Trading book credit risk capital calculation

The objective is to provide a consistent implementation across the eu of the. 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. Jd risk solutions dipak chotai is the founder of a specialist consultancy firm, jd risk solutions, and is a veteran of risk management. Under this approach the value of capital can be seen as a call option on the value of the firms debt. Economic capital is a measure of risk expressed in terms of capital. Rbc20 calculation of minimum riskbased capital requirements. This method is also common in banks internal models. 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. 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. Pwc discusses ten key points from basels fundamental. 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.

Here the banks typically accept credit risk and interest rate risk. More precisely, the irc is a capital charge that captures default and migration risks through a vartype calculation at 99. While frtb was not intended to increase banks capital costs beyond those. Rbc25 boundary between the banking book and the trading book. 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. Minimum capital for the trading books market risk is calculated separately from capital for its credit risk. The capital requirement for the general market risk of trading book securitization. The risks subject to market risk capital charges include.

Tier 3 capital includes shortterm subordinated debt and net trading book profits. Guidance note on the calculation of capital requirement. Before a bank can calculate rwa for credit risk and rwa for market risk, it must follow the. 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. 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. 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. 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.

The amendment to basel capital accord included standardised approach and internal models approach. 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. This led to the practice of indulging in regulatory arbitrage by firms to reduce capital charge by moving positions between banking and trading book. 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. The starting point in the calculation of the drc is the notional amount and marktomarket loss already taken on a credit position.

Basel iv revised trading and banking book boundary for market risk. Another approach based on stock prices uses the blackscholesmodel to calculate the market value of capital. Trading and capitalmarkets activities manual supplement 12april 2007 nature of changes examination objectives, examination procedures, and an internal control questionnaire sections 2030. A bank may, for instance, wonder what level of capital is needed in order to.

Thus, under the amended capital standards, positions in a banks trading book are subject to the market risk capital requirements but are exempt. Methodology for default risk capital calculation regulatory framework. However, the present value of premium payable receivable is. A credit default swap does not normally create a position for general market risk for either the protection buyer or protection seller. Cre55 counterparty credit risk in the trading book. 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. Capital requirements for overthecounter derivatives. As with the sensitivities based method, the default risk charge allows for some limited hedging recognition.

Basel capital rules for banks trading books will shift. 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. Stricter capital adequacy requirements apply to the trading book, since trading is a greater risk. Trading book and credit risk twofactor model for incremental default risk charge impact on the risk. 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. Together with the default ccr capital, introduced as a part of basel ii in june 2006, cva risk capital reflected. The financial crisis in 200708 exposed this oversight. 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. 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. The financial crisis in 200708 ex posed this oversight. 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. The notional amount is used to determine the loss of principal at default, and the marktomarket. Revised framework for market risk capital requirements.

Market risk can be defined as the risk of losses in on and offbalance sheet positions arising from adverse movements in market prices. Market risk capital will be required to be calculated daily at trading desk level. 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. 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. The banking book comprises all instruments that are not in the trading book and all other assets of the bank hereafter banking book exposures. 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. Deutsche bank annual report 2012 calculation trading book. This book covers all new approaches for the calculation of rwa.

Completion instructions return of capital adequacy ratio. 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. Calculation of regulatory capital requirements for trading book securitizations. This development has led to an increase in credit risk in the trading book and a. 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.