Revised regulatory framework for market risk capital requirements

On 14 January 2016 the Basel Committee on Banking Supervision (BCBS) issued the revised framework for market risk capital requirements. The framework represents one part of the BCBS overall efforts to reform banking regulatory standards in response to the global financial crisis. The BCBS introduced a set of revisions to the market risk framework already in July 2009 after it had recognised a number of deficiencies in the market risk framework which had been in place since 1996. But some of the deficiencies remained unaddressed and therefore, further changes were needed.

The final standard was preceded by two consultative documents and several quantitative impact studies. The last impact study assumed the revised market risk framework was fully in force as of end-June 2015. Based on this impact study, the revised market risk standard would result in a median increase of approximately 22% in total market risk capital requirements if compared with the current market risk framework.

The BCBS declares that the purpose of the revised framework is to ensure that the standardised and internal model approaches to market risk deliver credible capital outcomes and promote consistent implementation of the standards across jurisdictions.

The BCBS revisions focus on these main areas:

• A revised boundary between the trading book and banking book which should reduce incentives to arbitrage its regulatory capital requirements between the two regulatory books. The definition of the trading book is supplemented with a list of instruments presumed to be in the trading book. Strict limits on the movement of instruments between the banking book and trading book and capital disincentives are applied to the transfer of instruments between the banking book and trading book.
• A revised internal models approach for market risk replaces VaR (value-at-risk) and stressed VaR with a single Expected Shortfall (ES) metric. Moreover, it takes better account of “tail risks” and market illiquidity risk and introduces constraints on the capital-reducing effects of hedging and portfolio diversification.
• A revised standardised approach for market risk is appropriate for banks with limited trading activity while also sufficiently risk sensitive to serve as a credible fallback for, as well as a floor to, the internal models approach. A key change to the standardised approach is the greater reliance on risk sensitivities as inputs into capital charge calculations. It will also capture the risks from securitisation exposures in the trading book.

The Basel revised framework also contains the guidelines for supervisory review process under Pillar 2 in the market risk area, especially regarding policies and procedures delineating the boundaries of the firm’s trading book.