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Market Risk Regulation

Market Risk Regulation. University of Essex 14 th February 2014. Please note: all comments/opinions are entirely those of the presenter and cannot be ascribed to either the PRA or the University of Essex. Lecture Outline. Outline the international banking regulatory structure

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Market Risk Regulation

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  1. Market Risk Regulation University of Essex 14thFebruary 2014 Please note: all comments/opinions are entirely those of the presenter and cannot be ascribed to either the PRA or the University of Essex

  2. Lecture Outline • Outline the international banking regulatory structure • Outline the banking capital regulation framework • Explain the market risk capital framework • Explain the key market risk regulatory developments BANK CONFIDENTIAL

  3. The PRA organization structure Supervision Team Structure (Manager) Business Risk and External Context Capital and Liquidity Management, Governance and Resolvability Risk Management and Controls BANK CONFIDENTIAL

  4. The PRA’s Approach to Banking Supervision (April 2013) The Prudential Regulation Authority • The PRA has a general objective to promote the safety and soundness of firms, and within this it focuses primarily on the harm that they can cause to the stability of the UK financial system. • Consistent with the Act, it is not the PRA’s role to ensure that no firm fails. Rather, the PRA seeks to ensure that any firms that fail do so in a way that avoids significant disruption to the supply of critical financial services Risk Management and Control Framework • Firms should have robust frameworks for risk management and financial and operational control, commensurate with the nature, scale and complexity of their business, and consistent with their safety and soundness. Internal Capital Models • While quantitative models can play an important role in supporting firms’ risk management, the PRA expects firms to be prudent in their use of such models given the inherent difficulties with risk measurement. • If firms use internal models in calculating their regulatory capital requirements, the PRA expects the models to be appropriately conservative.Where the PRA judges the conservatism applied in internal models not to be sufficient, it will take appropriate action to address the situation, which can include requiring methodological adjustments or recalibration, setting capital floors or imposing adjustments to modelled capital requirements. • Importantly, where internal models are used for regulatory capital purposes, they should contribute to prudent risk management and measurement.. BANK CONFIDENTIAL

  5. Basel Committee on Banking Supervision • The Basel Committee on Banking Supervision is an institution created by the central bank Governors of the G10 nations . It was created in 1974, after the failure of Herstatt Bank caused significant disturbances in Global Currency Markets. • National representation on the committee is via Central Banks and other agencies with responsibility for Banking Supervision. • The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice The purpose of the committee is to encourage convergence toward common approaches and standards. • The committee does not have the legal authority to enforce recommendations. Recommendations are enforced through national (or EU-wide) laws and regulations. • Recommendations issued by the Basel Committee eventually become embedded in legal frameworks such as the European Capital Requirement Directive (CRD). • http://www.bis.org/bcbs/ BANK CONFIDENTIAL

  6. Basel Accords • The Basel (or Basle) Accords refers to the Banking Supervision Accords i.e. Recommendations on Banking Supervision Laws and Regulations. • Basel I and Basel II issued by the Basel Committee on Banking Supervision (BCBS). • Basel I – 1998 Accord plus 1996 Market Risk Amendment for VaR/ CAD2 (Trading Book Regime) • Basel II – 2004 • Basel Rules on Capital Measurements and Capital standards implemented via the Capital Requirements Directive (CRD). • CRD Replace 2 European Directives • CAD2 – Capital Adequacy Directive (98/31/EEC) • BCD – Bank Consolidation Directive (2000/12/EEC) BANK CONFIDENTIAL

  7. “Basel I” & Amendment for Market Risk • Cooke Ratio – Defined as the ratio of capital to risk weighted on-balance sheet assets plus off-balance sheet exposures, where weights are assigned on the basis of counterparty credit risk. • Basel I is limited. It does not address: • Portfolio Effects & Netting • Capital adequacy of Trading Book securities • MARKET RISK 1996 Amendment – Banks given the opportunity to develop their own Market Risk models - VaR • Subject to Minimum Requirements. • Strong & Independent Market Risk Management Infrastructure • Sound Risk Management Policies & Practices • Effective capture of relevant risks • Capture of Equity and Interest Rate Specific Risk (i.e. Name related Risk) BANK CONFIDENTIAL

