Trading book credit risk capital calculation

Subject to 3, a firm may calculate its capital requirements for its trading book business in accordance with the standardised approach to credit risk or, if it has. Before a bank can calculate rwa for credit risk and rwa for market risk, it must follow the. The financial crisis in 200708 ex posed this oversight. Cre55 counterparty credit risk in the trading book. Using economic capital to determine risk investopedia. This book covers all new approaches for the calculation of rwa. Calculation of regulatory capital requirements for trading book securitizations. He was most recently a managing director at ubs reporting into the global head of fx, rates and credit as the head of risk management for the fixed income business, and was part of the ib leadership team. Thus, under the amended capital standards, positions in a banks trading book are subject to the market risk capital requirements but are exempt. A credit default swap does not normally create a position for general market risk for either the protection buyer or protection seller. Under this approach, it is also difficult to segregate capital for credit, market and operational risk. The trading book lists transactions by the banks dealing desk, buying and selling securities so that either additional profits can be made from trading or to hedge held positions. Tom jenkins, partner, head of financial risk management, kpmg.

Revised trading and banking book boundary for market risk presumed assignment to the trading book alternative allocation possible through explicit supervisory approval there is a general presumption that any of the following instruments are being held for at least one of the above. Interest rate risk, credit spread risk, equity risk, foreign exchange risk, commodities risk and default risk for trading book instruments. The drc captures the jumptodefault risk at 1 year horizon and its calibrated on the basis of the banking book credit risk treatment in order to reduce the potential discrepancy in capital requirements for similar exposures in the. However, the assets are valued at their book value and a write down in asset value happens only in case of defaults. Pdf economic capital for credit risk in the trading book. Risk weights for unrated exposures will be based on the standardised credit. The regulatory capital requirements for the market risk of trading book securitizations are determined based on a combination of internal models and regulatory standard approaches pursuant to section 314 et seq.

The financial crisis in 200708 exposed this oversight. Alternatively, a firm may consistently include for the purposes of calculating capital requirements for counterparty credit risk all credit derivatives included in the trading book forming part of internal hedges or purchased as protection against ccr exposure where the credit protection is recognised under the bcd. Rbc25 boundary between the banking book and the trading book. The starting point in the calculation of the drc is the notional amount and marktomarket loss already taken on a credit position. This development has led to an increase in credit risk in the trading book and a. Completion instructions return of capital adequacy ratio. However, the present value of premium payable receivable is. Economic capital is a measure of risk expressed in terms of capital. Methodology for default risk capital calculation regulatory framework.

Revised framework for market risk capital requirements. Evolution of the capital accord basel i basel iii basel i minimum risk based capital, definition of capital mra market risk treatment in the trading book. A bank may, for instance, wonder what level of capital is needed in order to. A major gap thus revealed by the 2008 nancial crisis was the inability to adequately identify the credit risk of the trading book positions any component of. Independent from the treatment in the cva risk capital requirement and the market risk capital requirement, internal risk transfers between the cva portfolio and the trading book can be used to hedge the counterparty credit risk exposure of a derivative instrument in the trading or banking book as long as the requirements of rbc25. Market risk can be defined as the risk of losses in on and offbalance sheet positions arising from adverse movements in market prices. Minimum capital for the trading books market risk is calculated separately from capital for its credit risk. An illustration based on a hypothetical portfolio on how various types of financial instruments are reported and how market risk capital charges are calculated under the. Tier 3 capital includes shortterm subordinated debt and net trading book profits. From a regulatory perspective, market risk stems from all the positions included in banks trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet. Under this approach the value of capital can be seen as a call option on the value of the firms debt. Jd risk solutions dipak chotai is the founder of a specialist consultancy firm, jd risk solutions, and is a veteran of risk management. Stricter capital adequacy requirements apply to the trading book, since trading is a greater risk.

The banking book comprises all instruments that are not in the trading book and all other assets of the bank hereafter banking book exposures. Economic capital ec refers to the amount of risk capital that a bank. Capital requirements for overthecounter derivatives. The basel committee on banking supervision bcbs wants to make banks treat the assets in their trading books more like those in their banking books by forcing them to hold increased capital against assets designated for trading historically, lower capital requirements for trading book assets had encouraged banks to shift assets from the more expensive banking book into the trading. Pwc discusses ten key points from basels fundamental. Basel iv revised trading and banking book boundary for market risk. The risks subject to market risk capital charges include. Through the frtb rules, bcbs is seeking, for example, to establish a more objective boundary between the trading book and the banking book, and to eliminate capital arbitrage. The guidance for the calculation of market risk capital charge for credit derivative contracts booked in a reporting institutions trading book is set out in annex iva. The capital requirement for the general market risk of trading book securitization. This method is also common in banks internal models. Deutsche bank annual report 2012 calculation trading book. Rbc20 calculation of minimum riskbased capital requirements.

Trading and capitalmarkets activities manual supplement 12april 2007 nature of changes examination objectives, examination procedures, and an internal control questionnaire sections 2030. Basel capital rules for banks trading books will shift. Before a bank can calculate rwa for credit risk and rwa for market risk, it must follow the requirements of rbc25 to identify the instruments that are in the trading book. Trading book and credit risk twofactor model for incremental default risk charge impact on the risk. Banks must calculate the counterparty credit risk charge for overthecounter otc derivatives, repostyle and other transactions booked in the trading book, separate from the capital requirement for market risk. Here the banks typically accept credit risk and interest rate risk. This led to the practice of indulging in regulatory arbitrage by firms to reduce capital charge by moving positions between banking and trading book. Frequently asked questions on market risk capital requirements 1 introduction in january 2016, the basel committee on banking supervision the committee published the standard minimum capital requirements for market risk.

Employing methodologies similar to the calculation of banks capital requirements against trading book exposures, this paper assesses the sensitivity of central counterparties required risk buffers, or capital requirements, to a range of model inputs. As a consequence, credit risk rules were applied more to the banking book assets and the market risk capital rules were applicable more to the trading book assets. A revised boundary between the trading book and banking book the final rules establish a more objective boundary that serves to reduce incentives to arbitrage between the banking book and trading book, especially arbitrage in regulatory capital requirements between the two books. Rbc20 calculation of minimum riskbased capital requirements bis. Together with the default ccr capital, introduced as a part of basel ii in june 2006, cva risk capital reflected.

The notional amount is used to determine the loss of principal at default, and the marktomarket. The objective is to provide a consistent implementation across the eu of the. As with the sensitivities based method, the default risk charge allows for some limited hedging recognition. Bcbs estimates a median capital increase of 22% and a weightedaverage capital increase of 40%. While frtb was not intended to increase banks capital costs beyond those. Credit risk focuses on the development of bts, guidelines and reports regarding the calculation of capital requirements under the standardised approach and irb approach for credit risk and dilution risk in respect of all the business activities of an institution, excluding the trading book business. Revised internal models approach for market risk 11 the history of the trading book regime 1996 basel i first methodology laid out by the bcbs to set out capital requirements for market risks. Irr in the trading book is subject to pillar i and hence carries a capital charge, whereas interest rate risk in the banking book irrbb is subject to pillar 2 and does not carry a regulatory charge. Another approach based on stock prices uses the blackscholesmodel to calculate the market value of capital. Cre55 counterparty credit risk in the trading book bis. Risk capital consists of investment funds allocated to speculative activity and refers to the funds used for highrisk, highreward investments such as junior mining or emerging biotechnology. Guidance note on the calculation of capital requirement.