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Highlights:
The proposed rule:
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Applies to banks with aggregate trading assets and liabilities equal to 10
percent or more of quarter-end total assets, or aggregate trading assets and
liabilities equal to $1 billion or more.
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Establishes more explicit eligibility criteria for positions that receive
market risk capital treatment; sets requirements for prudent valuation,
robust stress testing and the control, oversight and validation mechanisms
for models; and expects banks to have an internal capital adequacy
assessment for market risk.
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Introduces a stress-value-at-risk requirement, which better captures market
risk during periods of stress.
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Introduces an incremental risk charge, which captures default and migration
risks at a 99.9 percent confidence level over a one-year horizon.
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Introduces a risk-based capital charge for correlation trading positions.
The proposed rule does not reference the use of credit ratings for the assignment
of standardized charges for securitization positions. However, the agencies
intend to implement these standardized charges in a subsequent rulemaking in a
manner that appropriately reflects the requirements of Section 939A of the
Dodd-Frank Wall Street Reform and Consumer Protection Act. The agencies
intend to develop alternatives that will result in capital requirements for
securitization positions that are comparable to the Basel Committee for Banking
Supervision's proposed charges for such positions.
Continuation of FIL-87-2010
Distribution:
FDIC-Supervised Banks (Commercial and Savings)
Suggested Routing:
Chief Executive Officer
Chief Financial Officer
Chief Risk Officer
Related
Topics:
Risk-Based Capital Rules
12 CFR Part 325
Basel II
Market Risk
Attachment:
Joint Notice of Proposed Rulemaking,
Risk-Based Capital Standards: Market Risk - PDF
(PDF Help)
Contact:
Karl Reitz, Senior Capital Markets Specialist, at kreitz@fdic.gov or (202) 898-6775
Bobby R. Bean, Chief, Policy Section at
bbean@fdic.gov or (202) 898-6705
Note:
FDIC financial institution letters (FILs) may be accessed from the FDIC's Web
site at www.fdic.gov/news/news/financial/2010/index.html.
To receive FILs electronically, please visit http://www.fdic.gov/about/subscriptions/fil.html.
Paper copies of FDIC financial institution letters may be obtained through the
FDIC's Public Information Center, 3501 Fairfax Drive, E-1002, Arlington, VA
22226 (1-877-275-3342 or 703-562-2200).
Key Aspects of the Proposed Rule on Risk-Based
Capital Standards: Market Risk
I.
Introduction
The attached interagency Notice of Proposed Rulemaking (Proposed Rule) explains
how the banking agencies (the agencies) plan to adopt certain revisions to their
current market risk capital rule, as detailed in Revisions to the Basel II
Market Risk and The Application of Basel II to Trading Activities and the
Treatment of Double Default Effects, which were published by the Basel
Committee on Banking Supervision (Basel Committee) in July 2009 and July 2005,
respectively. The Proposed Rule would be required for banks with worldwide
consolidated trading activity equal to at least 10 percent of total assets or $1
billion. Further, the agencies reserve the authority to require any bank to
adopt the framework to ensure the bank operates in a safe-and-sound manner.
II.
Overview
The Proposed Rule is a modification of the existing risk-based capital treatment
of market risk, which was published on September 6, 1996, and is based on the
Market Risk Amendment of 1996 (MRA). The existing rule1 was intended to provide risk-based capital
requirements for banks with significant exposures to market risk to support the
risks arising from such exposures.
Changes to the trading book rules are warranted because of changes in the
markets and the large trading book losses banks suffered in 2007 and 2008. For
example, the existing rule does not adequately capture the credit risk of
positions held in banks' trading books. Among other changes, the Proposed Rule
ensures that capital is held against these positions by applying credit risk
capital charges to trading positions.
III.
Minimum Risk-Based Capital Requirements under the Proposed Rule
The Proposed Rule defines covered positions, which are positions eligible for
treatment under the market risk framework, and specifies how banks must
calculate their capital requirement for the market risk on these covered
positions. The capital requirement for market risk is determined by calculating
capital requirements for general market risk and specific risk. Additionally,
the Proposed Rule introduces several new capital requirements, including
stressed-value-at-risk (SVaR), the incremental risk charge, and charges for
correlation trading positions.
Covered Positions. The existing rule does not specify
with sufficient clarity which positions are eligible for treatment under the
market risk capital framework as opposed to the credit risk capital framework.
As a result of this ambiguity, banks can arbitrage the capital standards for
market and credit risk by calculating capital for a given position under the
framework that resulted in the lowest capital requirement. The Proposed Rule
addresses this concern by establishing specific criteria that define which
positions can be designated as covered positions. In addition to all foreign
exchange and commodity positions, covered positions include trading assets or
liabilities held by the bank for the purpose of short-term resale or with the
intent of benefiting from actual or expected price movements or to lock in
arbitrage profits. To further reduce capital arbitrage opportunities, credit
derivatives used to hedge banking book exposures (for example, loans) are not
covered positions. Banks would have to establish clearly defined policies and
procedures for identifying traded positions, factoring in the ability to hedge
such positions with reference to a two-way market, and taking into account
liquidity considerations; and have procedures to ensure prudent valuation of
less liquid-traded positions. Finally, banks would have to establish a trading
and hedging strategy, approved by senior management, which would articulate the
expected holding period of the position and ensure sufficient controls are in
place to preclude the use of capital arbitrage strategies.
