Guillaume Garnotel, Senior Consultant

The 2008 market unrest seriously complicated hedging strategies, trading book valuations, and capital raising, all of which significantly reduced business activity. The prudential rules adhered to by Euro-zone banks since 2006 had emphasized bank portfolio, operational, and credit risk while the practice assessment for trading credit risk and liquidity risk were postponed to a later date. The new rules established in July 2009, will require the full attention of risk managers at major banks. The quantitative impact study, made public by the Basel Committee in October, gives us a preliminary impact idea of these new standards. Particularly, the likely tripling of requirements related to market risks beyond securitization exposure can be noticed. The principal objectives are to reduce capital procyclicality, in order to improve credit risk evaluation, and to gain an exhaustive understanding of risks to corporate, trading book CDOs.

Reducing procyclicality of capital
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Within the Basel II regulatory framework, nearly everything is procyclical, emphasizing positive and negative fluctuations in the economy. In this regard, at the center of the capital requirements calculation is the market VaR. On average, it is multiplied by 2.6 in periods of major market instability relative to periods of full growth. This requires banks to reduce their activity and possibly temporarily shutting down certain activities to keep a low profile. The addition of a new charge, indexed to the stressed VaR, is calibrated to a period of heavy market stress. This remedies the volatility but at an increased price of 110% in market risk capital, according to early estimates.
 

Risk evaluation is also equally based on accounting standards and the fair value principle, prevailing the last few years. However, during periods of major market instability, the latter creates problems as the banks’ P&L and the published earnings no longer reflect firms’ financial health. This is the reason for an increase in the number of exceptions to the fair value valuation, provided for in the standard set to replace IAS 39.

The effectiveness of an accounting system is gauged by its ability to furnish information concerning the balance sheet of the firm. It should not supplant risk analysis or determine the reaction to a decrease in capital. The revision of IAS 39, planned for summer 2010, thus provides for keeping only two categories of financial securities (as opposed to the current 4) and anticipated loss funding linked to counterparty quality deterioration.

Improving measurement of trading book credit risk
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The IRC’s objective underscores the need to balance the capital requirement (against credit risk) between the trading book and the bank portfolio. Consequently, it underscores the need to eliminate arbitrage (the IRB calculation being more costly than the funds required for market risk). A capital charge is already in effect under the standard method for specific risk which corresponds to the credit risk carried on the trading book. The recent crisis and the degradation of credit quality have made the insufficiency of reserves to mitigate this risk clear. The IRC will therefore reinforce capital accounting for issuer migration and default risks, with probability figured over a one-year period with a confidence index of 99.9%.

Preliminary impact calculations show an average increase of 103% in capital allocated to market risk as a result of the IRC. Nonetheless, a large disparity between different banks has been observed. On average, doubling capital relative to the standard method is expected. Many banks have already anticipated a charge in excess of the IRC in their internal models.
Furthermore, a minimum liquidity horizon set at three months, allows an additional reduction in the required IRC amount by integrating liquidity positions into the calculation as a one-year risk-mitigation factor.

This idea still seems difficult to implement due to the complexity that it adds to the calculation. The next impact studies should more clearly show why it might be worthwhile to include it. As securitization positions are excluded from the IRC, an additional charge should address this type of exposure. An initial impact study has already been conducted for secondary securitization positions, which come under a fixed charge.

In other securitization cases, the amount of capital that must be put up against the correlation portfolio has been addressed by the Basel Committee. Like the bank portfolio, either a fixed charge or an exhaustive valuation of all price risk (“comprehensive risk”) should be utilized.

Correlation portfolio: Ongoing
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As the securitization market has not lost all liquidity, certain banks will propose the implementation of a charge specific to correlation portfolios called a “comprehensive risk capital charge” to national regulators. This allows banks the possibility of paying a reduced charge on certain securitization activities that are considered liquid, while at the same time reducing arbitrages between the trading book and the bank portfolio.

The charge must be based on the bank’s internal model and stress tests must allow back-testing its accuracy. Furthermore, a minimum threshold corresponding to a percentage of the fixed charge will be established in early 2010. This will result in exhaustively modeling market (price) risk of these activities.

This charge must account for the following risks, among others:
> Joint defaults
> First- and second-order credit spreads
> The volatility of the base correlation and the spread/correlation swap effects
> The basis risk
> Recovery rate
> Rebalancing hedging of securitization positions.

This new freedom given to banks is more technical in its implementation than the IRC and 2010 year end timeframe seems a real challenge.


2011, 2012 and after…
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All of these measures came as an immediate response to the 2008 crisis. They will have to be added to new capital, transparency, and policy evaluation requirements which will take longer to implement. The latest Basel Committee publications present a coherent group of new proposals scheduled to begin in 2012. Some have mentioned that a grace period will be granted to allow implementation of the changes. Consensus is to avoid hindering economic recovery by abruptly imposing the implementation of stricter rules.

The Committee thus wants to reinforce the capital necessary to face counterparty risk on OTC derivatives and repos (Credit Valuation Adjustment). Broadly, it plans to create new reserves against expected losses to fight against procyclicality via creating a capital cushion. New proposals must also respond to model and liquidity risks, which remain the most difficult uncertainties to quantify.