By Terry Flanagan

Tracking Risk at the Source

One of the outcomes of the Basel III capital regime will be to standardize the way that banks calculate their risk-weighted assets, and by extension their capital ratios. In order to differentiate themselves, banks will need to calculate risk at the source, i.e. at the trade level.

“As a result of regulatory forces, banks have become more identical in terms of how they value their business,” said Sven Ludwig, senior vice president of risk and analytics for EMEA at SunGard. “This forces them to find ways to differentiate. To do this, they will need to evaluate every trade, every business activity, upfront. At the inception of a trade, they have to evaluate if a trade is profitable over its entire lifetime. And this entire lifetime is a very new element.”

Prior to the financial crisis, the big change in risk regulation was the principle behind Basel II – that sophisticated banks could rely on their own internal risk models if they were deemed good enough by the regulators. And they could reduce their capital adequacy obligations as a result.

Post-crisis, model risk has been highlighted as a key concern, and regulators want to see greater commonality in the risk models and methods employed by banks, enabling them to make regular comparisons.

In particular, the Basel Committee’s Regulatory Consistency Assessment Programme (RCAP) is fostering a demand for consistency and the preparation for changes.

“It is often forgotten that Basel III, as part of its ‘Strengthening the global capital framework,’ also focuses on consistency, transparency, simplicity and comparability as well as risk coverage including fundamental review of the trading book [FRTB],” said Ludwig.

The Basel Committee’s RCAP (issued as BCBS219 in April 2012) is intended to ensure consistent implementation of Basel III across banks and jurisdictions. This was further reinforced by BCBS 258 “The regulatory framework: balancing risk sensitivity, simplicity and comparability,” issued in July 2013.

“One may argue that the comparability finds also its way into the FRTB via the so called ‘flooring’ ability of an internal model approach,” said Ludiwg.

The floor, according to a Dec. 2014 consultative paper issued by the Basel Committee, is meant to mitigate model risk and measurement error stemming from internally-modelled approaches. It would enhance the comparability of capital outcomes across banks, and also ensure that the level of capital across the banking system does not fall below a certain level.

“One may argue that the banks are faced with a level playing field in major components in respect to capital requirement calculations,” said Ludwig. “This is driving the financial markets to ‘monocultures,’ but also this leads to a battle of sophistication to ensure profitability of a business transaction.”

As a consequence, there is an increasing degree of sophistication around pricing adjustments, or what Ludwig terms “the battle of sophistication to ensure profitability of a business transaction. Given the need to ensure profitability while meeting in addition the capital requirements, it is vital that each trade is profitable across its entire lifetime.”

This pricing is required pre-deal, or “in other words it requires risk at inception,” Ludwig said. “The required thought leadership and integrated agile IT infrastructure will be increasingly expensive, unaffordable for non-specialized lower tier banks. Banks specializing solely on the sophistication and not addressing operational efficiency will outsource these tasks of the value chain.”

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