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Minimum Capital Requirements for Market Risk

Developments in Basel Regulation

Studienarbeit 2017 16 Seiten

BWL - Investition und Finanzierung


Table of Contents

1. Introduction

2. Why has market liquidity become an issue in recent regulatory development?

3. Steps to the incorporation of market illiquidity into the new standards on minimum capital requirements for market risk
3.1 Revisions to the Basel II market risk framework
3.2 Consultative Document I: Fundamental review of the trading book
3.3 Consultative Document II: Fundamental review of the trading book - A revised market risk framework
3.4 Consultative Document III: Fundamental review of the trading book - OutstandingIssues
3.5 Standard: Minimum Capital Requirements for Market Risk - Final Standard

4. Academia on illiquidity risk and reference to Basel III

5. Conclusion

6. References

1. Introduction

The Basel framework has gone through substantial transformation during the last coupleof years amidst a political, regulatory and societal environment that has pushed forstricter and more prudential supervisory activity. This has been a natural developmentas it became clear that the regulatory framework proved to be inappropriate to cope withthe latest developments in the financial services industry. The Basel Committee itselfrecognized that the pre-crisis regime and overall design of the framework showedmaterial weaknesses in ensuring adequate capital requirements that could absorb themagnitude of losses that the banking industry experienced in 2007/2008. In particular,losses that occurred within banks’ trading books as a result of their trading activitiescontributed the most to the financial instability (Consultative Document I, 2012). Mostof the new revisions and reforms therefore targeted aspects of market risk that financialinstitutions are exposed to, which will also be the focus of this paper. More specifically,the main research question is to analyze how the Basel Committee incorporated marketilliquidity risk into the new framework for the internal models approach of market riskand what specific steps led to this. It will also be important to demonstrate why theCommittee deemed the incorporation of market illiquidity an important cornerstone ofthe new standard. The Basel framework is far from being a trivial topic and hasexperienced an increasing degree of complexity, but more importantly, an increasingdegree of importance for the future financial landscape. The motivation is to cut throughthis complexity and to present the essence of the process that was supposed to have ledto a more efficient and balanced regulatory framework. An important additionalcontribution will be to compare this to the academic literature which dealt with marketliquidity in general or the application of market liquidity in a regulatory environment.We will go through the revisions to the Basel II Market Risk Framework, the finalStandard on Minimum Capital Requirements for market risk, the consultativedocuments that are known as Fundamental Reviews of the Trading Book which wereissued parallel to the design process of the new framework and academic literature andcompile the most important aspects of the incorporation of market illiquidity risk in thispaper. The starting point is the explanation of why it might be important to incorporatemarket illiquidity into a regulatory framework from the perspective of the BaselCommittee. The second part will guide in a chronological order through the actualprocess from 2009 to 2016 that resulted in the final framework as we know it today.Before the conclusion of this paper, a reference and comparison to academiccontributions will be done in the third paragraph.

2. Why has market liquidity become an issue in recent regulatory development?

The ability to buy, sell or hedge out a position in a timely and operational manner is akey factor in financial markets and asset pricing. The regulatory domain, however, hadseemed to underestimate this factor in the years before the financial crisis. The reasonwhy it was underestimated but not completely ignored is the fact that in 2005 already,the Basel Committee/IOSCO Agreement contained an incremental default risk charge toaccount for an increasing exposure to often illiquid products whose risk is not reflectedin value-at-risk models (Revisions to Basel II, 2010). The pre-crisis framework also already contained “prudent valuation guidance for treatment for illiquid positions” (Basel II Framework, Section VI.B.2). But these guidelines remained relatively uncommitting in the sense that they rather appealed to systems and controls, procedures,senior managers and risk managers. A rather unbinding approach made it easy forfinancial institutions to avoid or to justify against an overly strict treatment of tradingpositions. The Committee acknowledged that the entire framework was based onassumptions that positions were sufficiently liquid to ensure an exit or hedge within avery short time horizon. But the crisis proved this assumption to be false as banks wereforced to hold positions much longer than expected (Consultative Document I, 2012).Banks were unable to exit their trading positions because of illiquidity and incurredheavy mark-to-market losses on many positions. A survey of industry practices revealedthat financial industry members generally acknowledge that shorter horizons do notcapture liquidity risks sufficiently enough and that a capital level necessary to remain inbusiness in periods of financial stress requires longer periods of assessment(Consultative Document I, 2012). But in a competitive landscape, a lenient regulatoryframework is likely to be exploited in the short term, even in light of an understandingof the importance of these industry practices. In general, the framework was too heavilybased on a reliance on risk drivers determined by banks themselves, which contributedto missing one of the main goals of regulation in banking, ensuring a sufficient capitalbase for the banking system as a whole (Explanatory Note, 2016). The Basel Committeetherefore correctly assessed that a future reliable regulatory framework requiresprovisions that mandate the incorporation of important risk drivers such as marketliquidity. The new provisions, which will be described in the following chapters, can ingeneral and as a consequential result be described as being much more quantitative andspecific to counteract the issues that were identified above.

