Oct 12

Basel II: Market risk

by David Harper, CFA, FRM, CIPM

FRM |

The original (1998) Accord charged banks for credit risk only. The 1996 Amendment added market risk.  Basel II rounded out the risk triumvirate by adding operational risk.

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Scope of the market risk charge

Basel distinguishes between the bank's trading book (typically valued at cost and held for longer terms) and the banking book (typically marked-to-market and held for shorter terms). The banking book holds our traditional view of a bank loan asset; the trading book holds the rapidly-growing list of complex instruments that can include credit derivatives, securitizations and leveraged loans. Naturally, the SEC (which is a, after all, a U.S. "supervisor") is concerned about the ability of the Accord to keep pace here with market innovation. In order for positions to be eligible for trading book treatment, they must meet several requirements (e.g., a documented trading strategy).

Market risk scope includes:

  • Risks pertaining to interest rate related instruments and equities in the trading book; and
  • Foreign exchange risk and commodities risk throughout the bank (i.e., in both trading and banking books)

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Two approaches

Under credit risk, banks can use a standardized or internal ratings-based approach. Similarly, market risk has two broad approaches: standardized or internal models approach (IMA). Under the standardized (a.k.a., building block) charges are applied to each position and then simply summed:

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Of course, this ignores diversification benefits. The charges are parsed into:

  • a general market risk charge, and
  • a specific risk charge

The charges have been criticized for their blunt uniformity. For example, in regard to equities the general charge is 8% (net positions: long minus short) and the specific charge is 8% (gross positions: sum of long plus short equity).

 

Internal Models Approach (IMA)

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As with all advanced approaches under Basel II, the Internal Models Approach (IMA) has several incremental qualitative and quantitative requirements (including, as usual, supervisor approval - so, again, the Second Pillar has an active relationship with the First Pillar). For those banks that qualify to use IMA, they develop the market risk charge based on daily value at risk (VaR). The market risk charge must use VaR but Basel does not insist on a particular VaR model. Minimum standards include:

  • Daily VaR assuming a 99th percentile confidence
  • Ten-day time horizon. That is, the price shock over ten trading day; i.e., typically we scale 1-day VaR to 10-day VaR by multiplying by the square root of ten ["square root rule"]
  • The historical observation period must be at least one year
  • Banks must update their datasets at least quarterly
  • No particular VaR model is specified. Banks can use variance-covariance, historical simulation or Monte Carlo simulation

The market risk charge (MRC) is the higher of:

  • the previous day's VaR, or
  • average VaR over the last sixty (60) business days multiplied by a multiplicative factor (k), which is at least three (k >=3.0)

The multiplier has been criticized. One line of criticism is, "we go to the trouble of making a precise VaR estimate, then arbitrarily kludge on a giant 3.0 multiplier?"

The Basel Committee defends the multiplier on two grounds, both of which are instructive to an FRM candidate

  • VaR is just a starting point. Technically, it says nothing about losses in the extreme tail, in excess of VaR. In English, over sufficiently long periods of time, we can eventually expect a loss that exceeds VaR
  • A buffer or cushion to mitigate the model risk that attaches to VaR. There are some thematic model risk problems cited here: fat-tails, time-varying volatilities, inability to capture event risk

Stress testing (a qualitative requirement of IMA) and backtesting

Importantly, banks that use the IMA approach, must stress test their internal models. The guidance here is necessarily flexible.

In addition to stressing their models (and/or conducting scenario analysis), banks must backtest their VaR model. To backtest the VaR is to verify its accuracy; if the backtest proves the VaR model unreliable, the multiplier can be "plus-ed" up from three to something higher, as a penalty. More on backtesting in the next post.

Comments

  1. nasreen alqaseer 02 Dec 2007

    I would like to recieve other part of risk defined under basel ii in the same format of market risk. This is an excellent way in understanding the concept and defining it.

    Thank you

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