The proposed changes to trading book capital requirements are “a regulatory trade-off among the objectives of simplicity, risk sensitivity, and comparability,” said Mark Levonian, Managing Director and Global Head at Promontory Financial Group, and the first of two speakers at a webinar sponsored by the Global Association of Risk Professionals held February 11, 2014.

Levonian acted as “tour guide” for the Basel Committee’s recently proposed changes to the trading book capital requirements. Highlights of the changes are: the revised standardized approach, more rigorous testing, and replacement of the value at risk (VaR) measurement with expected shortfall.

“The perception from the financial crisis was that the calculated capital did not properly reflect the trading book activities,” especially for structured products, Levonian said, so the Basel Committee quickly responded in 2009 with what has been called “Basel 2.5.”

Two rounds of the Regulatory Consistency Assessment Program (RCAP), tabled January 2013 and December 2013, found that institutions holding the same assets came up with materially different capital estimates. Thus, it was time to address the discrepancy.

The Fundamental Review of the Trading Book (FRTB) incorporates lessons from RCAP and appeared in its second version in October 2013. Levonian gave a roadmap of the FRTB consultative document. It looks at the boundary between the banking book and the trading book; includes “new thinking on the treatment of credit risk”; and expands liquidity definitions well beyond the common 10-day period. It also recognizes hedging and diversification. There are revisions to the internal models approach as well as the standardized approach.

Trading Book Capital_1_deskLevonian said that expected shortfall, with a 97.5 percent cut-off, will come in, calculated as an average of outcomes in the tail.  This means capital is “reduced, relative to 99 percent VaR,” he noted. However, the move to bring in other time horizons will increase the capital requirement. The rule of thumb he suggested is that a doubling of the time horizon will increase capital by 40 percent.

Financial institutions must calibrate to a stress period using a “reduced” set of risk factors, and examine the stress effect on a desk-by-desk level instead of overall. There will be more back-testing requirements, he said, as well as requirements to attribute the profit and loss. The new reporting will require more extensive disclosure of market-risk capital and its components.

“It’s like the old RiskMetrics approach,” Levonian said of the proposed standardized approach. It will involve a standard deviation calculation, with a regulator-specified variance-covariance matrix for risk factors.

To fulfill its goal of comparability, the new regulations state that all banks must calculate standardized-approach capital, and that this must be disclosed at the trading desk level.

The road ahead is under construction. The comments period on the FRTB closed on January 31, 2014. A quantitative impact study (QIS) will inform the final proposal. “Many parameters remain to be calibrated,” he noted. ª

Click here to go the second presentation. ª

The webinar presentation slides can be found at:

The comments on the FRTB can be found at: