In last week's issue of DW we looked at the treatment of credit risk mitigation in the recently released consultation paper by the European Commission on new capital adequacy rules for European Union financial institutions. Comparisons were drawn with similar proposals by the Basel Commission on Banking Supervision. In this final article, we will discuss how the Commission approaches other types of risk, including interest-rate risk in the banking book and operational risk.
"The move towards more risk-sensitive capital requirements for credit risk and the related erosion of the capital buffer embedded in the 8% format of the solvency ratio requires the development of an explicit capital requirement for interest-rate risk in the banking book and for other risks."
The Commission adopts the controversial policy already proposed by the Basel Committee of imposing additional risk charges on risks that so far have not attracted explicit capital requirements, because they qualify as neither market nor credit risks, "to preserve the stability of the financial system." Criteria to establish capital requirements for these other risks include:
* Technical feasibility
* Suitability for application to a wide range of institutions
* Incentives for sound risk management
* Implications for supervisory resources
* Legislative acceptance in national jurisdictions.
INTEREST-RATE RISK IN THE BANKING BOOK
Outliers
A capital charge on interest-rate risk in the banking book should target what the Commission calls "outliers"--institutions that are most vulnerable to adverse changes in interest rates. An institution falls within that definition if a sudden shift of market interest rates of N basis points for all currencies reduces its capital by more than X percent, parameters for both of which remain to be calibrated. It also proposes the implementation of a "free zone"--only interest-rate risk exposures above this zone, calculated under a generic formula, would be subject to a capital charge. The objective of the regime is not to prevent outliers from being outliers, but to ensure they hold higher levels of capital in respect to the higher levels of risk they run.
The Commission recognizes that some financial institutions have little or no banking book exposures, such as investment firms that focus primarily on trading. It thus wants to introduce a materiality threshold, a "de minimis exemption." Criteria to determine whether the banking book exposure is small enough for the bank to be exempt could include:
* Relative size of the banking book compared to overall
activities
* Relative size of the banking book compared to the
trading book
* Absolute size of the banking book
* Relative importance of interest income in total income.
Duration-Based Capital Charge
The duration-based method for calculating interest-rate risk in the banking book requires the measurement of the sensitivity of positions to changes in yield. Though the Commission wants to implement standard methods that are consistent with trading book treatment, it acknowledges that adaptations may be necessary in specific areas, such as:
* Term structure (number and width of maturity bands)
* Assumed interest-rate changes
* Weighting factors
* Disallowance factors used in the context of matched
positions within maturity bands, within "zones" and
between "zones".
The Commission points out that the slotting of positions in appropriate time-bands, as required for the duration-based method, may prove difficult whenever the "actual time horizon differs from the contractual time horizon," for example, deposits or loans with embedded optionality. Though it calls for EU-wide guiding principles, it notes that a degree of national digression in dealing with this issue is necessary to account for the specific characteristics of the domestic markets. The Commission also says that capital charges should be calculated for each currency, however, an exception could be made for positions in currencies with highly correlated interest-rate behavior.
Model-Based Capital Charge
Internal models to calculate capital charges on market risk exposures in the trading book could also be used in the banking book, the Commission suggests, but notes the usage of internal models would be conditional upon permission from the relevant supervisory authority. Again, parameters would have to be established to account for specific patterns in the banking book as opposed to the trading book.
OTHER RISKS
"The Commission services believe that the introduction of an explicit capital requirement for other risks will raise managerial awareness and will stimulate the development of sound internal systems."
The Commission wants to introduce a capital charge on other risks that so far have not been addressed in the capital adequacy framework to "provide a buffer." Market participants were disappointed with the Commission's negative definition of other risks, which describes them as being neither credit, market or interest-rate risks, and encompassing, but not being confined to, operational, legal and reputational risk. According to the Commission, they include low probability/high impact events that could potentially wipe out the available capital cushion. The Commission, like Basel, fails to define these risks, including operational risk, saying only that "there is no harmonised definition for these categories." However, it offers common features of other risks, saying they cut across business lines, techniques for quantifying them are still in their infancy, their management is very partial and they are generally not captured in the pricing of products.
The Commission proposes qualitative measures to evaluate the systems used by banks to monitor other risks:
* Distinction between other risks and credit and
market risks
* Adequate procedures to identify, measure and control
other risks
* Adequacy of compliance functions and quality of
operational risk personnel
* Internal control system
* Contingency plan
* Limits or procedures to reduce other risks
* Provisions to mitigate other risks, such as insurance policies.
Capital Charge Based On Size And Income
Though the Commission concedes that benchmarks measuring other risks, such as operational risk, should include the volume and complexity of transactions, the complexity of systems and process, and the nature and degree of outsourcing, it proposes a simplistic generic approach based on the size and income of an institution. The industry already is rejecting this "top-down" approach, saying that the method would not accurately reflect a bank's operational risk exposure, and would favor small financial institutions (DW, 12/6).
The suggested capital charge is a linear function of size and income, and of possible other indicators for other risks, according to the Commission. It says the application of such a methodology could take several forms--a flat charge or a progressive/regressive charge depending on assumptions on the behavior of other risks in relation with selected parameters. A criterion for size could be total assets adjusted for off-balance sheet items, as well as volume indicators. Income measures could include non-interest income, fee income, all income, as well as earnings volatility.
Alternative Methodologies
The industry greatly favors "bottom-up" approaches based on self-assessment and market price observation, which the Commission mentions. Self-assessment methodologies could include:
* Internal modeling based on the identification and
quantification of the relevant risk factors (causal
modeling) or of worst-case scenarios (stochastic
modeling). The Commission notes that the experience of
insurance companies in pricing event risk may be helpful
in developing such models.
* A box approach based on relative exposure of different
business lines.
Methodologies based on market price observations could include the value-at-risk differential between a bank's equity returns and that of a relevant market index, or volatility of cost earnings.
"At this stage the Commission services do not recommend the use of alternative methodologies based on internal assessment or on the observation of market prices as the basis for the minimum capital requirement applicable to credit institutions and investment firms across the EU."
The Commission rejects alternative methodologies because, among other reasons, modeling techniques for other risks are still in their infancy, consistency would be difficult to achieve and market price observations would apply only to listed institutions. Instead, it sticks to its recommendation of the controversial "top-down" approach.
This week's Learning Curve was written by Elisabeth Bertalanffy, managing editor of Derivatives Week in London, with the help of Simon Gleeson, an attorney in Allen & Overy's financial services group.
