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Market Risk
From the
Basel ii framework:
Market Risk A. The risk measurement framework Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The risks subject to this requirement are: • The risks pertaining to interest rate related instruments and equities in the trading book; • Foreign exchange risk and commodities risk throughout the bank. 1. Scope and coverage of the capital charges The capital charges for interest rate related instruments and equities will apply to the current trading book items prudently valued by banks. The capital charges for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions, subject to some discretion to exclude structural foreign exchange positions. It is understood that some of these positions will be reported and hence evaluated at market value, but some may be reported and evaluated at book value. In the same way as for credit risk, the capital requirements for market risk are to apply on a worldwide consolidated basis. Where appropriate, national authorities may permit banking and financial entities in a group which is running a global consolidated book and whose capital is being assessed on a global basis to report short and long positions in exactly the same instrument (e.g. currencies, commodities, equities or bonds), on a net basis, no matter where they are booked. Moreover, the offsetting rules as set out in this section may also be applied on a consolidated basis. Nonetheless, there will be circumstances in which supervisory authorities demand that the individual positions be taken into the measurement system without any offsetting or netting against positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis. Moreover, all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. Supervisory authorities will be especially vigilant in ensuring that banks do not pass positions on reporting dates in such a way as to escape measurement. A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed. A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments (or cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset; or the contractual right to exchange financial assets on potentially favourable terms, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or to exchange financial liabilities under conditions that are potentially unfavourable. Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making. Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Section and taking into account the bank’s risk management capabilities and practices. Compliance with these policies and procedures must be fully documented and subject to periodic internal audit. These policies and procedures should, at a minimum, address the general considerations listed below. The list below is not intended to provide a series of tests that a product or group of related products must pass to be eligible for inclusion in the trading book. Rather, the list provides a minimum set of key points that must be addressed by the policies and procedures for overall management of a firm’s trading book: • The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes; • The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market; • For exposures that are marked-to-model, the extent to which the bank can: (i) Identify the material risks of the exposure; (ii) Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market; (iii) Derive reliable estimates for the key assumptions and parameters used in the model. • The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner; • The extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure; • The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and • The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers. The following will be the basic requirements for positions eligible to receive trading book capital treatment. • Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon). • Clearly defined policies and procedures for the active management of the position, which must include: – positions are managed on a trading desk; – position limits are set and monitored for appropriateness; – dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy; – positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis; – positions are reported to senior management as an integral part of the institution’s risk management process; and – positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc. • Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book. |
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