Last Thursday, the Basel Committee for Banking Supervision (BCBS) finalized its market risk capital framework, known as the Fundamental Review of the Trading Book. The final rule, which updates the Basel II and 2.5 approaches and takes effect January 2019 will increase the transparency and consistency of reporting risk-weighted assets (RWA) and capital metrics, which is a key goal of the BCBS agenda for 2016.
Under the new standards, banks’ reported market risk capital measures will be more comparable because of consistent risk factor identification, a more rigorous model approval process, and an enhanced standardized capital calculation serving as a capital floor to the internal models-approach calculation. The revised market risk capital framework enhances both the standardized and models-based approaches of calculating market risk exposure, recognizing that model variability is one of the key drivers of differing riskweighting and capital treatment for similar exposures across banks. Under the revised framework, internal models-approach banks will need to calculate market RWA under both methods, at trading desk level. Also, as the model validation process is reinforced under the framework, coverage of risks by the internal models approach could be narrowed – for example, they would be moved to the standardized approach.
These final rules will especially affect our rated universe of global investment banks (GIBs), which generally have significant trading operations, use internal models to calculate capital requirements, and have the largest share of market RWA as a percent of total RWA. We estimate that our rated GIBs’ market RWA account for about 10% of total RWA on average. It is unclear how the new market risk capital rules will specifically affect the capital requirements of the GIBs after the GIBs take mitigating actions, however, the BCBS estimated that in aggregate, banks would have a 40% higher market risk capital requirement on a weighted average basis and 22% higher on median basis under the new market risk standard versus the existing one. We expect that the finalization of these rules, which GIBs anticipated, will motivate them to further reduce and/or exit more capital-intensive trading activities. Although market risk has generally been smaller relative to credit and operational risk in bank capital requirements, the potential capital increase comes on top of other capital requirements that will start being phased in and will be material for some banks.
Key aspects of the internal models-approach include shifting the measure of stress loss risk or tail risk to an expected-shortfall measure from a value-at-risk measure to better capture the potential magnitude of tail losses, and including a stressed capital add-on for risk factors that cannot be modeled. The capital floor (capital charge under the internal-models approach relative to capital under the standardized approach) is set at 100%, meaning that banks have no incentive to move to the internal models-approach and suggesting that the BCBS believes that model-risk remains high despite the improvements in the new framework. The revised standardized approach uses an expanded factor sensitivities-based method, so that risks are evaluated more extensively and consistently across jurisdictions. Capital charges for risk factor sensitivities (i.e., delta, vega, and curvature risk) are applied to a broad group of risk classes, including interest rate risk, foreign-exchange risk and credit-spread risk.
