Basel IV Market Risk Framework

Managing Market Risk Under The Basel IV Framework
Copyright © 2016 CapitaLogic Limited
Chapter 13
Basel IV
Market Risk Framework
Managing Market Risk Under The Basel IV Framework
The Presentation Slides
Website : https://sites.google.com/site/quanrisk
E-mail : quanrisk@gmail.com

Copyright © 2016 CapitaLogic Limited 2
Declaration
Copyright © 2016 CapitaLogic Limited.
All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
Authored by Dr. LAM Yat-fai (林日林日林日林日辉辉辉辉),
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration (Finance),
CFA, CAIA, FRM, PRM.

Outline
Default contagion
Basel IV framework
Regulatory market risk
Internal model approach
Standardized approach

Banking activities
Deposits
< 1%
Shareholders’
equity
Dividend +
equity price
appreciation
3% - 20%
FX,
equities,
treasuries.
Bank

Highly leveraged business
Succeed
Fixed nominal yield to
depositors
Higher return to
shareholders
Failed
Invested equity lost by
shareholders
Liabilities lost by
depositors
Shareholders tend to
invest as little equity as
possible
Use depositors’ monies
to bet in investments of
highest return
Highest return
⇒ highest risk

Shareholders’ loss vs bank assets
0
1
2
3
4
5
0 1 2 3 4 5 6 7 8 9 10
Bank assets
Debtinvestors'loss
Liabilities Profit and equity

Regulatory concern
Contagion
The default of one bank will cause the default of another
bank, for either financial or confidence reasons
The default of a number of banks together will cause the
default of the entire banking system
Mitigation
To prevent the default of the first bank
To ensure that the investment loss even under an extreme
scenario is well covered by shareholders’ monies

Capital charge
A prudent estimate of the potential loss from
a bank’s investments under an extreme
situation
To be matched by long term funding to a bank
Following the Basel IV framework

Outline
Contagion
Basel IV framework

4 (=3+1) pillars of Basel IV
Basel IV
Minimum
capital
requirements
Public
disclosure
Supervisory
review
process
Liquidity
sufficiency
Basel II

Minimum capital requirements
Minimum capital
requirements
Credit risk Operational risk
Basic indicator
approach
Standardized
approach*
Advanced
measurement
approach*
Market risk
Internal model
approach*
Standardized
approach
Standardized
approach
Internal ratings
based approach*
* Regulatory approval required

Supervisory review process
A bank should have a process in place to assess its overall capital
adequacy in relation to its risk profile and a strategy to maintain its level
of capital
A regulator should review and evaluate a bank’s internal capital adequacy
assessments and strategies, as well as the bank’s ability to monitor and
ensure compliance with capital sufficiency. A regulator should take
appropriate supervisory action if it is not satisfied with the result of a
bank’s process
A regulator should expect a bank to operate above the minimum
regulatory capital sufficiency and should be able to request a bank to hold
additional regulatory capital
A regulator should seek to intervene at an early stage to prevent a bank’s
regulatory capital from falling below the minimum levels and mandate a
bank to take rapid remedial action if the regulatory capital is not
maintained or restored

Public disclosure
The organization structure of a banking group, the entities to which the
Basel IV framework is applicable and the entities to which the Basel IV
framework is irrelevant
The terms and conditions of the major features of the financial
instruments which are qualified as regulatory capital
The list of financial instruments qualified as common equity and
additional tier one capitals
The total amount of tier two capital
The capital charges arising from the credit, market and operational risks
General information of other risks to which a bank is exposed and the
relevant methods that the bank has applied in managing these risks
The structure and operations of the bank’s risk management function

Liquidity sufficiency
Liquidity ratios
Liquidity coverage ratio
Net stable funding ratio
Supervisory monitoring tools
Contractual maturity mis-match
Concentration of funding
Available unencumbered assets
Financial market monitoring tools

Outline
Contagion
Basel IV framework

The potential losses of financial investments arising
from the changes within a short holding period in:
Foreign exchange rates
Equity prices
Interest rates
Commodity prices
Credit spreads
Default events
Calculated in accordance with the Basel IV rules

Trading book vs banking book
Trading book exposures
A bank’s investments
Short-term resale
Profiting from short-term price movements
Locking in arbitrage profits
Hedging risks that arise from instruments meeting criteria above
Subject to capital charge for market risk
Banking book exposures
Any exposures not on the trading book
Primarily subject to capital charge for credit risk
Foreign exchange rate and commodity price exposures
also subject to capital charge for market risk

Regulatory market risk components
√Equity prices
√Interest rates
Banking bookTrading bookExposure
√√Commodity prices
√Default events
√Credit spreads
√√FX rates

Current de minimis exemption
By default, banks in Hong Kong must report
their market risk capital charges quarterly
Banks with small market risk exposures may
seek exemption from the HKMA to report
their market risk capital charges annually
Newly licensed banks must report their
market risk capital charges quarterly during
the first year of business

