a uniform 10-day liquidity horizon for each market risk position is also under consideration. In future, it will be replaced by different liquidity periods for each risk position. Here, the exogenous market liquidity risk will be determined by assigning risk factors that have been specified by the regulator (altogether there will be 24 groups of risk factors) to one of the five market liquidity horizons. The appropriate capital requirements will then be determined by applying the simulated risk factor shocks for the respective position-related liquidity horizon.

More requirements - in the IT area, too

In the future, the calculation of the Standardised Approach will be mandatory for all institutions. The results will have to be published so that a basis for comparison can be created for institution-internal models. Institutions with internal models will have to calculate the Standardised Approach for each trading desk as if it were a stand-alone regulatory portfolio. For institutions that currently only use an internal model-based approach for market risk, in particular, this means that it might be necessary to set up a new additional IT application. Institutions that, in the future, do not wish to use the internal model-based approach (any more), will "only" have to implement the new SA. However, for the majority of institutions this would involve increased expenditure.

You can learn more about the new framework for market price risks and the potential impact of the regulations from the second BCBS consultative document in our FRTB article in the German language specialist journal RISIKO MANAGER.

The resulting initial effects will be seen, at the earliest, from July 2104

The Basel Committee is planning to carry out a quantitative impact study (QIS), probably from July 2014, to analyse the effects of the proposed changes. It should be assumed that the final version of the revised framework will be prepared and published on the basis of the results of the QIS. 

Now is the time to confront the new challenges with experience

The SKS Group is specialised in carrying out quantitative impact studies and we have repeatedly initiated, realised and provided support for these in establishments of varying sizes. For the upcoming market price risk QIS, too, the SKS Group has developed a standardised procedure as well as a reliable tool for the revised Standardised Approach.

One tool that provides an overview of all the operational implications 

This computational tool has a modular format and a generic import interface for the required data in the individual risk classes. The set of formulas as well as the entire aggregation logic for the Standardised Approach in full have been stored in the tool. What we have found from carrying out diverse QISs is that a large part of the costs goes on the acquisition,structuring, reconciliation and quality assurance of the data. However, setting up and also implementing a project for the collection and simulation of data, in the run-up to the SA, offers the advantage of being able to make an assessment of the operational implications and to perform a simulation of their impact on the required capital.  Upon request, we would be very pleased to personally present to you our approach in this regard, as well as our computational tool, within the scope of an individual on-site workshop.