Info Service on Finance and Development (May12/01)
14 May 2012
Third World Network
BCBS proposes beefing up trading book capital standards
Published in SUNS #7366 dated 9 May 2012
Geneva, 8 May (Kanaga Raja) -- The Basel Committee on Banking Supervision
(BCBS) has presented some initial policy proposals relating to trading
book capital requirements, which it has said will strengthen capital
standards for market risk, thereby contributing to a more resilient
These proposals are in a consultative document on the fundamental
review of trading book capital requirements. The document was issued
late last week by the BCBS, whose secretariat is based at the Bank
for International Settlements in Basel.
In a press release, the Basel Committee said that the consultative
document sets out a revised market risk framework and proposes a number
of specific measures to improve trading book capital requirements.
These proposals reflect the Committee's increased focus on achieving
a regulatory framework that can be implemented consistently by supervisors
and which achieves comparable levels of capital across jurisdictions,
According to the press release, key elements of the proposals include:
-- A more objective boundary between the trading book and the banking
book that materially reduces the scope for regulatory arbitrage;
-- Moving from value-at-risk to expected shortfall, a risk measure
that better captures "tail risk";
-- Calibrating the revised framework in both the standardised and
internal models-based approaches to a period of significant financial
stress, consistent with the stressed value-at-risk approach adopted
in Basel 2.5;
-- Comprehensively incorporating the risk of market illiquidity, again
consistent with the direction taken in Basel 2.5;
-- Measures to reduce model risk in the internal models-based approach,
including a more granular models approval process and constraints
on diversification; and
-- A revised standardised approach that is intended to be more risk-sensitive
and act as a credible fallback to internal models.
The Committee, the press release further said, is also proposing to
strengthen the relationship between the models-based and standardised
approaches by establishing a closer link between the calibration of
the two approaches, requiring mandatory calculation of the standardised
approach by all banks, and considering the merits of introducing the
standardised approach as a floor or surcharge to the models-based
(The proposed new approach is expected to have, at least in the short-term,
greater impact on European banks with large fixed income desks that
would need to raise additional equity capital. They have been using
the internal models-based approach of Basel-II, unlike US banks that
have been using the standardised approach.)
According to the BCBS consultative document, the financial crisis
exposed material weaknesses in the overall design of the framework
for capitalising trading activities and the level of capital requirements
for trading activities proved insufficient to absorb losses.
The document noted that as an important response to the crisis, the
Committee introduced a set of revisions to the market risk framework
in July 2009 (part of the "Basel 2.5" rules). These sought
to reduce the cyclicality of the market risk framework and increase
the overall level of capital, with particular focus on instruments
exposed to credit risk (including securitisations), where the previous
regime had been found especially lacking.
However, the Committee said it recognised at the time that the Basel
2.5 revisions did not fully address the shortcomings of the framework.
As a result, the Committee initiated a fundamental review of the trading
book regime, beginning with an assessment of "what went wrong".
"The fundamental review seeks to address shortcomings in the
overall design of the regime as well as weaknesses in risk measurement
under both the internal models-based and standardised approaches."
According to the Committee, the consultative document sets out the
direction the Committee intends to take in tackling the structural
weaknesses of the regime, in order to solicit stakeholders' comments
before proposing more concrete revisions to the market risk capital
The Committee has set a deadline of 7 September 2012 for comments
to be submitted on the consultative document.
According to the document, the Committee has focused on the following
key areas in its review: the trading book/banking book boundary; stressed
calibration; moving from value-at-risk to expected shortfall; a comprehensive
incorporation of the risk of market illiquidity; treatment of hedging
and diversification; relationship between internal models-based and
standardised approaches; revised models-based approach; revised standardised
approach; and the appropriate treatment of credit.
With respect to the trading book/banking book boundary, the Committee
said it believes that its definition of the regulatory boundary has
been a source of weakness in the design of the current regime.
