White Papers
SUCCESSFUL RISK MANAGEMENT: HOW TO INTRODUCE QUALITATIVE ELEMENTS TO ACHIEVE A BALANCE BETWEEN THE TRADING AND BANKING BOOKS
Recent market turmoil has compelled regulators to introduce new measures to help financial institutions meet the challenges of globalized financial markets. And firms themselves are looking for new ways to improve and tighten risk management.
A close examination of the Basel Committee's new trading book requirements reveals how these new rules will have an impact on the way banks assign assets to both their trading and banking books.
A key component of the new requirements is the incremental risk charge (IRC). The inclusion of CDO s, CD Ss and other structured and exotic products in the trading book inevitably produces a rise in default risk, correlation and skew risk. These are risks that ought to be captured in specific risk models. However, in practice they have proved difficult to capture adequately with VaR. The July 2009 IRC Guidelines Paper introduces a new minimum regulatory capital charge, which captures default risk and credit migration.
The IRC will have a measurable impact on the trading book's capital charge, compounded with the proposed 'stressed VaR' (also published in the July 2009 paper and based on historical data from a 12-month period of severe market stress). The quantitative impact study, published by the BIS Committee in October 2009, demonstrated that these changes to the trading book framework will increase average trading book capital requirements by two to three times their current levels.
This paper examines the new rules and shows how they relate to two of the most important tasks of modern risk management: moving away from 'silos' to an integrated approach encompassing market price, credit, (including counterparty risk exposure methodologies), liquidity and operational risks; and, re integrating qualitative elements into risk-management models.
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