Abstract
In its October 2013’s consultative paper for a revised market risk framework (FRTB), and subsequent versions published thereafter, the Basel Committee suggests new ways of dealing with market risk in banks’ trading and banking books. The Basel Committee estimates that the new rules will result in an approximate median capital increase of 22% and a weighted average capital increase of 40% [1], compared with the current framework. Key changes can be found in the internal model approach, in the standard rules and in the scope/approval process. Among the significant changes that are being introduced by the FRTB is a stricter separation of the trading book and banking book. Regardless of whether they use standardised or internal models, banks will need to review their portfolios to determine if existing classifications of instruments and desks as trading book or banking book are still applicable or whether a revision of desk structure is needed. In this article, we analyse the theoretical foundations of the internal model approach (IMA), which are the stressed expected shortfall, liquidity adjustments, default & migration risk and non-modellable risk factors. We thoroughly investigate the criticisms for Internal Risk Model (IMA) and the introduction of a standardised floor, the sensitivity based approach (SBA) with Delta, Vega and Curvature, shock scenarios and the aggregation with asymmetric correlation and reflection of basis/default risk.
Highlights
In January 2016 the Basel committee published the minimum capital requirements for market risk [2]
Essential changes to older Fundamental Review of the Trading Book (FRTB)-rules are the introduction of a revised standardized model for market risk, which is based on price sensitivities, a substitution of value at risk (VAR) with an expected shortfall (ES) risk measure at a 97.5 percentile, one-tailed confidence level to an internal model desk level and the introduction of liquidity horizons in the ES calculation
Expected shortfall has a number of advantages over VAR
Summary
In January 2016 the Basel committee published the minimum capital requirements for market risk [2]. Essential changes to older FRTB-rules are the introduction of a revised standardized model for market risk, which is based on price sensitivities, a substitution of value at risk (VAR) with an expected shortfall (ES) risk measure at a 97.5 percentile, one-tailed confidence level to an internal model desk level and the introduction of liquidity horizons in the ES calculation. Disclosure and transparency of market risk capital charges including capital ratios calculated using standardized and internal model have to be applied. Vigorous backtesting is required for institutions retaining an internal model approach (IMA) to a trading desk level. Failure to meet the validation criteria force a trading desk to revert to using the standardized approach with higher incremental capital charge. Regardless of size, complexity or whether they have allotted to retain an IMA, must report capital charge based on the standardized model. In this article the standardized model and the internal model approach is analyzed with industry experience, the two approaches are compared, the consequences for the banks are described and practice examples are used to demonstrate the models
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