"A key determinant of the boundary is banks' intent to trade,
an inherently subjective criterion that has proved difficult to police
and insufficiently restrictive from a prudential perspective in some
jurisdictions. Coupled with large differences in capital requirements
against similar types of risk on either side of the boundary, the
overall capital framework proved susceptible to arbitrage."
While the Committee considered the possibility of removing the boundary
altogether, it concluded that a boundary will likely have to be retained
for practical reasons.
According to the document, the Committee has now put forth for consideration
two alternative boundary definitions:
(1) "Trading evidence"-based boundary: Under this approach,
the boundary would be defined not only by banks' intent, but also
by evidence of their ability to trade and risk manage the instrument
on a trading desk. Any item included in the regulatory trading book
would need to be marked to market daily with changes in fair value
recognised in earnings. Stricter, more objective requirements would
be used to ensure robust and consistent enforcement. Tight limits
to banks' ability to shift instruments across the boundary following
initial classification would also be introduced.
Fundamental to this proposal is a view that a bank's intention to
trade - backed up by evidence of this intent and a regulatory requirement
to keep items in the regulatory trading book once they are placed
there - is the relevant characteristic for determining capital requirements.
(2) Valuation-based boundary: This proposal would move away from the
concept of "trading intent" and construct a boundary that
seeks to align the design and structure of regulatory capital requirements
with the risks posed to a bank's regulatory capital resources.
The Committee said that fundamental to this proposal is a view that
capital requirements for market risk should apply when changes in
the fair value of financial instruments, whether recognised in earnings
or flowing directly to equity, pose risks to the regulatory and accounting
solvency of banks. This definition of the boundary would likely result
in a larger regulatory trading book, but not necessarily in a much
wider scope of application for market risk models or necessarily lower
On stressed calibration, the Committee said it recognises the importance
of ensuring that regulatory capital is sufficient in periods of significant
market stress. As the crisis showed, it is precisely during stress
periods that capital is most critical to absorb losses. Furthermore,
a reduction in the cyclicality of market risk capital charges remains
a key objective of the Committee.
Consistent with the direction taken in Basel 2.5, the Committee said
it intends to address both issues by moving to a capital framework
that is calibrated to a period of significant financial stress in
both the internal models-based and standardised approaches.
The Committee also said that a number of weaknesses have been identified
with using value-at-risk (VaR) for determining regulatory capital
requirements, including its inability to capture "tail risk".
For this reason, the Committee said it has considered alternative
risk metrics, in particular expected shortfall (ES). ES measures the
riskiness of a position by considering both the size and the likelihood
of losses above a certain confidence level. In other words, it is
the expected value of those losses beyond a given confidence level.
"The Committee recognises that moving to ES could entail certain
operational challenges; nonetheless it believes that these are outweighed
by the benefits of replacing VaR with a measure that better captures
tail risk. Accordingly, the Committee is proposing the use of ES for
the internal models-based approach and also intends to determine risk
weights for the standardised approach using an ES methodology."
The Committee further said it recognises the importance of incorporating
the risk of market illiquidity as a key consideration in banks' regulatory
capital requirements for trading portfolios. Before the introduction
of the Basel 2.5 changes, the entire market risk framework was based
on an assumption that trading book risk positions were liquid, i.
e. that banks could exit or hedge these positions over a 10-day horizon.
"The recent crisis proved this assumption to be false,"
said the Committee, adding that as liquidity conditions deteriorated
during the crisis, banks were forced to hold risk positions for much
longer than originally expected and incurred large losses due to fluctuations
in liquidity premia and associated changes in market prices.
Basel 2.5 partly incorporated the risk of market illiquidity into
modelling requirements for default and credit migration risk through
the incremental risk charge (IRC) and the comprehensive risk measure
According to the consultative document, the Committee's proposed approach
to factor in market liquidity risk comprehensively in the revised
market risk regime consists of three elements:
-- First, operationalising an assessment of market liquidity for regulatory
capital purposes. The Committee proposes that this assessment be based
on the concept of "liquidity horizons", defined as the time
required to exit or hedge a risk position in a stressed market environment
without materially affecting market prices. Banks' exposures would
be assigned into five liquidity horizon categories, ranging from 10
days to one year.
-- Second, incorporating varying liquidity horizons in the regulatory
market risk metric to capitalise the risk that banks might be unable
to exit or hedge risk positions over a short time period (the assumption
embedded in the 10-day VaR treatment for market risk).
-- Third, incorporating capital add-ons for jumps in liquidity premia,
which would apply only if certain criteria were met. These criteria
would seek to identify the set of instruments that could become particularly
illiquid, but where the market risk metric, even with extended liquidity
horizons, would not sufficiently capture the risk to solvency from
large fluctuations in liquidity premia.
Additionally, the Committee said it is consulting on two possible
options for incorporating the "endogenous" aspect of market
liquidity. Endogenous liquidity is the component that relates to bank-specific
portfolio characteristics, such as particularly large or concentrated
exposures relative to the market.
The main approach under consideration by the Committee to incorporate
this risk would be further extension of liquidity horizons; an alternative
could be application of prudent valuation adjustments specifically
targeted to account for endogenous liquidity.
"Hedging and diversification are intrinsic to the active management
of trading portfolios. Hedging, while generally risk reducing, also
gives rise to basis risk that must be measured and capitalised. In
addition, portfolio diversification benefits, whilst seemingly risk-reducing,
can disappear in times of stress," said the document.
Currently, it noted, banks using the internal models-based approach
are allowed large latitude to recognise the risk-reducing benefits
of hedging and diversification, while recognition of such benefits
is strictly limited under the standardised approach.
The Committee is proposing to more closely align the treatment of
hedging and diversification between the two approaches. In part, this
will be achieved by constraining diversification benefits in the internal
models-based approach to address the Committee's concerns that such
models may significantly overestimate portfolio diversification benefits
that do not materialise in times of stress.
The Committee also considers the current regulatory capital framework
for the trading book to have become too reliant on banks' internal
models that reflect a private view of risk.
To strengthen the relationship between the models-based and standardised
approaches, the Committee said it is consulting on three proposals:
first, establishing a closer link between the calibration of the two
approaches; second, requiring mandatory calculation of the standardised
approach by all banks; and third, considering the merits of introducing
the standardised approach as a floor or surcharge to the models-based
According to the document, the Committee has identified a number of
weaknesses with risk measurement under the models-based approach.
In seeking to address these problems, the Committee intends to (i)
strengthen requirements for defining the scope of portfolios that
will be eligible for internal models treatment; and (ii) strengthen
the internal model standards to ensure that the output of such models
reflects the full extent of trading book risk that is relevant from
a regulatory capital perspective.
To strengthen the criteria that banks must meet before regulatory
capital can be calculated using internal models, the Committee said
it is proposing to break the model approval process into smaller,
more discrete steps, including at the trading desk level.
The Committee explained that this will allow model approval to be
"turned-off" more easily than at present for specific trading
desks that do not meet the requirements. At the trading desk level,
where the bank naturally has an internal profit and loss (P&L)
available, model performance can be verified more robustly.
The Committee said it is considering two quantitative tools to measure
the performance of models. First, a P&L attribution process that
provides an assessment of how well a desk's risk management model
captures risk factors that drive its P&L. Second, an enhanced
daily back-testing framework for reconciling forecasted losses from
the market risk metric with actual losses.
"Although the market risk regime has always required back-testing
of model performance, the Committee is proposing to apply it at a
more granular trading desk level in the future. Where a trading desk
does not achieve acceptable P&L attribution or back-testing results,
the bank would be required to calculate capital requirements for that
desk using the standardised approach."
The Committee has also identified a number of important shortcomings
with the current standardised approach.
According to the consultative document, a standardised approach serves
two main purposes. Firstly, it provides a method for calculating capital
requirements for banks with business models that do not require sophisticated
measurement of market risk. This is especially relevant to smaller
banks with limited trading activities.
