Market risk affects both the trading book and investment portfolio positions. This is true of all traded assets and liabilities, including debt and equity securities, derivative instruments, loans, commodities, and other newer types of assets like credit for carbon emissions. These assets and liabilities are classified into two major groups: hedges and those held for trading purposes. The difference is based on management’s intent for each individual item.
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In the past, prior to accounting standards like GAAP and IFRS, conservative banks accounted for their inventoried instruments on the basis of the lower of original cost or current price (the latter being rather liberally defined). For inven- toried wares, the accounting rule offered three options:
● First in, first out (FIFO)
● Last in, first out (LIFO), or
● Weighted average of prices.
Today, for security transactions recorded on a trade date basis and mapped into the accounting book, the options are: original value (cost) or fair value. Fair value is defined as the price agreed by knowledgeable willing parties in an arm’s length transaction, under conditions other than an involuntary liquidation or distressed sale. The difference is in management intent:
● A hedge that management intends to keep to maturity is carried in the books at original value
● A transaction resulting in an asset or liability held for trading must be accounted for in fair value.
Quoted market prices are used when available to measure the instrument’s fair value. This is known as marking to market. If quoted market prices are not available, fair value is estimated using valuation models that consider prices for similar assets or similar liabilities, or alternatively by simulating the commodity’s value.
This is known as marking to model:
● Marking to model always considers a functioning market, not the case of panics
● Yet, it is in the case of a panic that a given portfolio may become nearly worthless overnight.
Marking to model is necessary because many instruments, like over-the-counter (OTC) derivatives, have no quoted market price. If marked to model, their market risk is expressed as a change in the price of the underlier plus some other factors, such as time and price. For instance, a forward obliges one party to buy and the other party to sell the underlying instrument at a specified time and price.
However, it is sensible to keep in mind that the market price can be quite different at exercise time.
Changes in the value of derivatives held for trading have to be proportionate to changes in the price of the underlier, but not necessarily in a linear fashion. Also,
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market risk of an option-based derivative can be much more complex to model, because it depends on factors affecting option valuation, such as:
● The option’s exercise price
● Time remaining to expiration
● Volatility of the underlier, and so on.
Securities borrowed and securities loaned that are cash collateralized are included in the balance sheet at amounts equal to the cash advanced or received. If secur- ities received in a transaction as collateral are sold or re-pledged, they are recorded as securities received as collateral, and a corresponding liability to return the secur- ity is also recorded. Fees and interest received or paid are recorded in ‘Interest and dividend income’ and ‘Interest expense’ respectively, on an accrual basis.
Purchases of securities under resale agreements (reverse repurchase agreements) and securities sold under agreements to repurchase substantially identical secur- ities (repurchase agreements) are treated as collateralized financing transactions, and carried at the amount of cash disbursed or received respectively:
● Reverse repurchase agreements are recorded as collateralized assets
● Repurchase agreements are recorded as liabilities, with the underlying secur- ities sold continuing to be recognized in ‘Trading assets’ or ‘Investment securities’.
Assets and liabilities recorded under the above-mentioned agreements are accounted for on an accrual basis, with interest earned on reverse repurchase agreements and interest incurred on repurchase agreements reported in ‘Interest and dividend income’ and ‘Interest expense’ respectively. Reverse repurchase and repurchase agreements are netted if:
● They are with the same counterparty
● They have the same maturity date
● They settle through the same clearing institution, and
● They are subject to the same master netting agreement.
A bank’s accounting rules and regulations must comply to both Basel II and IFRS.
Accounting entries necessarily reflect changes associated with risk estimates and capital requirements, with reference to the trading book, as these aim to clarify the types of exposures qualifying for capital charge, as well as providing guid- ance on prudent valuation.
Changes effected by new regulations for the trading book include the exclusion of a limited number of positions from a trading book capital charge, because they are
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subject to capital requirements under credit risk or securitization frameworks of the new capital adequacy requirements. At the same time, such changes have brought explicit requirements for prudent valuation methods for trading book positions.
Changes under Basel II’s Pillar 1 (capital adequacy clauses) also include the updating of standardized specific risk charges for sub-investment-grade govern- ment debt positions and non-qualifying debt positions. They also incorporate revisions to qualifications and treatment for modelling of:
● Specific risk
● Default likelihood, and
● Event risk.
There is also a Pillar 1 requirement that banks using internal models incorporate stress testing in their Pillar 2 (national supervisory requirements) internal capital assessment. Capital requirements, connected to trading book positions, target instruments held with trading intent for short-term resale, and/or with the intent of benefiting from actual or expected short-term price movements, or to lock in arbitrage profits.
This definition prevents any positions that are not financial instruments from being booked in the trading book. It also specifies that an instrument having the nature of an exposure that is other than short term, or that constitutes a hedge for regulatory capital purposes of a banking book credit risk exposure, should not be included in the trading book. Correspondingly, Pillar 2 clauses seek to strengthen banks’ assessment of their internal capital adequacy for market risk, taking into account the output of their:
● VAR model
● Stress tests, and
● Valuation adjustments.
Basel II Pillar 2 standards require that banks demonstrate that they hold enough internal capital to withstand a range of severe but plausible market shocks. Internal capital assessments include an evaluation of market concentration and liquidity risks under stressed conditions, as well as market risks that are not adequately captured in a VAR model. For example:
● Gapping of price
● One-way markets
● Jumps to defaults
● Non-linear/deep out-of-the-money products
● Significant shifts in correlations (Chapter 4), and so on.
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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.