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Constraints and proposed changes in the consultative document on reducing variation in credit risk-weighted assets when using the internal model approaches

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The consultative document about reducing variation in credit risk-weighted assets and its constraints on the use of internal model approaches gives insight into the Committee’s proposed alternations. The changes are mainly focused on the advanced internal ratings-based approach and the foundation internal ratings-based approach. A number of proposed changes to this approach include complementary measures, which aim to diminish the often complex regulatory framework, improve its correlation and address inordinate variability in the capital requirements for credit risk. Specifically to this change the Basel Committee set out the following adjustments: • Remove the IRB approaches option for certain exposures, because the approaches’ parameters cannot adequately and accurately estimate regulatory capital purposes   • Maintain exposure-level, model-parameters floors to establish a minimum level of conservatism for portfolios where the IRB approaches remain available   • Reduce variability in risk-weighted assets (RWA) for portfolios where the IRB approaches remain available by equipping parameter estimation practices with stronger specifications The Committee has previously consulted on the design of aggregate capital floors based on standardised approaches and is still considering the design and calibration. This would complement the proposed constraints discussed in this consultation paper.

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Basel Committee issues proposed revisions to the operational risk capital framework

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On March 4th 2016, the Basel Committee on Banking Supervision (BCBS) specified the proposed alternations to the operational risk capital framework, also known as the new Standardised Approach (SMA). The SMA is part of BCBS’s consultation paper which has been issued in October 2014. The suggested alternations of the operational risk capital framework are aimed at achieving BCBS’ broad objectives of balancing simplicity, comparability and risk sensitivity. The changes are necessary to make a step towards completing the post-crisis reforms of the current year. The objectives of the proposals are necessary, but they will have a neutral impact on overall capital requirements of most banks. BCBS recommends simplifying the regulatory framework by replacing three existing standardised approaches for calculating operational risk capital, as well as the Advanced Measurement Approach (AMA). Besides the regulatory framework, the risk-sensitive framework that combines financial statement-based measures of operational risk with an individual firms’ past operation losses have to be strengthened. Finally, the AMA needs to be discharged. Removing this framework will lead to a less complex modelling of the operational risk for regulatory capital purposes and less variable in risk weighted assets and insufficient levels of capital.

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Revised Market Risk Framework published

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The BIS has published on January 14th, 2016 the revised market risk framework,  also referred to as Fundamental Review of the Trading Book (FRTB). The 2007-2008 period of severe market stress exposed weaknesses in the framework for capitalising risks from trading activities. In 2009, the Committee introduced a set of revisions to the Basel II market risk framework to address the most pressing deficiencies. A fundamental review of the trading book was also initiated to tackle a number of structural flaws in the framework that were not addressed by those revisions.This has led to the revised market risk framework, which is a key component of the Basel Committee’s reform of global regulatory standards in response to the global financial crisis. The purpose of the revised market risk framework is to ensure that the standardised and internal model approaches to market risk deliver credible capital outcomes and promote consistent implementation of the standards across jurisdictions. The final standard incorporates changes that have been made following two consultative documents published in October 2013 and December 2014 and several quantitative impact studies. The key features of the revised framework include: A revised boundary between the trading book and banking book A revised internal models approach for market risk A revised standardised approach for market risk A shift from value-at-risk to an expected shortfall measure of risk under stress Incorporation of the risk of market illiquidity The revised market risk framework comes into effect on 1 January 2019. More information can be found on http://www.bis.org/bcbs/publ/d352.htm.

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Review of the Credit Valuation Adjustment (CVA) risk framework – consultative document

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A Review of the Credit Valuation Adjustment Risk Framework is being undertaken by the Basel Committee. The objectives of the review are to (i) ensure that all important drivers of credit valuation adjustment (CVA) risk and CVA hedges are covered in the Basel regulatory capital standard; (ii) align the capital standard with the fair value measurement of CVA employed under various accounting regimes; and (iii) ensure consistency with the proposed revisions to the market risk framework under the Basel Committee’s Fundamental review of the trading book. The Basel III capital framework already establishes a minimum capital charge to capture the potential mark-to-market losses faced by a bank from the deterioration in a counterparty’s creditworthiness. This capital treatment addresses any variability in CVA that arises due to changes in credit spreads but does not take account of variability arising from daily changes in market risk factors (ie account exposure variability). This consultative paper envisages a CVA risk framework that takes into account the market risk exposure component of CVA along with its associated hedges. The regulatory capital requirement for CVA risk would be based on exposure models that banks also use to determine their accounting CVA, subject to conditions intended to reduce potential variability due to risk-weighted asset (RWA) calculations or remaining discrepancies in financial reporting practices across banks and jurisdictions. For a broad range of internationally active banks, accounting CVA is fair-valued through the profit and loss (P&L) account and is sensitive to the same risk factors as instruments held in the trading book. The consultative paper therefore proposes an internal models approach and a standardised approach for CVA risk that have been adapted from the revised market risk framework under the Committee’s Fundamental review of the trading book. A basic approach for CVA risk is also proposed for banks that are less likely to regularly compute CVA sensitivities to a large set of market risk factors, owing to the nature of their trading operations. The consultation document can be found here.

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