Secondly, it provides a fallback in the event that a bank's internal
market risk model is deemed inadequate as a whole or for specific
trading desks or risk factors. This second purpose is of particular
importance for larger or more systemically important banks.
The Committee said it has adopted the following principles for the
design of the revised standardised approach: simplicity, transparency
and consistency, as well as improved risk sensitivity; a credible
calibration; limited model reliance; and a credible fallback to internal
In seeking to meet these objectives, the Committee proposes a "partial
risk factor" approach as a revised standardised approach. The
Committee also invites feedback on a "fuller risk factor"
approach as an alternative.
The consultative document states more specifically:
-- Partial risk factor approach: Instruments that exhibit similar
risk characteristics would be grouped in buckets and Committee-specified
risk weights would be applied to their market value. The number of
buckets would be approximately 20 across five broad classes of instruments,
though the exact number would be determined empirically.
The Committee said that hedging and diversification benefits would
be better captured than at present by using regulatory correlation
parameters. To improve risk sensitivity, instruments exposed to "cross-cutting"
risk factors that are pervasive across the trading book (e. g. FX
and interest rate risk) would be assigned to more than one bucket.
For example, a foreign-currency equity would be assigned to the appropriate
equity bucket and to a cross-cutting FX bucket.
-- Fuller risk factor approach: This alternative approach would map
instruments to a set of prescribed regulatory risk factors to which
shocks would be applied to calculate a capital charge for the individual
risk factors. The bank would have to use a pricing model (likely its
own) to determine the size of the risk positions for each instrument
with respect to the applicable risk factors. Hedging would be recognised
for more "systematic" risk factors at the risk factor level.
The capital charge would be generated by subjecting the overall risk
positions to a simplified regulatory aggregation algorithm.
According to the consultative document, a particular area of Committee
focus has been the treatment of positions subject to credit risk in
the trading book. Credit risk has continuous (credit spread) and discrete
(default and migration) components. This has implications for the
types of models that are appropriate for capturing credit risk.
In practice, including default and migration risk within an integrated
market risk framework introduces particular challenges and potentially
makes consistent capital charges for credit risk in the banking and
trading books more difficult to achieve.
The Committee is therefore considering whether, under a future framework,
there should continue to be a separate model for default and migration
risk in the trading book.
"The Committee thinks it is important to note that there are
two particular areas that it has considered, but are not subject to
any detailed proposals in this consultative document."
According to the consultative document, one is interest rate risk
in the banking book. Although the Committee has determined that removing
the boundary between the banking book and the trading book may be
impractical, it is concerned about the possibility of arbitrage across
the banking book/trading book boundary.
A major contributor to arbitrage opportunities are different capital
treatments for the same risks on either side of the boundary. One
example is interest rate risk, which is explicitly captured in the
trading book under a Pillar 1 capital regime, but subject to Pillar
2 requirements in the banking book, it said.
The Committee said it has therefore undertaken some preliminary work
on the key issues that would be associated with applying a Pillar
1 capital charge for interest rate risk in the banking book. It intends
to consider the timing and scope of further work in this area later
On the other area of interaction of market and counter-party risk,
it said that Basel III introduced a new set of capital charges to
capture the risk of changes to credit valuation adjustments (CVA).
This is known as the CVA risk capital charge and will be implemented
as a "stand alone" capital charge under Basel III, with
a coordinated start date of 1 January 2013.
"The Committee is aware that some industry participants believe
that CVA risk, as the market component of credit risk, should be captured
in an integrated fashion with other forms of market risk within the
market risk framework. The Committee has agreed to consider this question,
but remains cautious of the degree to which these risks can be effectively
captured in a single integrated modelling approach. It observes that
there is no clear market standard for the treatment of CVA risk in
banks' internal capital."
For the time being, the Committee said it anticipates that open questions
regarding the practicality of integrated modelling of CVA and market
risk could constrain moving towards such integration.
In the meantime, the industry should focus on ensuring a high-quality
implementation of the new stand-alone charge on 1 January 2013, it