3. Steps to the incorporation of market illiquidity into the new standards on minimum capital requirements for market risk

3.1 Revisions to the Basel II market risk framework

As a fast and initial response, the Basel Committee issued the “Revisions to the Basel IImarket risk framework” in July 2009, which was part of what became known as theBasel 2.5 package. Although it paved the way for the developments that led to the newStandards of Minimum Capital Requirements of Market Risk, it yet remained rathersilent on the incorporation of market illiquidity. The Basel Committee noted that it stillsuffered from the inability to capture the risk of market illiquidity, mainly because itwas still based on the assumption that banks can exit or hedge trading book positionsover a 10-day period without affecting market prices (Explanatory Note, 2016). The factthat the Committee had highlighted this already hints to the fact that that this becamethe main aspect of change in tackling the notion of market illiquidity risk. What it did,however, is to refine the prudent valuation guideline for treatment of illiquid positions,which we already mentioned in our previous paragraph. Basel 2.5 extended the scope toa wider range of instruments subject to fair value accounting and used a more consistentand clarifying language. It also introduced new paragraphs that particularly specifiedsecuritized products and credit derivatives requiring assessment on additional valuationadjustment to reflect illiquidity (Revisions to Basel II, VII., B, 2010). Another newaspect was the implementation of stressed VaR calculation calibrated to a 12-monthperiod of significant financial stress. However, the Committee pointed out later thatmarket illiquidity is yet not factored into this capital charge calculation, as it stillassumes a 10-day horizon for exiting all risk positions (Explanatory Note, 2016). Basel 2.5 introduced the concept of varying liquidity horizons to account for credit-relatedliquidity risk in the calculation of the Incremental Risk Charge (IRC) andComprehensive Risk Measure (CRM) (Consultative Document I, 2012). From then on,the concept of liquidity horizons received more detailed attention in the subsequent firstConsultative Document.

3.2 Consultative Document I: Fundamental review of the trading book

The next important development and the main focus of the first Consultative Document,with respect to market liquidity, was the further development of the concept of liquidityhorizons. The Committee pointed out that the incorporation of market liquidity risk isyet neither comprehensive nor complete, even after the Basel 2.5 reforms, as it only reached out to the IRC and CRM measure described earlier and as it was restricted to a 10-day exit period assumption for the stressed VaR measure. The Committee thereforeproposed that liquidity horizons would become the main operationalizing assessment ofthis risk, ranging from 10 days to one year, and that these will be incorporated into theregulatory market risk metric of Basel III. To achieve this, the Committee not onlyshifted from a VaR to an Expected Shortfall measure as its risk metric, but also includedvarying liquidity horizons as a weighting and scaling mechanism of risk factors in itscalculation.

Two more aspects were introduced in the first Consultative Paper. First, the Committeeproposed to “incorporate capital add-ons for jumps in liquidity premia […] for sets ofinstruments that could become particularly illiquid” (Consultative Document I, p.3,2012). Second, the Committee was working on a way to incorporate endogenousaspects of liquidity risk that occur for internal, bank-specific reasons when, for example,banks hold such large and concentrated position assets, which itself could become acause for illiquidity. The most favored possibility was to apply liquidity horizons andfurther extend them or to apply valuation adjustments to account for endogenousliquidity.

Liquidity horizon

Liquidity horizons are best understood as the time required to sell a financial instrument, or hedge all its material risk in a stressed market without materially affecting market prices (Consultative Document I, 2012). So in general, the longer theliquidity horizon for a particular risk exposure, the more capital the bank would needprovide to hold this exposure. In defining potential liquidity horizons, the Committeehad to weigh a very fine-tuned, granular calibration of liquidity against the cost ofgreater complexity in the regulatory regime. To reduce these costs, the Committeedecided on a few generic “buckets” of liquidity horizons. The way these areincorporated into the risk metric is through assigning risk factors, which determinereturns of financial instruments within the trading book and which was already acommon approach in market risk modeling, to the generic liquidity horizons. To avoidregulatory arbitrage, the Committee developed detailed quantitative and qualitativeguidelines on the assignment and introduced floors for horizons on specific risk factors.The Committee acknowledged that determining these floors is exposed to some degreeof judgment, but that it will seek to base this on an informed quantitative analysis. Itwas also seeking input on how to specifically apply these horizons to longer risk factor shocks (e.g. 1 year) due to potential lack of market data. Without going into too much detail, the Committee was debating between using short horizons and scaling them up by the square root of time to longer horizons, or using a longer horizon in the first place. Shorter horizons would solve the problem of insufficient and overlapping market data, but lead to unrealistically high risk charges in some cases, as it not fully capturescorrelation effects. The Committee was also contemplating on determining the stressed shocks on a portfolio level, including correlation effects, and scaling this output up to the weighted average liquidity horizon. The problem with this is determining what the average liquidity horizon of a trading portfolio is.

Capital add-ons for liquidity premia jumps

The Committee, in particular based on crisis experience with some structured products,was concerned that for certain instruments and risk metrics, historical price data couldunderestimate the risk of jumps in liquidity in times of stress, regardless of how longone would extend the liquidity horizon. To approach this, the Committee proposed aprocess of determining whether capital add-ons for jumps in liquidity should be appliedand if so, how precisely this application would look like. The criteria to assess the needfor capital add-ons were set out by benchmark volatilities to each horizon category. Ifbanks internal model showed lower actual volatilities for certain risk factors, it wouldbecome necessary to provide additional capital add-ons. A capital charge would alsobecome necessary in general for instruments that are marked to model for unobservableinputs. Lastly, the Committee might directly mandate instruments for which an additional capital charge would apply. For its first Consultative Document, the Basel Committee also made use of academic resources and input, one of which was the distinction between exogenous and endogenous liquidity, which it subsequently decided to include into the reform process.

Endogenous liquidity risk

More than that, presumably because it is a rather new concept in the Basel framework,the Committee seeked active participation from stakeholders on determining how todeal with bank portfolios that, with respect to size of exposure or position relative to thewhole market, themselves pose a source of exacerbating liquidity in time of financialstress. The Committee favored the application of liquidity horizons above the regulatoryfloor to retain the advantages of the single concept within the trading book regime, butwas also open for individual capital adjustments to the portfolio.



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Universität Mannheim
minimum capital requirements market risk developments basel regulation



Titel: Minimum Capital Requirements for Market Risk