  8. Basel II • In June 1999, the Basel Committee issued a first proposal to replace Basel I with a more risk sensitive agreement covering Market, Credit and Operational Risks. • Following consultation etc, Basel II was released mid 2004, for implementation year end 2006, for all but the most advanced approaches. Advanced approaches were due for implementation year end 2007. • Basel II was more flexible, offering a range of risk sensitive approaches and incentives for better Risk Management. • The overall objective of Basel II is to increase the safety and soundness of the (international) financial system by • making capital requirements for banks more risk sensitive • Economic risks are better implemented than in Basel I (e.g. more sophisticated approaches for calculating credit risk requirements) BANK CONFIDENTIAL

  9. Basel II – 3 Pillars BANK CONFIDENTIAL

  10. Basel II.5 • Proposed by Basel Committee in July 2009 • Focuses on trading book - priority area for reform following financial crisis • New concept of Re-securitisations introduced and given higher risk weights than securitisations – applies to banking book • Securitisations and re-securitisations in the trading book have to be treated under the Banking Book risk weights approach – cannot model them as previously • New models introduced: • Stressed VaR • IRC (extension of IDRC) • CRM (Comprehensive Risk measure) for certain securitisation products • Introduced into European legislation as CRD3 • Implemented on 31st December 2011 BANK CONFIDENTIAL

  11. Basel III • Improve the quality and quantity of capital • Strengthening the risk coverage of the framework (e.g. counterparty credit risk exposures arising from derivatives, repos and securities financing activities) • Introducing a leverage ratio as a supplementary measure to the Basel II risk-based framework • Countercyclical capital buffers - build-up of capital buffers in good times that can be drawn upon in periods of stress • Introducing a global minimum liquidity standard • More details available at: http://www.bis.org/press/p091217.htm • Also reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions (SIFIs). • Introduced into European legislation as CRR/CRD4 BANK CONFIDENTIAL

  12. Pillar 1 Market Risk Capital BANK CONFIDENTIAL

  13. Pillar 1 – Market Risk • Since 1 January 1998, banks in G10 countries were required to maintain regulatory capital to cover market risk (Market Risk amendment to the Basel Accord, 1996/ 1998). • Market Risk can be defined as the risk of movements in the market prices of a banks on- or off- balance sheet positions. General Market Risk – Refers to movements in market prices resulting from General market behaviour. It includes: Changes in interest rates, FX rates, commodities prices. Movements in stock indices Changes in the slope or shape of yield curves Widening/ tightening of credit spreads Specific (or residual) Market Risk refers to movements in market prices which are specific to an instrument and independent of general market movements in prices. It includes for example prices of equity securities resulting from factors specific to individual issuers. • Banks' Capital Requirements for Market Risk based on 2 methods: • Standardized Approach – adopts “building block” approach to interest-rate related and equity instruments which differentiates capital requirements (changes) for specific risk from those for general market risk. • Internal Models Approach – VaR – Enables a bank to use its proprietary in-house method which must meet the qualitative and quantitative criteria set by the Basel Committee & is subject to the explicit approval of the bank’s Regulator. • Most banks use a combination of the 2 methods depending on extent of VaR Model Approval given. • VaR method has associated capital add-ons…… BANK CONFIDENTIAL

  14. Regulatory Definition – Specific & General Market Risk • Market Risk can be defined as the risk of movements in the market prices of a banks on- or off- balance sheet positions. • General Market Risk – Refers to movements in market prices resulting from General market behaviour. It includes: • Changes in interest rates, FX rates, commodities prices. • Movements in stock indices • Changes in the slope or shape of yield curves • Widening/ tightening of credit spreads • Specific (or residual) Market Risk refers to movements in market prices which are specific to an instrument and independent of general market movements in prices. It includes for example prices of equity securities resulting from factors specific to individual issuers. BANK CONFIDENTIAL

  15. Revisions to Basel II Market Risk Framework • Revisions to Basel II Market Risk framework (July 2009). • The revisions are intended to enhance the Basel II framework & strengthen the 1996 rules governing Trading Book capital. http://www.bis.org/publ/bcbs158.htm • Colloquially known as “Basel 2.5” • Implemented in EU as CRD3 • Implemented on 31st December 2011 • Changes intended to reduce “Regulatory Arbitrage” • Additional Stressed VaR Requirement – Banks required to calculate a stressed VaR taking into account a “1 year observation period relating to significant losses” . Intended to reduce the procyclicality of the minimum capital requirements for market risk. • VaR to be supplemented with Incremental Risk Capital Charge (IRC) - includes migration risk as well as Default Risk for unsecuritized credit products. • Securitized products will not be eligible for VaR – Banking Book treatment will apply. • Credit Correlation products – Regulators may allow comprehensive risk capital charge to be used – based on minimum qualitative criteria & stress tests. A floor to the charge will apply. • Data sets to be updated every month (currently standard is every 3 months) BANK CONFIDENTIAL

  16. Pillar 1 Market Risk from 31 Dec 2011 (Basel II.5) • IRC = Incremental Risk Capital – includes Credit Migration & Spread Risk, Equity price Risk, as well as Default Risk. • CRM = Comprehensive Risk measure/Floor = CRM floor • Stressed VaR = SVaR = –Based on 1 year observation period of “significant losses”. i.e volatile period e.g. 2007-2008. Involves penal VaR Multiplier MMF. • Again may be other Add-ons due to qualitative market risk considerations e.g. minor systems and controls weaknesses BANK CONFIDENTIAL

  17. VaR Basics • CAD2 is Regulatory based VaR plus add-ons • Regulatory VaRvs Economic VaR • An aggregated $ risk measure used to estimate the risk of a trading portfolio • Takes into account correlation between (& within) asset classes • VaRexpresses many different types of risk as a ‘common currency’ • E.g. can compare risk for equities and commodities businesses on the same basis. • One would expect to lose at least the $ VaR amount over a specific “holding period” to a certain level of “confidence” • So a 1 day 99% VaR of $1m tells you that you would expect to lose $1m or more on one day in every hundred – or 2-3 times a year. • 95% VaR is a ‘once a month’ measure. • Typically firms use 1 day 95% or 1 day 99% for Economic Capital • PRA require firms use a 99% confidence interval for a 10 day holding period for their PRR calculation • Firms can scale the 1 day VaR by √10 (i.e. multiply 3.162) or use 10 day overlapping / non-overlapping periods. BANK CONFIDENTIAL

  18. S&P500 Data- March 2007 – March 2009 BANK CONFIDENTIAL

  19. Introduction to RegVaR • Basel market risk amendment (1996) • Allowed regulators to set market risk capital requirements using a VaR model • Must meet minimum standards • Qualitative and quantitative standards • Includes use of backtesting and stress-testing • Alignment of internal and regulatory capital incentives • Promotes good risk management • CAD2 gives large capital benefit • Partly from more scientific calculation of risk • Standard rules are inflexible and penal • Not because they are large, but because minimal netting benefit. • CAD1 is a basic model approach based on scenario matrices • Most of the capital saving, however, is obtained from diversification. CAD1 & CAD2 are especially beneficial for options portfolios. BANK CONFIDENTIAL

  20. General and Specific Risk • It is harder to get a Specific Risk recognition.. • - Specific Risk models – Name specific risk is modelled directly by full Historical Simulation or a n-factor regression model is used. Specific Risk is the residual component which cannot be explained by market factors. • Specific Risk models have generally performed worse in volatile conditions that General Risk-only models • Most excessive backtesting exceptions issues relate to Specific Risk models. • Many firms have experienced backtesting exceptions over the period 2007 -2008 due to volatile market conditions. • Banking Crisis - Rescue of AIG, collapse of Bear Stearns & Lehman Brothers, RBS etc. BANK CONFIDENTIAL

  21. Model Validation • Model Validation • Checking whether a model is adequate • Includes Backtesting, stress testing, independent review & oversight • A firm must have processes in place to ensure that its VaR model has been adequately validated by suitably qualified parties independent of the development process to ensure that it is conceptually sound and adequately captures all market risk…. • MV must be conducted when VaR model initially developed & when significant changes are made • MV must be conducted on periodic basis & where there have been significant changes in market or portfolio • Firm must follow advances in MV techniques/ best practice • MV must not be limited to Backtesting. Firms should carry out their own MV tests, use hypothetical portfolios & investigate the limitations of VaR. BANK CONFIDENTIAL

