The Basel Committee on Banking Supervision (BCBS) published changes in the market risk capital requirements in January 2019, the last important element of the finalized Basel III framework. The version published in the original standards of 2016 was revised in response to widespread criticism. Changes suggested in the ensuing consultation paper were subsequently adopted by the BCBS in 2019. At European level, the market-risk standards have not yet been incorporated into the amended Capital Requirements Regulation (CRR 2), but the regulatory framework is being continuously expanded by the level-2 mandates of the European Banking Authority (EBA). On 27 June 2019, the EBA published a roadmap according to which a total of 26 regulatory technical standards (RTS), one implementing technical standards (ITS), two guidelines and one report must be drawn up in the area of market risk to meet its 30 mandates.
The starting point for the EBA is all relevant changes in BCBS 457, which includes new and clearer criteria for determining the boundaries of the trading and banking books, new definitions, a new version of the standardised approach, a revision of the simplified standardised approach and changes in the internal models approach (IMA).
Inconsistencies in the allocation of individual financial instruments to the trading book or the banking book have been resolved by a new system. Securities underwritings are only included in the trading book if the bank expects to purchase the security on the settlement date. Both repos for liquidity management (that are valued at accrual for accounting purposes) and real-estate portfolios and the associated derivatives are included in the banking book. Funds only belong to the trading book if their individual components have been verified by an independent authority (look-through approach) or if daily prices are available. The management of transactions from a trading desk is also not a sufficient condition for their allocation to the trading book.
In addition, internal risk transfer (IRT) was made more flexible. External hedging of both credit and equity risk may be carried out through multiple external transactions and with multiple counterparties, if the aggregation is reflected within the overall IRT. A sensible, sensitive limit now applies to the consideration of FX positions, which may be excluded for capital requirements.
A further change to the framework concerns the newly adjusted sensitivities in the standardised approach, through which the BCBS attempts to reduce the capital burden. This reduction is achieved by the possibility of using the base currency for certain FX positions. Furthermore, the scaling in the low correlation scenario is reduced. As a result, institutions are less adversely affected by highly-correlated risk factors (e.g. interest rates). Methodically, the instruments are no longer aggregated by risk factors but into buckets, so that larger jumps in the requirements for curvature risk are avoided. The problem of double counting in FX is addressed by the introduction of a factor 1.5, which divides the curvature-risk capital requirement for FX instruments. In addition, instruments without optionality are included in the curvature-risk calculation. This change extends the approach to all sensitive instruments and requires consistent valuation calculations. Compared to the BCBS standards published in 2016, the risk weights for interest-rate risk have been reduced by 30% and for FX by 50%. In addition, the risk weights for covered bonds and high-yield government bonds have also been reduced.
The simplified standardised approach minimises the burden on those institutions with a small and non-complex trading book. The increase in market-risk capital is calculated using the newly defined four scaling factors (interest-rate risk, equity risk, commodity risk and FX risk). However, this means that the smaller FX factor will increase the requirements by 20% compared to the current level.
The applicability of an IMA depends on the approval of individual trading desks and is based on three criteria:
A profit and loss attribution (PLA) test is carried out by the trading desk to validate the model and is taken into account in the approval process. In addition, approval will depend on the organisational infrastructure and risk management. The final standard will accept the following two tests: the Spearman correlation for the hypothetical P&L (HPL) and the risk-theoretical P&L (RTPL) and the Kolmogorov-Smirnov test for RTPL and HPL distribution. The test based on the reference data of the last 12 months must be performed quarterly. In addition, the binary pass or fail classification of the metrics has been replaced by a traffic-light principle. As a result, all tests classified as "red" are calculated using the standardised approach. If the results of the tests are "green", the IMA may be used. The newly introduced “amber” area allows the application of a simple formula for the calculation of a capital surcharge and thus avoids a sudden capital increase between the green and red areas. The premium is calculated from the average difference in requirements between the IMA and the standardised approach. The PLA test comes into force on 1 January 2022, whereas the traffic light metric does not become active until one year later.
Another change concerns the risk factor eligibility test, especially regarding real price observation criteria. According to the latest standards, at least 24 price observations per year are required if there are at least four real price observations in every 90-day period. As an alternative to these requirements, 100 real price observations per 12 months are required. The "bucketing approach" was specified where the risk factor is a point on a curve or a surface. Banks can either use a regulatory bucket rate or define their own buckets. In order to avoid being treated as a NMRF, risk factors must pass the risk factor eligibility test and meet seven additional qualitative criteria for ‘modellability’. In particular, the obligation to provide evidence and the risk factors in the RTPL must be considered.
All in all, the FRTB is expected to lead to increased capital requirements, with the changes made in many places in 2019 smoothing the effects compared with the original 2016 standards.