CRD 3 and beyond How are you left?

1. CRD 3 and beyondHow are you left? Simon Hills British Bankers Association British Bankers’ Association

2. Evolution of regulatory capital for the trading book • Basel 1 - 8% capital against RWAs (1992) • CAD 1 and basic market risk approaches (1993) • Basel Market Risk amendments (1997) • Market risk on debt, FX, equities options & commodities in Trading book • Internal VaR models • Basel II new capital adequacy framework (2007 in EU) • IDRC (in Europe) • Basel trading book package = CRD 3 1 January 2011 • Stressed VaR, Incremental Risk Charge, standardised charges for securitisation, correlation trading models British Bankers’ Association

3. The construct • Regulatory split of assets between banking book and trading book • Banking book unless you can convince regulator otherwise • Trading book capital treatment if: • “A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed.” • Trading intent? • “Positions held with trading intent are those held intentionally 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, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making.” British Bankers’ Association

4. Banking / trading book boundary • FX & commodity position – uniform (market risk) capital requirements whether in trading book or banking book • Equities/credit: trading / banking book boundary determines whether capital held for market risk or credit risk • Banking book (credit risk) long only regime, 1 year 99.9% calibration • Trading book, long + short (portfolio approach) 10 99% calibration British Bankers’ Association

5. What you do now............. • Fair valuation of positions – accounting / regulatory definition • Profits/losses taken immediately • Losses reduce Tier 1 capital immediately • Unrealised ‘verified’ profits can be recognised as Tier 1 • Hedging recognition depends on standard rules or modelled approach • Market risk primary focus of regulatory capital British Bankers’ Association

6. .............and the future? • “Capital required against trading book activities should be increased significantly (e.g. several times) and a fundamental review of the market risk capital regime (e.g. reliance on VAR measures for regulatory purposes) should be launched” • “The BCBS should follow up its current proposals for short-term reform of trading book capital with a fundamental review, to include the role of VaR measures and the boundary between the trading and banking books” • Turner Review March 2009 British Bankers’ Association

7. .............and the future? • Current regulatory boundary means some risks not properly captured: • Credit risk in trading book • No market risk charge for fair valued assets in banking book • Intent vs. trading feasibility • What about market liquidity risks? • Is ten day capital horizon appropriate? • Are counterparty credit risk requirements enough? • Charge for Credit Valuation Adjustment?? • So capital requirements too low?? British Bankers’ Association

8. The problems • Risk management & modelling • Does VaR modelling for regulatory purposes capture tail risk? • Modelled capital requirements very cyclical • Complexity and modelling don’t mix? • Valuing traded assets • Get it right – it is the building block • Accounting Point in Time vs. forward looking regulatory requirement • Existing prudent valuation requirements – are they enough? British Bankers’ Association

9. Stressed VAR Incremental risk charge (IRC) A regulatory response so far – specific measures - The Proposal July 2009 Basel Committee (CRD 3) package for implementation by January 2011 Measure Impact • Increase in capital requirement for modelled positions • Reduction in relative cyclicality of VAR capital requirement • Increase in capital requirement for modelled positions • Reduction in relative cyclicality of VAR capital requirement Additional capital charge based on stressed calibration of VAR model inputs Additional capital charge based on stressed calibration of VAR model inputs • Improves risk capture on traded credit positions • Calibrated to one year 99.9% level Firms must capture incremental (to VAR) credit default and migration risk on modelled credit products in the trading book • Improves risk capture for correlation portfolio • Reduces scope for regulatory capital arbitrage on securitisation products • Expected to lead to significant increase in capital requirements • Improves risk capture for correlation portfolio • Reduces scope for regulatory capital arbitrage on securitisation products • Expected to lead to significant increase in capital requirements • Additional modelling standards for “correlation portfolio” • Application of banking book credit risk weights to other net securitisation positions • Additional modelling standards for “correlation portfolio” • Application of banking book credit risk weights to other net securitisation positions Traded securitisation products British Bankers’ Association

10. Challenges ahead • Stressed VAR • Doubles (at least) capital requirement • I year period • Implemented across multiple levels of portfolio • Ability to perform 10 day VaR rather than scaling up • How to combine VaR and stress testing • Data for stressed time series? • Duplicate models for risk management and regulatory capital British Bankers’ Association

11. Challenges ahead • Credit Valuation Adjustment • Concept OK • Bond equivalent approach doesn't reflect economic hedges • Needs close alignment of many internal functions • Industry believes market implied approach better • 2nd consultation for CVA?? British Bankers’ Association

12. Challenges ahead • Overall calibration – QIS results awaited • CCPs - reduced spreads? • Leverage ratio • Ignores netting • Nominal not regulatory equivalent numbers • Impact on strategy and appetite • Unrated re-securitisations = 1250% weighting or deduction British Bankers’ Association

13. What to do ? • Risk and finance data integration • Coordination of market risk and regulatory reporting • Required data histories for long term analysis • Model validation quality – internal and for FSA • Identification of re-securitisations • Review trading book governance – intent vs. feasibility British Bankers’ Association

14. Summary • Lots changing • Much more capital • Risk of double counting • Impact on business models • Will risk be managed better? • Lobby now British Bankers’ Association