Minimum capital requirements for market risk

Significant weaknesses in the Basel capital framework for trading activities resulted in materially undercapitalised trading book exposures prior to the 2007–08 period of the financial crisis. To deal with the most pressing weaknesses, the BCBS introduced a set of revisions to the market risk framework in July 2009. Nonetheless, at the time, the BCBS recognised that a number of structural flaws in the market risk framework remained unaddressed.

In response, it undertook the Fundamental Review of the Trading Book (FRTB) to improve the overall design and coherence of the capital standard for market risk.

Consistent with the policy rationales underpinning three consultative papers on the FRTB, the BCBS published in January 2016 revised standards for minimum capital requirements for market risk. This revised market risk framework consists of the following key enhancements:

• Revised boundary. The boundary between the banking book (BB) and trading book (TB) has been revised to reduce incentives for a bank to arbitrage its regulatory capital requirements between the two regulatory books.
• Revised Standardised Approach (SA). It has been revised to make it sufficiently risk-sensitive to serve as a credible fallback for 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.
• Revised Internal Models Approach (IMA). The enhancements to the IMA have three main aims: (i) more coherent and comprehensive risk capture that takes better account of “tail risks” and market illiquidity risk; (ii) a more granular model approval process whereby internal models are approved for use at the trading desk level; and (iii) constraints on the capital-reducing effects of hedging and portfolio diversification.

This document prepared by Management Solutions R&D department analyses these revised standards.

Executive summary

These revised standards, which are expected to be implemented by January 2019, apply to internationally active banks on a worldwide consolidated basis. They have been elaborated consistently with the policy rationales underpinning the BCBS consultative papers on the FRTB.

Scope of application:

• Internationally active banks, on a worldwide consolidated basis.

Main content:

• Revised boundary between the TB and the BB: definition of the TB and the BB which includes a list of instruments presumed to be in the TB, supervisory powers, documentation of instrument designation, policies for TB instruments, and restrictions on moving instruments; and requirements for trading desks, limits to the internal risk transfers, and counterparty credit risk (CCR) charge.
• Revised standardized model (SA): sensitivities-based method; default risk charge; residual risk add-on.
• Revised Internal Model Approach (IMA): eligibility of trading desks; capital charge (i.e. Expected Shortfall, Default Risk Charge and stressed capital add-on); general criteria for the approval of internal models.

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