On the choice of liquidity horizon for incremental risk charges: are the incentives of banks and regulators aligned?

Abstract

The recent incremental risk to the Basel market risk requires banks to estimate, separately, the default and migration risk of their trading portfolios that are exposed to credit risk. The regulation requires the total regulatory charges for trading books to be computed as the sum of the market risk capital and the incremental risk charge for credit risk. In the calculation of incremental risk charges a key component is the choice of the liquidity horizon for traded credits. In this paper we explore the effect of the liquidity horizon on the incremental risk charge and in particular validate that the framework for assigning liquidity horizons proposed by regulation is consistent with bank's motivation to conserve the regulatory capital requirement. We consider a stylized portfolio of 28 bonds with different ratings and liquidity horizons to evaluate the impact of the choice of the liquidity horizon for a certain rating class of credits. We find that choosing the liquidity horizon for a particular credit there are two important effects that need to be considered. The first effect is the bonds with short liquidity horizons can avoid further downgrading by frequently trading to a bond of the same initial quality. The second effect is the possibility of multiple defaults. Our findings are also supported by empirical result of credit spread term structure. Therefore, the liquidity horizon specification in the incremental risk charge requirement from Basel committee is consistent with the market reality, banks' incentive in capital requirement conservation and consequently alleviates the concerns in IRC model validation.