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The Market Risk Framework in Brief

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The Market Risk Framework in Brief Basel Committee BIS on Banking Supervision The market risk framework In brief January 2019 Revised market risk framework The failure to prudently What is market risk and why is its measurement being measure risks associated updated? with traded instruments caused major losses for Many banks have portfolios of traded instruments for some banks during the short-term profits. These portfolios – referred to as global financial crisis. trading books – are exposed to market risk, or the risk of The Basel Committee’s losses resulting from changes in the prices of instruments revised framework such as bonds, shares and currencies. Banks are required marks a significant to maintain a minimum amount of capital to account for improvement to the this risk. pre-crisis regulatory framework by addressing The significant trading book losses that banks incurred major fault lines. during the 2008 global financial crisis highlighted the need for the Basel Committee to improve the global market risk framework. As a stop-gap response, in July 2009 the Committee introduced the Basel 2.5 framework to help improve the framework’s risk coverage in certain areas and increase the overall level of capital requirements, with a particular focus on trading instruments exposed to credit risk (including securitisations). The main drivers of market risk nterest “Market rates risk: the risk uity redit of losses prices spreads arising from ommodity Foreign movements in prices echange market prices.” 1 2016 revised framework and review Following up on the What changes were proposed? Basel 2.5 framework, the Committee initiated From 2012, the Committee initiated a fundamental review of a fundamental review the trading book. This comprehensive review sought to address of the trading book the inadequacies in the design and calibration of the market regime. Based on risk framework’s internal models and standardised approaches. multiple consultations and quantitative impact The result of this review – the 2016 revised framework, studies, the Committee originally scheduled for implementation in 2019 – set out published a revised stricter criteria for assigning instruments to the trading standard in January 2016. book. It overhauled the internal models methodology to In 2018, the Commitee better address risks observed during the crisis, reinforced consulted on further the process for supervisors to approve the use of internal targeted revisions to the models and introduced a new, more risk-sensitive standardised framework. methodology. While monitoring the implementation and impact of the new framework, the Committee acknowledged ongoing implementation challenges and issues in design and calibration. To address these, and give banks more time to develop their infrastructure, the Group of Governors and Heads of Supervision, the Committee’s oversight body, in 2017 extended the implementation date to 2022. In 2018, the Committee proposed a set of targeted revisions to the market risk framework related to the assessment that decides whether a bank’s internal risk management models properly reflect the vulnerabilities facing individual trading desks. The consultation also proposed refinements to and recalibrations of the standardised approach. Measures of market risk Value-at-risk (VaR) Expected shortfall (ES) A measure of the worst A measure of the average of expected loss on a portfolio all potential losses exceeding of instruments resulting the VaR at a given confidence from market movements level, which makes up for over a given time horizon VaR’s shortcomings in and a pre-defined capturing the risk of extreme confidence level. losses (ie tail risk). 2 Revised market risk framework, January 2019 In January 2019, the What are the key elements? Committee revised the framework to address Changes to the boundary of the banking book and the trading outstanding design book and calibration issues The revisions clarify the scope of positions subject to the market of the 2016 framework risk framework, including the treatment of equity investments in and to provide further funds and the treatment of foreign currency positions. clarity to facilitate its Changes to the internal models approach implementation. The revisions overhaul the design of the profit and loss attribution test to better differentiate between well and poorly performing models. Targeted changes address the impact of non-modellable risk factors (NMRFs). Changes to the standardised approach The revisions better align the treatment of foreign currency positions, options and index instruments with the associated risks. Risk weights are lowered by 30% for general interest rate risk and by 50% for FX risk. Banks with relatively small or simple trading portfolios may continue to use a recalibrated Basel 2.5 standardised approach, subject to supervisory approval. What is the impact of the revisions? Compared with Basel 2.5, the amended framework is estimated to increase market risk capital requirements by 22%, on average. Market risk-weighted assets (RWAs) would account for 5% of total RWAs on average, compared with 4% under Basel 2.5. Estimated change in share of total market risk-weighted assets as a percentage of total Basel III risk-weighted assets based on December 2017 data All banks, in percentage points 8 6 4 2 0 –2 Sample (horizontal axis) = 37 banks; weighted average = 0.9%p. Source: Basel Committee on Banking Supervision. 3 A history of minimum capital requirements for market risk Amendment Amendment Initial standard September The application of Basel II January Revisions to the Basel II to trading activities and Amendment to the capital 2008 market risk framework the treatment of double accord to incorporate 1997 default effect Global market risks 2009 (Basel 2.5) January Amendment July Financial Consultation July Modifications to the Revisions to the Basel II 1996 market risk amendment 2005 Crisis market risk framework 2009 Revised standard Amendment Consultation June Minimum capital December May Revisions to the Basel II requirements Fundamental review of market risk framework - for market risk the trading book (FRTB) updated as of 2017 (Basel III) 2014 2012 31 December 2010 Consultation January Consultation October Consultation December Simplified alternative to FRTB: outstanding issues Fundamental review the standardised of the approach to market risk 2016 2013 trading book 2010 capital requirements Consultation January Revisions to the minimum capital requirements for market risk 2019 March Revised standard Minimum capital 2018 requirements for market risk 4 Key features of the revised market risk framework Boundary between the banking Use and validation of banks' Risk measurement under the Risk measurement under the book and trading book internal models internal models approach standardised approach ork Assignment to thetrading book Model approval/removal Capital requirements primarily Risk measurement based on an primarily reliesonthe bank'sintent determined on a bank-wide basis determined using value-at-risk exposureb--y exposure building to trade an instrument (VaR) models block approach Issue: weak definitionprovides Issue: model approval processes Issue: insufficient measurementof Issue: outdated calibration and opportunityfor bankstomove poorly positioned to deny/remove tail risks and liquidity risk of trading insufficiently risk-sensitive to instruments across the trading book- approval fortrading desksthatare portfolios; permitsunrestrained serve as a credible complement bankingbook boundaryinpursuit of deemed inappropriatefor modeluse diversificationbenefits and fall back to the internal (amended in 2010) lower capitalrequirements models approach Current Basel 2.5 framew Robust boundarytoclearly specify Model approval/removal determined Expected shortfallmeasure Risk-sensitivemeasurement d appropriatecontentsofthe at thetrading desk level; separate, replacing VaR; separate NMRF primarily basedonthe loss abank trading book andrestrictarbitrary more stringent capital requirements capital requirement;fallback to the couldsuffer (iesensitivities) under reassignment for risks not appropriate for standardised approach for trading adefined stress scenario tandar modelling("non-modellablerisk desksthatfailmodel approval S factors" or NMRFs) assessments (issued in 2016) d ) Further specification of regulatory New test metricstodiscern poorly Adjustment to capital requirements Refined measurement method for book assignment requirementswith performing models;improved to addresscliff effects and FX risk,options andindex better articulatedprecedenceand criteria for theidentification of calibration issues for trading desks instruments; recalibratedrisk clarification for certain exposures NMRFs andrisks that fall shortofprocesses weights for general interest rate risk to assess modellability andFXrisk evised standar (issued in 2019 R 5.
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