De minimis exemption criteria
Market risk exposures normally less than 5%
of total on- and off-balance sheet exposures
(and never exceed 6%)
Market risk exposures normally less than
HKD 50 mn (and never exceed HKD 60 mn)
Not using internal rating based approach to
report regulatory credit risk capital charge

MRCC calculation methods
Internal model approach (“IMA”)
Subject to regulatory approval
For internationally active banks
Expected shortfall approach
Standardized approach (“STA”)
Generic method
For small and medium size banks
Variance-covariance method approach

Outline
Contagion
Basel IV framework

Capital charges calculated by
ES model at 10-day 97.5th percentile confidence level
Advantages
ES as an industry standard for market risk measurement
Very risk sensitive
Disadvantages
Highly quantitative and complicated
Subject to regulatory approval at a high standard

Qualitative standards
Adequate board and senior management oversight
Effective market risk management system
Independent market risk control unit
Material factors captured and accurately reflected
Use of internal models for daily risk management
purposes
Proper documentation
Internal validation
Comprehensive stress-testing
Independent review or audit

Quantitative standards
ES computed on a daily basis
97.5th percentile confidence interval
10 days base holding period
During a stress period
Data updated at least once a month
Including options risks
Non-linear value effect
Volatility effect
Subject to internal, external and regulatory model
validations

Model validation standards
Assumptions
% change distributions
Valuation models
Replicating portfolios
Back-testing
Sufficient long testing period
At least three years

Liquidity adjusted ES
( ) ( ) ( )
( ) ( )
2 2 2
10 20 40
2 2
60 120
ES + ES + 2 ES
ES =
+ 2 ES + 6 ES

Market risk factors
20Other currencies
60Small capitalization volatility
20Large capitalization volatility
40Volatility
10Large capitalizationEquity index
60Volatility
10USD, EUR, JPY, GBP, AUD, SEK, CAD and a bank’s
domestic currency
Interest rate
20Small capitalization
20Other currency pairs
10USD as domestic currency or foreign currencyFX rate
Holding
period
CategoryMarket
risk factor

Regulatory back testing
Compare 1-day static value with the 1-day
99% worst case value
1 violation if
1-day static value < 1-day 99% worst case value
Count the number of violations in 250
consecutive trading days

Back testing multiplier
210 or more
1.929
1.888
1.837
1.766
1.75
1.50 to 4
Back testing multiplierNo. of violations

MRCC components under the IMA
For foreign currencies, equities and treasuries,
the larger of
Last trading day’s
Liquidity adjusted expected shortfall
Average of the last 60 trading days’
Liquidity adjusted expected shortfall
× Back testing multiplier

ES approaches
Historical simulation
Simple and model independent
Outdated historical information incorporated
Monte Carlo simulation
Simple to incorporate any model assumptions
Computationally intensive
Variance-covariance method
Fast
Material linear model error

Why and why not the IMA?
Why?
ES used for both risk management and regulatory
reporting
An exhibition of advanced market risk
management expertise
Why not?
Expensive investments in experts and systems
Extensive regulatory model validation

Outline
Contagion
Basel IV framework

Capital charges calculated by regulatory
variance-covariance method
Advantages
Simple regulatory rules
Less risk management expertise required
Disadvantages
Less risk sensitive
Capital arbitrage
Encourage higher risk trading activities

Linear financial exposures
FX risk
Foreign currencies
FX forwards
Equity risk
Equities
Equity futures
Equity index futures
Interest rate risk
Government bonds
Certificate of deposits

Regulatory
variance-covariance method
Bank estimates
Quantities
FX rates
Equity prices
Equity index levels
Interest rates
Regulatory estimates
Standard deviations
Correlation matrix

FX risk for individual
foreign currency
For each foreign currency
Value
Quantity × FX rate
Expected shortfall ratio (“ESR”)
30% / √2 for USD as domestic or foreign currency
30% for other domestic currencies
Expected shortfall
ES = - Value × ESR

Total FX risk
[ ]
[ ]
[ ]( )
1 2 3 M
1
2
3
M
Q = ES ES ES ... ES
ES1 0.6 0.6 ... 0.6
ES0.6 1 . ... .
CorrelMatrix = Transpose Q = ES0
[Ctrl]-[Shi
.6 . 1 ... .
:: : : ... :
ES0.6 . . ... 1
Λ = Sum Q × CorrelM ft]-[Enter]atrix × Tra
E
nspose Q
S
  
  
  
  
  
  
     
= - Λ

Equity risk buckets

Equity risk buckets
Capitalization
Large – Market cap. > USD 2bn
Small – Market cap. < USD 2bn
Economy
Advanced market
United States, Canada, Mexico, Euro zone, United Kingdom,
Norway, Sweden, Denmark, Switzerland, Australia, New
Zealand, Japan, Singapore and Hong Kong
Emerging market
Not advanced market

