Market risk and CVA risk charge
Market risk
Implementation of FRTB in Europe
In the ever-evolving landscape of banking supervision, the introduction of the Fundamental Review of the Trading Book (FRTB) marks a seminal shift in regulatory practices. Instituted in response to the 2007/2008 financial crisis, the FRTB underpins a comprehensive overhaul aimed at bolstering the robustness of the financial system in the field of market risks and refining risk management methodologies. Initiated by the Basel Committee on Banking Supervision, the development of the FRTB from its initial conceptualisation in 2012 through to its gradual implementation highlights a progression towards advanced capital adequacy frameworks and a more detailed comprehension of trading book risks.
The FRTB framework comprises several integral components, including the Simplified Standardised Approach, designed as a less complex method for institutions with smaller trading activity to manage market risks. It also features the Alternative Standardised Approach and the Alternative Internal Models Approach, catering to more complex financial entities capable of sophisticated risk modelling. Central to the framework is the Revised Trading Book Boundary, which crucially distinguishes between trading and banking books, ensuring accurate risk categorisation and capital allocation.
Redefining the trading and banking book boundary: A new paradigm
CRR III adopts a detailed approach that goes beyond the traditional concept of trading intent. This shift provides a more distinct separation between trading and banking books. Financial institutions are required to implement strong policies and procedures for assigning positions, with adherence ensured through annual reviews and ongoing risk management.
Navigating the set of approaches: A-SA, A-IMA, and S-SA
The heart of FRTB as well as CRR III lies in its introduction of three distinct market risk approaches:
- Alternative Standardised Approach (A-SA): This approach uses sensitivities-based calculations and incorporates additional qualitative requirements, reflecting a more complex risk assessment framework.
- Alternative Internal Models Approach (A-IMA): The internal models approach for market risk now centers on the expected shortfall instead of the value at risk, incorporating stricter requirements ranging from data utilization to profit and loss allocation. This approach underscores the importance of compliance, achieved through enhanced technical and governance standards.
- Simplified Standardised Approach (S-SA): The Simplified Standardised Approach (S-SA) modifies the existing standardised approach for market risk by applying supervisory factors, and it's applicable under certain conditions. This entails a monthly evaluation of the institution's on-balance and off-balance sheet exposures to market risk. To qualify for the S-SA, on the last day of the month, these exposures must meet two criteria: a) they should not exceed 10% of the institution's total assets, and b) they must be €500 million or below. The S-SA is designed as a less complex option for banks with smaller trading activities.
FRTB-aligned capital requirements pose distinct challenges, particularly for smaller institutions, which may now need to maintain a trading book. The shift in market risk approaches is likely to significantly affect capital requirements, highlighting the importance of early and strategic analysis for institutions.
Despite these challenges, the full implementation of FRTB offers a strategic opportunity for banks to refine their position management and trading strategies. Proactive adaptation to the new requirements allows banks to not only ensure compliance but also to strengthen their role within the financial ecosystem.
CVA risk capital charge
Overview of the CVA framework
Credit Valuation Adjustment (CVA) is a key factor in managing counterparty credit risks in derivative transactions. Following the 2007-2009 financial crisis, the significance of CVA risk has become more pronounced, resulting in major regulatory changes. The most recent updates to the CVA framework, included in CRR III, introduce refined approaches for regulatory capital requirements.
Three defined approaches for risk capital charges
There are three distinct approaches for banks to calculate the CVA risk capital charge, each tailored to different institutional profiles and complexities of derivatives portfolios:
- Standardised approach for CVA (SA-CVA): This approach requires banks to calculate CVA sensitivities to various risk factors, subject to supervisory approval. It is designed for institutions with sophisticated risk management capabilities, offering improved hedge considerations and avenues for capital efficiency.
- Basic approach for CVA (BA-CVA): Accessible without approval from competent authorities, BA-CVA is not reliant on sensitivities and offers two versions, with and without considering eligible hedging transactions. While simpler, it typically leads to an increase in capital requirements, balanced by a "discount scalar" of 0.65.
- Simplified approach for CVA: Intended for smaller institutions (derivatives business volume ≤ €100 million and not more than 5% of total assets), this formula-based approach does not consider CVA hedges, offering a straightforward calculation method.
The implementation of SA-CVA requires a detailed analysis of dependencies on market risk factors and hedging strategies, leading to a CVA risk capital charge that is highly sensitive to these elements. The complexity of SA-CVA, in contrast to the more straightforward BA-CVA, demonstrates a range of regulatory flexibility and stringency. The impact of these approaches will differ among institutions, depending on their specific portfolio structures and risk management techniques. As financial markets evolve, the CVA risk capital approaches highlight the necessity for a deeper focus on market risk factors and hedging practices. This move towards a more risk-aware framework brings both challenges and opportunities for institutions, necessitating improved analytical skills and strategic planning.
