Basel Committee on Banking Supervision …

1 Basel Committee on Banking Supervision Consultative document fundamental review of the trading book: A revised market risk framework Issued for comment by 31 January 2014 October 2013 This publication is available on the BIS website ( ). Bank for International Settlements 2013. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN 92-9131-971-6 (print) ISBN 92-9197-971-6 (online) fundamental review of the trading book: A revised market risk framework iii Contents Executive summary .. 1 Section 1: Overall revisions to the market risk framework .. 7 The trading book/ Banking book boundary .. 7 Treatment of credit .. 10 Factoring in market liquidity .. 13 Choice of market risk metric and calibration to stress conditions .. 18 Treatment of hedging and 19 Relationship between the standardised and internal model-based approaches.

2 21 Section 2: Revised models-based approach .. 23 The overall approach to internal models-based measurement .. 23 The identification of eligible trading desks .. 25 Section 3: Revised standardised approach .. 31 Objectives and rationale for a revised standardised approach .. 31 General features of the revised standardised approach .. 32 Calibration of the revised standardised 34 Proposed treatments by asset class .. 35 Section 4: Disclosure requirements .. 44 Section 5: Impact 45 Annex 1: Revised market risk framework .. 46 Annex 2: Actions to reduce variation in risk-weighted assets for market risk .. 116 fundamental review of the trading book: A revised market risk framework 1 fundamental review of the trading book: A revised market risk framework Executive summary This is the Basel Committee s ( the Committee )1 second consultative paper on the fundamental review of trading book capital The revisions to the capital framework set out in this paper aim to contribute to a more resilient Banking sector by strengthening capital standards for market risks.

3 They form part of the Committee s broader agenda to reform regulatory standards for banks in response to the financial crisis. The revisions in this paper also reflect the Committee s increased focus on achieving a regulatory framework that can be implemented consistently by supervisors across jurisdictions. As such, they incorporate the lessons learned from the Committee s recent investigations into the variability of market risk-weighted Background The financial crisis exposed material weaknesses in the overall design of the framework for capitalising trading activities. The level of capital required against trading book exposures proved insufficient to absorb losses. 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 package of reforms). At the time, the Committee recognised that the Basel revisions did not fully address the shortcomings of the framework.

4 In response, the Committee initiated a fundamental review of the trading book regime, beginning with an assessment of what went wrong . The Committee published the first consultative paper in May 2012. Having reflected on comments received, this paper sets out more detailed proposals for reforming the trading book regime, including draft text for the Basel Accord. Key areas of Committee focus The Committee has focused on the following key areas as part of its review : 1 The Basel Committee on Banking Supervision provides a forum for regular cooperation on Banking supervisory matters. It seeks to promote and to strengthen supervisory and risk management practices globally. The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

5 Observers on the Basel Committee are: the European Banking Authority, the European Central Bank, the European Commission, the Financial Stability Institute and the International Monetary Fund. 2 To view the first consultative paper, see Basel Committee on Banking Supervision , fundamental review of the trading book, May 2012 ( ). It is intended that this second consultative paper can be read as a standalone document , without the need for cross reference with the first consultative paper. 3 See Basel Committee on Banking Supervision , Regulatory consistency assessment programme (RCAP) Analysis of risk-weighted assets for market risk, January 2013 (revised February 2013), 2 fundamental review of the trading book: A revised market risk framework The trading book/ Banking book boundary The Committee believes that the definition of the regulatory boundary between the trading book and Banking book has been a source of weakness in the design of the current regime.

6 A key determinant of the boundary has been banks self-determined intent to trade. trading intent has proven to be an inherently subjective criterion that is 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 before and during the crisis. In May 2012, the Committee put forward for consideration two alternative definitions for the boundary: a trading evidence-based approach and a valuation-based approach. Having reflected on feedback from the first consultative paper, the Committee has developed a revised boundary that retains the link between the regulatory trading book and the set of instruments that banks deem to hold for trading purposes, but seeks to address weaknesses in the boundary by reducing the possibility of arbitrage and by providing more supervisory tools.

7 As such, this boundary is more likely to be aligned with banks own risk management practices relative to the valuation-based approach. The Committee is seeking to deliver more consistent implementation of the boundary across banks. Based on the new definition, the Committee provides example instruments which have to be assigned either to the Banking book or to the trading book. For certain instrument types, there will be a presumption that they are included in the trading book. This will facilitate the development of a common understanding among supervisors regarding the types of instrument that would typically be included in the different books. The Committee has also agreed on a range of documentation that banks would need to make available to supervisors, as part of new valuation and evidence-based reporting requirements for all trading book positions.

8 This will facilitate a better understanding of the types of activity that are within the scope of trading book capital requirements, and increase the supervisability of the boundary. The Committee remains concerned about the risk of arbitrage. To reduce the incentives for arbitrage, the Committee is seeking a less permeable boundary with stricter limits on switching between books and measures to prevent capital benefit in instances where switching is permitted. The Committee is also aiming to reduce the materiality of differences in capital requirements against similar types of risk on either side of the boundary. For example, the Committee has decided that the calibration of capital charges against default risk in the trading book will be closely aligned to the Banking book treatment, especially for securitisations. The Committee is also investigating the development of Pillar 1 charges for interest rate and credit spread risk in the Banking book.

9 Reflecting the revised boundary s focus on contributing to reducing arbitrage rather than on quantitative evidence as a condition for inclusion in the trading book, the Committee is referring to the new boundary simply as the revised boundary (rather than the evidence-based boundary ). Section 1 sets out the main changes to the boundary, and provides a proposed presumptive list of instruments presumed to be included in the trading book as well as a list of instruments that does not meet the revised definition of the trading book. Treatment of credit Credit-related products were a key source of losses during the crisis and the treatment of these positions proved particularly flawed. In responding to the lessons from the crisis, the Committee has agreed, as a general principle, to bring trading book requirements closer to those of the Banking book. More specifically, the Committee has agreed a differential approach to securitisation and non-securitisation exposures: fundamental review of the trading book: A revised market risk framework 3 Securitisation exposures: The Committee remains sceptical that existing internal models-based risk measurement methodologies used by banks can adequately capture the risks associated with securitised products.

10 As a result, capital charges for securitisation positions in the trading book including correlation trading activities will be based on the revised standardised approach. This also simplifies the framework by obviating the need for a specific correlation trading portfolio (CTP). Non-securitisation exposures: Internal modelling will continue to be allowed for non-securitisation positions. But the Committee has decided that joint modelling of the discrete (default risk) and continuous (spread risk) components of credit risk is likely to involve particular practical challenges. It could also make a more consistent capital treatment of credit risk across the balance sheet more difficult to achieve. As a result, the Committee has agreed that non-securitisation credit positions in the trading book will be subject to a separate Incremental Default Risk (IDR) charge.