Expected shortfall ratios
and correlation coefficients
70
50
70
50
40
ESR (%)
0.125
0.075
0.25
0.25
Correl
0.25
0.25
0.15
0.15
0.15
0.15
Correl
356
11305
10554
9453
8602
7551
BucketESR (%)Bucket

Individual equity risk
For each equity in buckets 1 to 10
Value
Quantity × FX rate × Equity price
Expected shortfall
es = - Value × ESR
For each equity in buckets 11
Value
Quantity × FX rate × Equity price
Expected shortfall
es = - | Value | × ESR

Bucket (k = 1 to 10) equity risk
[ ]
[ ]( )
k k k k
1 2 3 1
k
1
k
2
k
3
k
k
M
Q = es es es ... es
1 ρ ρ ... ρ es
ρ 1 . ... . es
CorrelMatrix = Transpos
[Ctrl]-[Shift]-[
ES
e Q =ρ . 1 ... . es
: : : ... : :
ρ . . ... 1 es
Λ = Sum Q × CorrelMatrix × Transpo EnteQ re ]s
  
  
  
  
  
  
  
     
= - Λ

Bucket 11 equity risk
ES11
Sum of all expected shortfalls in bucket 11

Total equity risk
[ ]
[ ]( )
1 2 3 10
1
2
3
10
Q = es es es ... es
es0 0.15 0.15 ... 0.15
es0.15 0 . ... .
CorrelMatrix = Transpose Q = es0.15 . 0 ... .
:: : : ... :
es0.
[Ctr
15 . . ... 0
Λ = Sum Q × CorrelMatrix × Transpos le Q
  
  
  
  
  
  
  
     
∑ ∑ ∑ ∑
∑
∑
∑
∑
M
2
EQ k 11
k=1
ES = - Λ - E
]-[Shift]-[En
S +
er]
ES
t
∑

Interest rate risk for
individual treasury rate curve
For each treasury rate curve
For each tenor
Value
Cash flow × FX rate / discount factor
Exposure
PV01 of value × 10,000
Expected shortfall
es = - Exposure × ESR

Expected shortfall ratios
and correlation coefficients
1.5
ESR (%)
301.733
201.882
152.251
102.40.5
52.40.25
Tenor (years)ESR (%)Tenor (years)

Inter-tenor correlation coefficient
[ ]AB
| Tenor A - Tenor B |
ρ = Max exp - , 40%
Min Tenor A, Tenor B
  
   
   

Inter-tenor correlation coefficient
10.98510.97040.94180.86070.76340.65700.41900.40000.400030
0.985110.99000.97040.91390.84370.76340.56550.40000.400020
0.97040.990010.98510.94180.88690.82280.65700.41900.400015
0.94180.97040.985110.97040.93240.88690.76340.56550.400010
0.86070.91390.94180.970410.98020.95600.88690.76340.56555
0.76340.84370.88690.93240.980210.98510.94180.86070.71893
0.65700.76340.82280.88690.95600.985110.97040.91390.81062
0.41900.56550.65700.76340.88690.94180.970410.97040.91391
0.40000.40000.41900.56550.76340.86070.91390.970410.97040.5
0.40000.40000.40000.40000.56550.71890.81060.91390.970410.25
3020151053210.50.25

Single curve (k) interest rate risk
[ ]
k k k k
0.25 0.5 1 30
k
0.25,0.5 0.25,1 0.25,30 0.25
k
0.5,0.25 0.5
k
1,0.25 1
k
30,0.25 30
Q = es es es ... es
1 ρ ρ ... ρ es
ρ 1 . ... . es
ρ . 1 ... .CorrelMatrix = Transpose Q = es
: : : ... : :
ρ . . ... 1 es
Λ = Sum
  
  
  
  
  
  
  
  
   
[ ]( )
k
[CtQ × rl]-CorrelMa [Shift]-trix × Transpose
ES
[EQ nter]
= - Λ

Total equity risk
[ ]
[ ]( )
1 2 3 M
1
2
3
M
Q = es es es ... es
es0 0.5 0.5 ... 0.5
es0.5 0 . ... .
CorrelMatrix = Transpose Q = es0.5 . 0 ... .
:: : : ... :
es0.5 . . ... 0
Λ = Sum Q × CorrelMatrix × Transp [Ctrlose Q ]-[Shift
  
  
  
  
  
  
  
     
∑ ∑ ∑ ∑
∑
∑
∑
∑
M
2
IR k
k=1
ES = - Λ - E
]-[Ente
S
r]
∑

Market risk capital charge
Three scenarios
Base correlation
Base correlation × 1.25
Base correlation × 0.75
Market risk capital charge
MRCC = Max[-ESFX] + Max[-ESEQ ] + Max[-ESIR ]
Risk weighted amount
RWA = 12.5 × MRCC

Capital adequacy ratio
Regulatory capital
CAR =
Total risk weighted amount
Regulatory capital
=
Total capital charge × 12.5
Regulatory capital 1
= ×
Total capital charge 12.5
1 × 8%
8%
≥
≥

Basel IV Market Risk Framework

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