In order to keep trade book risk under control, new Pillar 2 rules require that banks demonstrate to their supervisor that they combine their different risk meas- urement techniques in an appropriate system; also that their way of arriving at overall internal capital assessment for their market exposure is sound.
Rules concerning Basel II’s Pillar 3 (market discipline) seek to improve the robustness of trading book disclosures, requiring that banks inform about their internal capital allocation for the trading portfolio, disclose qualitative informa- tion on trading book valuation techniques, and demonstrate the soundness of standards used for modelling purposes – as well as make transparent the method- ologies they used to achieve a rigorous internal capital adequacy assessment.
‘In politics you judge the value of a service by the amount you put in. In busi- ness you judge it by the amount you get out,’ suggests Margaret Thatcher.2The new rules for trading book risk aim to improve the amount banks get out of trad- ing but make their risk management system more rigorous. This benefits all of the bank’s stakeholders.
Critics say that the 4⫻multiplier has created a disincentive for banks to improve their own risk models in order to capture better default and event risks, because this would generally result in higher capital charges. Another shortcoming of VAR is its limitations in addressing concentrations of market risk, which:
● Diminishes banks’ ability to diversify market risk factors
● Renders opaque the contribution of industry sectors, and
● Opens the gates of contagion to an institution’s market risk exposure.
The pros say that concentrations are captured in some VAR applications by adjusting correlation coefficient factors for the same issuer, across products. This argument forgets that banks are not very strong in computing correlations (Chapter 4) and therefore an added value tool would be welcome. The use of a liquidity-adjusted VAR for long-term equity holdings has apparently given commendable results.
Moreover, as we saw in Chapter 5, well-managed banks are sensitive to expos- ures to both single names and industry sectors. Therefore, they see to it that such exposures are captured at trading desk level across products. Aggregating single- name and industry sector trading exposures is, however, a challenging job, par- ticularly so when:
● Combining cash and derivative positions
● Integrating equity and credit instruments
● Unbundling baskets of assets, and
● Decomposing risk components of an asset, such as interest rate, forex rate, credit spread and so on.
To make matters more complex, since 1996 plenty of credit risk-related products have been booked in the trading book. Examples are credit default swaps (CDSs) and tranches of collateralized debt obligations. As explained in Chapter 6, such instruments may lead to a concomitant rise in default and jump-to-default risk.
Both have proved difficult to capture adequately with VAR.
Additionally, a growing number of inventoried instruments held in the trading book are generally not liquid, giving rise to risks that are very difficult to track, monitor and measure with VAR. In fact, not only VAR as a model, but also the trading definition itself is challenged by instruments for which liquidity is ques- tionable and/or that are held for medium-term periods. Examples are:
● Credit-related products, such as loans, bonds, CDOs and other credit deriva- tives, and
● Exotic derivatives like long-term foreign exchange and interest rate swaps, equity swaps, weather derivatives and the like.
Risk Accounting and Risk Management for Accountants
154
Ch07-H8422.qxd 7/4/07 4:37 PM Page 154
The importance of these references is magnified by the fact that while ten years ago such trading transactions were more or less the exception, today their num- ber is fast growing. In the sample of banks participating in a recent study by the Basel Committee, the instruments outlined in the above two bullets represented up to 15% of institutions’ trading book contents.
The years of VAR utilization have led regulators to the conclusion that the model answers some of their requirements, while for others it has limitations or is not quite appropriate. Another factor is the lack of standards for modelling specific risk, which has led to wide disparities in the robustness of models required by national supervisors.
In the aftermath of VAR’s inability to capture market risk associated with new financial instruments, regulators seem to have concluded that there is a need for better valuation methodologies, including closer interaction with new account- ing standards, their interpretation and their practical implementation. One of the basic regulatory requirements, where accounting plays a key role, is that of evalu- ating the adequacy of capital treatment for less liquid positions currently held in the trading book.
With ‘The Application of Basel II to Trading Activities and the Treatment of Double Default Effects’,3the Basel Committee intends to improve the identifica- tion of assumed market risk and of associated capital estimates. This is done by enhancing the risk sensitivity of methods used for assessing risks within the trad- ing book, by specializing them as Pillar 1, Pillar 2 and Pillar 3.
When there is a market for inventoried trading book positions, generally banks mark derivatives to the mid-market price, making adjustments to take into account close-out costs, illiquidity, spread model risk and the like. However, there is no general rule for such adjustments and, hence, they differ across mar- kets, jurisdictions and institutions. Some banks assume a short valuation horizon of about two weeks, while others adopt a longer horizon.
Research by the Basel Committee brought into perspective that most banks face valuation challenges for complex derivatives, or transactions that do not have readily available market inputs.4Examples are products with long-term volatil- ity, distressed assets and illiquid instruments like emerging market bonds, which are infrequently traded. Other examples are products with non-linear risks, struc- tured instruments, high yield debt and weather derivatives. For these, most banks infer the value by using:
● Proxies
● Stress tests
Chapter 7
155
● Stress scenarios, and
● Different add-ons.
All these bullets are used to supplement VAR measures. For example, stress tests have become useful sources of information on jump-to-default risk on credit prod- ucts, as well as in monitoring liquidity risk on exotic interest-rate instruments. In the judgement of banks participating in this 2005 Basel survey, marking to market can be a challenging task for positions where valuation is dependent on unobserved implied correlations or volatilities, as well as where liquidity of the market is an issue.