Market Risk Calculation

In addition to credit risks or counterparty risks and operational risks, market risks must also be backed by equity in accordance with the requirements of the CRR (Regulation No. 575/2013). Market risks include foreign currency risks and raw material risks as well as interest rate and equity price risks of a financial institution.

For each of these market risk types, the CRR provides standardized procedures in order to determine the degree of equity requirements. As an alternative to the standardized procedure, an institution may also use internal risk models after prior approval by the supervisory authority.

However, weaknesses in the equity backing of trade portfolios became apparent in the wake of the financial market crisis. The market price risk models failed to recognize the total risk potential that resulted from trading transactions. Accordingly, most value-at-risk models did not take sufficient account of the credit risk, underestimated the likelihood of extreme scenarios or neglected the risk of liquid markets. These factors led to a serious undercapitalization of the banking system as a whole during the financial market crisis.

These shortcomings were addressed in the context of the paper “Minimum capital requirements for market risk” (BCBS 352) by the Basel Committee on Banking Supervision in January 2016. The paper discusses not only the separation of transactions between the investment and trading book, but also in particular the measurement and controlling of market price risks on the basis of a standardized approach and the equity backing of these market price risks through internal models.

The Revised Standardized Approach for the Quantification of the Market Risk

The approach to quantifying the market risk was revised in the paper to the extent that henceforth the minimum capital requirement for the market risk consists of three components:

  • Sensitivity-based Method: Expansion of the Framework for Quantifying the Market Risk by Giving Greater Consideration to Sensitivities. The delta, vega and/or curve risk sensitivity prescribed by the regulatory authority is used for each financial instrument under the assumption of different scenarios and depending on the respective risk class.
  • Standardized Buffer for the Default Risk: This buffer takes account of the so-called jump-to-default risk, which means the loss that would arise if the counterparty actually defaults. This buffer was introduced in order to eliminate divergences in the calculation of the equity for the credit risk in the case of investment book and trading book transactions.
  • Residual Risk Add-on: This general buffer covers market risks that cannot be covered by the standardized approach. If this factor were explicitly modeled, the degree of complexity in the approach would be significantly greater, which is why one may make use of this general factor.

The Revised Internal Model Method

As before, it is possible to quantify the market risk in an alternative manner by using a model developed within the institution if this is approved.  

The main changes can be summarized as follows:

  • Substitution of the VaR and the Stressed VaR as a Risk Metric through the Expected Shortfall: The value-at-risk is neither coherent nor does it provide information on events or risks that go beyond a given quantile. By contrast, the expected shortfall also takes account of the risk of rare events. For non-modellable risks (NMRF), a stressed capital premium is derived on the basis of the expected shortfall for modellable risks.
  • Limiting Effects by Hedging / Portfolio Diversification: Such capital-reducing effects are no longer recognized in full. Rather, under the new regulations, the capital requirement is composed of a weighted average between the capital requirements that would arise without the hedging/diversification effect and the capital requirement including the hedging/diversification effects.
  • Continuous Statistical Review of the Forecast Quality at the Desk Level: Thus, the internal model must be precisely tailored to the trading desk in regard to the risk drivers, non-modellable risks, backtesting, etc. A trading desk is defined as a group of trade activities in regard to a certain business strategy within an active risk management system.

FAS Support for Calculating the Market Risk

FAS AG will support you and your company in the analysis of your current system for measuring and controlling the market price risks, in the identification of gaps as a result of the new regulatory requirements, the design of suitable adjustment measures and in the context of implementation support. 

If you are interested or have any questions, please contact us.

 Dominik Konold Partner