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BCBS coming down hard on trading books

The Basel Committee on Banking Supervision (BCBS) has been ruminating on changes to prudential rules for trading activities at banks.  In October of this year, BCBS released its second consultation paper.  It follows the first document released in May 2013, and has definitive views of how trading books should be regulated.

The changes will be far-reaching and significant.  The phrase “Fundamental Review…” in the title of consultation paper is indeed appropriate.  Market risk managers need to be thinking about the proposal, and what will be required in the next few years as the changes hit.  Some banks may even need to debate the value of continuing their trading activities.

Tradingbookreview

Overview of the changes and their drivers

The Global Financial Crisis (GFC) highlighted a number of shortcomings with the framework at the time.  Some of these were addressed in Basel 2.5. Basel 2.5 added a “stressed” VaR component to the market risk capital requirement. Basel 3 introduces measures to address concerns e.g. no longer recognising Tier 3 capital to cover market risk.

In my view “strengthening the boundary” between banking and trading books is a key measure. Historically banks have been able to hold instruments, with much lower capital in the trading book than in the banking book.  The definition of what belongs in trading book was subjective.  This doesn’t change how risk is measured, but banks will need to provide greater reporting.  In addition to making a clear delineation, the new proposals aim to reduce the potential differences in capital between the two.

Trading book instruments are assumed to be highly liquid.  However during the GFC this was proven wrong in some cases.  Some banks were left holding instruments for much longer.  The current framework requires banks to use a 10 day holding period in calculating VaR for all positions.  BCBS proposes holding periods from 10 days to a year.

The treatment of hedging and diversification get a real dusting.  BCBS’s view is that the internal model approach gave too much benefit to diversification, while the standardised approach did not.  The proposals aim to bring the two closer.

BCBS sees an expanded role for the standardised approach.  For one banks will be expected to calculate and report capital on the standardised approach even if accredited to use the advanced approach.  For securitisations, this will be the only approach allowed.  Worryingly in my opinion, BCBS is considering using standardised capital as a floor.  This removes incentives to develop internal models and manage risks better.  BCBS cites the variability of capital under the internal models approach.  See Regulatory consistency assessment programme (RCAP) – Analysis of risk-weighted assets for market risk.

Finally the proposals address the issues in risk measurements themselves.  A key proposal is to move to expected shortfall (ES), rather than Value at Risk (VaR).  ES is a better measure of tail risk than VaR.  BCBS proposes ES at a 97.5% level of confidence to replace the current 99% confidence level using VaR.

Three key changes in more detail

1. Liquidity horizon

BCBS proposes moving away from a 10 day horizon to 5 different horizons depending on the instrument type.  The definition of a horizon is “the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of hedging instruments in stressed market conditions.”  A second set of measures proposed involves risk assessment at desk level to identify trades which are particularly complex and illiquid using non-model measures of risk.

The proposed horizons are based on a view of market or systemic liquidity.  Banks will need to categorise their exposures into 5 broad categories of horizons.  A sample of risk factors and associated horizons are listed below:

Risk factor category

Time horizon in days

Equity price (large cap)

10

Interest rate, Credit spread – sovereign (IG), FX rate, Energy price, Equity price (small cap), Equity price (large cap) volatility, Precious metal price

20

Interest rate ATM volatility, Interest rate (other), Credit spread – sovereign (HY), Credit spread – corporate (IG), FX volatility, FX (other), Other commodity price, Energy price volatility, Precious metal price volatility

60

Equity price (small cap) volatility, Equity (other) , Credit spread – corporate (HY), Other commodities price volatility, Commodity (other)

120

Credit spread – structured (cash and CDS), Credit (other)

250

 Different markets will have different levels of liquidity.  I assume supervisors in each market may adapt horizons to match the characteristics of their market.

A key consideration is how to calculate ES over longer horizons.  Options put forward by BCBS in its first consultation paper were:

  • Calculate ES directly using market shocks over longer historic windows

  • Calculate shocks for shorter windows then scale shocks to determine ES

  • Calculate ES over a shorter window and then scale up the ES.

BCBS has settled on the first approach.  To overcome the problem of having insufficient observations, BCBS will allow the use of overlapping time periods.  There is no requirement to have any assumptions on rebalancing or hedging at the end of the period, i.e. banks can liquidate or hedge positions by this time.

On the subject of hedging and rebalancing, the shock is applied instantaneously.  There is an implicit assumption that positions including hedges will remain unchanged throughout the liquidity horizon.

2. Choice of risk measures

The move to ES is a fundamental change in approach and philosophy.  BCBS states that VaR does not capture tail risk sufficiently.  ES includes losses beyond the threshold.  BCBS has proposed a 97.5% confidence level as they feel that this provides similar risk capture.  The other advantage of ES noted in the paper is less variation from extreme observations.

In my opinion, the choice of measure is not important.  ES has some nice properties compared to VaR and does take account of losses in excess of the threshold. However the assumed distributions and correlations are more important.  ES can also understate the risk if the model does not describe the tail correctly.  I find VaR slightly easier to explain than ES.  There is a direct link between the confidence level and the resulting loss or capital required when using VaR.

3. Recognition of correlation and diversification

The general thrust of the changes is to align the internal model approach and the standardised approach.  The internal model approach currently allows banks to recognise significant diversification benefits.  BCBS proposes constraining the level of diversification benefit.  This is done by taking a weighted average of capital with and without diversification.

On the standardised approach, BCBS proposes a framework which allows for correlation with long and short positions.  Unlike the banking book, the nature of the portfolio could mean that capital is lower when correlation is higher.  To counter this possibility, two sets of correlation parameters are specified.  One set applies where positions are offsetting ie. long / short.  The other parameter is used if positions are in the same direction e.g. long / long.  These correlation parameters are calibrated to the 25th and 75th percentile of historic correlation.

Conclusion

BCBS is proposing some fundamental changes. These changes are not only changes to methodology used for calculation.  The proposals also have implications for how trading books are defined as well as data and reporting processes.

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2 Comments

  1. Thanks Sen, very insightful article.

    Noting I’m not an SME in this area, to my understanding it appears there will be flow-on effects in the life insurance area (for bank-owned insurers).

    Cheers,
    Aamer

    • Thank you for your comments Aamer. In this case, I think the impacts are largely contained in the banking entity. This is because these proposed changes apply specifically to banking entities. Life insurers have a separate set of capital requirements.

      Cheers,
      Sen.

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