  22. Backtesting BANK CONFIDENTIAL

  23. Backtesting • Backtesting Exception = Daily Clean P&L shows a Loss which exceeds 1-day 99% VaR • For 99% expect 2 or 3 exceptions per year • One of the mechanisms for VaR model validation • Backtesting should be performed overall (Legal Entity Level) and at sub portfolio level (including specific risk portfolios) • PRA plus factor system increases VaR Capital via multiplier if more than 4 (Legal Entity Level) Backtesting Exceptions are observed over 1 year (=250 business days). Specific Risk Backtesting Exceptions – If 10 or more exceptions occur in 1 year period, the firm must take immediate corrective action • Firm must have the ability to analyze reasons for exceptions • VaR and P&L portfolios must be materially the same to eliminate bias. • Clean P&L - Actual P&L should be cleaned to exclude non-risky items e.g. fees, commissions, reserve moves & large one-off profits from new deals. • However, it should include P&L due to price testing adjustments & intra-day trading. • Clean hypo P&L for a business day means the clean P&L that would have occurred for that day if the portfolio on which VaR was based remained unchanged • Clean hypo P&L excludes intraday trading • Purer test of VaR model • Based on the days change in value on the same portfolio that was used to generate the VaR BANK CONFIDENTIAL

  24. Stress Testing • VaR will not capture extreme events • Relies on events within the data sets used • So VaR should be complemented with a comprehensive stress testing programme • Identify historical and/or possible scenarios relevant to current portfolio E.g. Tech Market Crash, Credit Crunch, 1987 Crash etc • Re-run frequently & review assumptions periodically • Board and senior management oversight • Need Front Office ‘buy-in’ • Importance of Stress Testing emphasized in ICAAP (Internal Capital Adequacy Assessment Process) requirements under Pillar 2 of Basel II BANK CONFIDENTIAL

  25. RNIV Framework • Firms should have a process and policy for identifying & quantifying RNIV • Examples of RNIV • Cash-Synthetic Basis for ABS • Single Stock Volatility Skew • Hedge Fund Gap Risk BANK CONFIDENTIAL

  26. IRC – Key Supervisory Standards • IRC covers equities as well as credit products. • IRC expands the scope of the capital charge to capture • Default risk • Credit Migration Risk • Credit Spread Risk • Equity Price Risk • Soundness Standard consistent with A-IRB • IRC estimates the Trading book’s exposure to these risks over a one-year capital horizon at 99.9% confidence, taking into account the liquidity horizons of positions. • Assumption of a constant level of risk over a 1 year capital horizon (not constant positions) BANK CONFIDENTIAL

  27. IDRC / IRC Models • For IDRC, most banks used Gaussian Copula Model • A-IRB Approach is a special case of a Gaussian Copula • http://www.fsa.gov.uk/pubs/occpapers/op29.pdf • http://www.fsa.gov.uk/pubs/international/gaussian_copula.pdf • A few firms use Binomial approach • If internal models do not map directly to the Supervisory Principles than the bank must prove the capital charge is comparable, otherwise they may be subject to a Capital Adjustment Factor. Challenges • Double Counting • Capital horizons & Confidence Levels different for VaR & IRC, but there is significant overlap. • Data/ Modelling challenges 1 year • Capital horizon • 99.9% Confidence • Assigning liquidity for each position • Sourcing PDs BANK CONFIDENTIAL

  28. CRM (Comprehensive Risk measure) • Known as All Price Risks measure in EU language • Applies to correlation trading portfolios • Securitisation and n-th-to default credit derivatives that are not re-securitisations and all reference entities are either single name instruments or commonly-traded indices based on those reference entities. • Reference instruments must be liquid • Internal model requirements: • 99.9%confidence interval over a 1 year capital horizon under assumption of constant level of risk and adjusted to reflect impact of liquidity, concentrations etc. • The following risks (among others) should be adequately captured: • Cumulative risk arising from multiple defaults in tranched products • Basis risk between the spread of an index and its constituent names • Recovery rate volatility • Floor of 8% of standardised charge • Stress testing requirement – supplemental capital charge possible BANK CONFIDENTIAL

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