Basel Risk Framework Could Reduce Liquidity

Shanny Basar

Basel’s finalised framework for the assessment of market risk could lead to global banks dropping activities which become too expensive, and reduce market liquidity, and may also be implemented differently in different jurisdictions.

The Basel Committee on Banking Supervision published its finalised framework for assessment of market risk, a major part of the Fundamental Review of the Trading Book, on 14 January 2016 following a lengthy consultation. National regulators must implement the new rules by 2019.

Fitch Ratings said in a note last week that the overhaul of the internal models approach – used by most banks with large trading books to calculate market risk capital requirements – will be costly.

Under the new rules banks will need to obtain approval for internal models on a desk-by-desk rather than on a bank-wide basis, which will make it easier for regulators to decline approval for a particular trading desk. However, it will be expensive for banks to build and run a greater number of more sophisticated models, which will increase the need for data analysis and for risk personnel.

The ratings agency said the model revisions should improve risk assessment capabilities, lead to higher capital charges for hard-to-model trading positions and make it easier for investors to compare bank results.

“But the model approval process and governance are being thoroughly revised and implementing the changes will require considerable investment in technology and risk management,” added Fitch.

The new internal models also replace value at risk (VaR) with an expected shortfall (ES) measure as VaR did not capture the losses during the financial crisis in 2008. Fitch thinks the ES models will be more realistic as it acknowledges that some instruments take longer to sell or hedge without affecting prices.

“ES will also constrain recognition of diversification and hedging benefits, extensively used in VaR models to reduce capital charges,” added Fitch. “We think this will make model outputs more prudent and force banks to better capitalise potential trading losses.”

The ratings agency said the amount of regulatory capital models-based banks will need to cover potential market risks following the revisions is uncertain. The Basel Committee calculated that for a sample of 12 internationally active banks with large trading books, market risk capital charges under the revised approach were 28% higher. However for a broader sample of 44 banks using internal models, the median market risk capital requirements fell by 3% under the revised models.

Fitch said: “Banks facing higher charges under the regime may re-assess whether certain activities remain profitable.”

Ian Kelly, senior manager, banking and capital markets, Deloitte said in a blog last week that the impact of the framework will be profound. Kelly said the ES approach applied on a desk-by-desk basis will effectively require each desk to be viable on a standalone basis.

“Perhaps most strikingly, desk structures must be ‘approved by supervisors’,” he added. “Supervisors will have to consider whether the proposed desk structures are sufficiently granular and meet all the governance conditions.”

Obtaining supervisory approval for trading desk structures could therefore be a difficult and time-consuming exercise for banks.

Kelly said all eyes will now turn to the European Commission and the European Banking Authority for an indication of how these standards will apply in Europe, and whether the European authorities will try to tweak or amend any final rules that are applied. He continued: “For globally active banks this once again raises the familiar worry that FRTB may end up being implemented differently in different jurisidictions.”

PwC said in a note that compared to the 2014 proposal, the final framework’s treatment of models that generate inaccurate results is more stringent. “The final framework’s daily P&L attribution and backtesting requirements will necessitate substantial technology infrastructure development by many institutions, and further challenge internal model review and governance,” added the note.

PwC also warned that banks will need more data and stronger data analysis to meet new risk measurement and reporting requirements such as monitoring market risk on an intraday basis and measuring market risk capital at the end of the previous day.

“We do not expect US regulators to adopt the standard until 2018 because they are likely to wait for any changes to the framework that may result from the impact of other evolving global standards and recalibration by BCBS,” added PwC.

The Global Financial Markets Association, the Institute of International Finance and the International Swaps and Derivatives Association said in a statement on the framework that they are concerned that, despite the regulator’s wishes to not significantly increase overall capital requirements, trading book capital will increase by 40% under the new rules.

“We worry that the rules may have a negative effect on banks’ capital markets activities and reduce market liquidity,” said the statement. “Further impact assessment needs to be run to assess if the gap between the standard and internal models based capital outcomes is reasonable, considering the BCBS’s future work on standardized floors.

Featured image by wollertz/Dollar Photo Club

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