Basel issues revised minimum capital requirements

MANILA, Philippines - The Basel Committee on Banking Supervision has issued the revised minimum capital requirements for market risk, among others, will result in a shift from value-at-risk to an expected shortfall measure of risk under stress.

The revised market risk framework is a key component of the Basel Committee’s overall efforts to reform global regulatory standards in response to the global financial crisis.

The revised market risk framework comes into effect on 2019.

The purpose of the revised market risk framework is to ensure that the standardized and internal model approaches to market risk deliver credible capital outcomes and promote consistent implementation of the standards across jurisdictions.

The final standard incorporates changes that have been made following two consultative documents published in October 2013 and December 2014 and several quantitative impact studies.

The key features of the revised framework include:

• A revised boundary between the trading book and banking book. A better-defined boundary will serve to reduce incentives to arbitrage between the regulatory banking and trading books, while still respecting banks’ risk management practices.

• A revised internal models approach for market risk. The new approach introduces a more rigorous model approval process that let supervisors remove internal modeling approval for individual trading desks. It also allows a more consistent identification and capitalization of material risk factors across banks, and sets constraints on the capital-reducing effects of hedging and diversification.

• A revised standardized approach for market risk. The standardized approach has been overhauled to make it sufficiently risk-sensitive to serve as a credible fallback as well as a floor to the internal models approach, while still providing an appropriate standard for banks that do not require a sophisticated treatment for market risk.

• A shift from value-at-risk to an expected shortfall measure of risk under stress. Use of expected shortfall will help to ensure prudent capture of “tail risk” and so maintain capital adequacy during periods of significant market stress.

• Incorporation of the risk of market illiquidity. Varying liquidity horizons are incorporated into the revised standardized and internal model approaches to mitigate the risk of a sudden and severe impairment of market liquidity across asset markets.

These replace the static 10-day horizon assumed under VaR for all traded instruments in the current framework.

The 2007-08 period of severe market stress exposed weaknesses in the framework for capitalizing risks from trading activities.

In 2009, the committee introduced a set of revisions to the Basel II market risk framework to address the most pressing deficiencies.

A fundamental review of the trading book was also initiated to tackle a number of structural flaws in the framework that were not addressed by those revisions.

The committee conducted impact analysis using data provided by banks and assuming the revised market risk framework was fully in force as of end-June 2015.

The revised framework produces market risk risk-weighted assets (RWAs) that account for less than 10 percent of total RWAs, compared to approximately six percent under the current framework.

Compared with the current market risk framework, the revised market risk standard would result in a median (weighted mean) increase of approximately 22 percent (40 percent) in total market risk capital requirements.

These impact estimates take account of the calibration refinements endorsed by the committee in December 2015.