Trading book risk

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Since the financial crisis began in mid-2007, an important source of losses and of the build up of leverage occurred in the trading book. A main contributing factor was that the current capital framework for market risk, based on the 1996 Amendment to the Capital Accord to incorporate market risks, does not capture some key risks. In response, the Basel Committee on Banking Supervision (the Committee) supplements the current value-at-risk based trading book framework with an incremental risk capital charge, which includes default risk as well as migration risk, for unsecuritised credit products. For securitised products, the capital charges of the banking book will apply with a limited exception for certain so-called correlation trading activities, where banks may be allowed by their supervisor to calculate a comprehensive risk capital charge subject to strict qualitative minimum requirements as well as stress testing requirements. These measures will reduce the incentive for regulatory arbitrage between the banking and trading books.

An additional response to the crisis is the introduction of a stressed value-at-risk requirement. Losses in most banks’ trading books during the financial crisis have been significantly higher than the minimum capital requirements under the former Pillar 1 market risk rules. The Committee therefore requires banks to calculate a stressed value-at-risk taking into account a one-year observation period relating to significant losses, which must be calculated in addition to the value-at-risk based on the most recent one-year observation period. The additional stressed value-at-risk requirement will also help reduce the procyclicality of the minimum capital requirements for market risk.

A consultative version of this paper was released in January 2009.

Counterparty risk survey

When Lehman Brothers folded in September 2008, counterparties were left scrambling to assess their exposure to the US bank. The default raised questions about the financial services industry’s approach to risk management, in particular to counterparty risk. Credit, in association with Fitch Solutions, has carried out a global survey of the asset management industry’s counterparty risk practices and the results point to some interesting trends.

The chief finding is that only a small number of fund managers use a systematic, derivative-based hedging framework to mitigate counterparty risk. Presently, collateral management remains the chief mitigation tool, although the introduction of central clearing for credit derivatives trades should give end-users greater security and more transparency.

One thing is clear, however: the impact of the Lehman default focused the attention on counterparty risk more than ever before, and nearly all respondents said they have boosted their counterparty risk management and monitoring practices since the US dealer’s bankruptcy.

Below we present a question-by-question analysis of the respondent’s answers. The results shed new light on the buy-side’s attitudes to counterparty risk management following one of the most turbulent periods in the history of the financial markets.

For the survey methodology, see page 39


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