General Market Risk. General market risk is the risk
that arises from broad market movements, such as changes in the general level of
interest rates, credit spreads, equity prices, foreign exchange rates, or
commodity prices. Banks would measure general market risk using a value-at-risk
(VaR) model2. Under the Proposed
Rule, a bank would have to obtain approval from its primary federal regulator
(PFR) before using its VaR model to calculate capital for general market risk,
or before extending the use of its model to additional products. The model would
be subject to ongoing validation requirements, and a bank's PFR has the
authority to rescind approval if the model no longer accurately measures risk.
Stressed-Value-at-Risk (SVaR). The recent financial
crisis demonstrated the need to have risk-based capital requirements for market
risk that capture risk during a period of financial stress. The proposed SVaR
requirement would be calculated using the same VaR model used to measure general
market risk, but using inputs based on "historical data from a continuous
12-month period of significant financial stress." The proposed SVaR requirement
would reduce procyclicality and ensure banks hold enough capital to survive a
period of financial distress.
Specific Market Risk. Specific risk is the risk that
arises from factors other than broad market movements and includes event risk,
default risk, and idiosyncratic variations. Banks would calculate their
risk-based capital requirement for specific risk using either an internal models
approach or a standardized approach. Under the Proposed Rule, a bank must
receive approval from its PFR before using an internal model to calculate
capital for specific risk. Also under the Proposed Rule, banks would now be
required to use the standardized approach to calculate the specific risk capital
charge on all securitization positions that are not correlation trading
positions.
Incremental Risk Charge. Banks have included certain
types of positions in the market risk capital framework that contain significant
levels of credit risk. This was not envisioned when the MRA was first
implemented. To address this situation, the Proposed Rule establishes a new
capital requirement, the incremental risk charge. Incremental risk is the
default and migration risk that is not reflected in a bank's VaR-based measures.
A bank must receive approval from its PFR before using its incremental risk
model.
The incremental risk capital requirement must be consistent with a one-year
horizon and a 99.9 percent confidence level, the measurement standard under the
credit risk capital framework. This capital requirement would include losses
arising from defaults and credit migrations in covered positions subject to
specific interest rate risk.
Correlation Trading. A correlation trading position is
a securitization position in which the underlying exposures are liquid and
related to the credit quality of a single company, including positions that are
liquid, commonly traded indices based on such exposures. Hedges of correlation
trading positions are also considered correlation trading positions. Banks would
model the risk-based capital charge for these correlation trading positions
using a comprehensive risk model. The model must capture "all price risks" at a
99.9 percent confidence interval over one year. If a bank is unable to develop a
comprehensive model for its correlation trading portfolio, it would instead
calculate the capital charge for correlation trading positions using the
standardized measurement method, which is the maximum of the standardized
specific risk charges for all long correlation trading positions and the
standardized specific risk charges for all short correlation trading positions.
The Proposed Rule subjects the comprehensive risk model charge to an initial
surcharge, which is set at 15 percent of the standardized measurement method.
Eventually, the surcharge approach may be replaced by a floor approach, with the
floor set to 8 percent of the standardized measurement method.
Securitization Positions. The Proposed Rule does not
reference credit ratings for the assignment of standardized charges for
securitization positions. Rather, the Proposed Rule states that the agencies
intend to implement these standardized charges in a subsequent rulemaking in a
manner that appropriately reflects the requirements of Section 939A of the
Dodd-Frank Wall Street Reform and Consumer Protection Act. The agencies
intend to develop alternatives that will result in capital requirements for
securitization positions that are comparable to the Basel Committee's proposed
charges for such positions.
IV.
Supervision under the New Market Risk Capital Rule
The proposed supervisory review process stresses the need for banks to assess
their capital adequacy positions relative to risk, and for PFRs to review and
take appropriate actions in response to those assessments, such as requiring
additional risk-based capital or requiring a bank to reduce its exposure to
market risk. The Proposed Rule would require banks to have an internal capital
adequacy program to address their capital needs for market risk and capture
these and all material risks. The Proposed Rule provides requirements for the
control, oversight, validation mechanisms, and documentation of internal models.
However, the Proposed Rule recognizes that models can be limited in their
ability to fully capture all material risks. Therefore, it requires that models
be supplemented periodically by stress tests with particular emphasis on
concentrations, illiquidity under stressed market conditions, and a view to
risks arising from the bank's trading activities that may not be adequately
captured in the bank's internal models.
V.
Disclosures under the New Market Risk Capital Rule
Market discipline is a key component of Basel II. Under the third pillar of
Basel II, disclosure requirements are established to allow market participants
to assess key information about a bank's risk profile and its associated level
of capital. Increased disclosures are intended to allow a bank's stakeholders to
more fully evaluate the bank's financial condition, including its capital
adequacy.
1"Risk-Based Capital
Standards: Market Risk," published in the Federal
Register on September 6, 1996 (see FIL-84-96, dated
October 10, 1996).
2VaR is a statistical measure
of a worst-case scenario loss and a standard for measuring market risk.
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