The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB) and the Federal Deposit Insurance Corporation (FDIC) – collectively, “the agencies” – published three notices of proposed rulemaking (NPRs) for comment that would revise and replace the agencies’ current regulatory capital framework in the August 30, 2012 Federal Register.1 The NPR on Advanced Approaches Risk-Based Capital Rule and the Market Risk Capital Rule focus on the revision of the current advanced approaches risk-based capital rule to introduce key points of Basel III (specifically from “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems”) and to address the evolving DoddFrank Wall Street Reform and Consumer Protection Act of 2010 (DFA) compliance requirements.
In line with proposed changes, the agencies are also proposing the expansion of the Market Risk Rule to federal and state savings associations, primarily to top-tier U.S. savings and loan holding companies. Key areas of focus of the NPR include:
- Changes to Counterparty Credit Risk
- Removal of Agency Credit Ratings (in line with Dodd-Frank requirements)
- Treatment of Securitization Exposures
- Additional Technical Amendments to the Advanced Approaches Rule
This NPR would apply to all banking organizations currently subject to minimum capital requirements, including national banks; state member banks; state nonmember banks; state and federal savings associations; top-tier bank holding companies domiciled in the United States not subject to the FRB’s Small Bank Holding Company Policy Statement; and top-tier savings and loan holding companies domiciled in the United States. Some of the proposed requirements in this NPR are not applicable to banking organizations with less than US$50 billion in total assets. The changes in this NPR are proposed to take effect on January 1, 2015, with an option for early adoption.
The agencies also incorporated requirements for compliance with newly finalized market risk rules.2 These Basel II.5-based revisions to the Current Market Risk rule would impact all national banks, state banks and bank holding companies with significant market risk exposures.3
Challenges Resulting From Changes in Counterparty and Securitization Exposure Capital Rules
- Implementation of capital treatments for exposures to central counterparties (CCPs) and higher correlation factors for large financial institutions that are unregulated
- Introduction of more risk-sensitive approaches for CCPs to address increased systematic risk resulting from derivative and repo-style transactions imposes additional capital calculations and charges
- Removal of credit ratings consistent with DFA through the introduction of an “investment grade” standard methodology may require an overall rework of the counterparty methodology Addressing revisions to financial collateral eligibility requirements can raise costs and lower profitability
- Introduction of standardized supervisory haircuts for securitization exposures in the measurement of exposure at default (EAD)
- Recognition and management of “Wrong-Way Risk,” which occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty, needs to be fully integrated and monitored. The NPR proposes the addition of a credit valuation adjustment (CVA)-based capital charge that would need to be incorporated using either standardized or advanced approaches based upon the market risk requirements of the bank.
- The expansion of resecuritization exposure definitions to include any exposures that directly or indirectly reference a resecuritization exposure can have significant impact on risk weights and capital treatments
Challenges Resulting From Updated Market Risk Rules
- Integration and communication of impacts of updated market risk rules on the lines of business and trading desk. This is specifically important, as updated market risk rules can have a large impact on profitability due to higher capital requirements resulting from the addition of stressed and incremental Value at Risk (VaR).
- Compliance with updated definitions of covered positions and the treatment of illiquid assets in the trading book may result in the need to change the bank’s approach.
- Banks will need to provide evidence under the newly finalized market risk rules demonstrating that the internal market risk models used for capital calculation purposes accurately reflect the true risk exposures of the positions held.
- Backtesting of VaR estimates will require using clean P&L estimates that may not be available in current model infrastructures.
- Implementation of an adequately stressed VaR framework for incorporation of stressed VaR-based capital charges to the general market risk model can introduce problems due to data availability and proxy selection.
- Development of sound control, oversight and validation mechanisms for all internal market risk models used for capital calculation will be paramount in ensuring adequate coverage for ongoing use.
- Compliance with documentation requirements surrounding all aspects of a banking organization’s internal models can be cumbersome.
- Modeling specific risk and/or the application of standard-specific risk charges will have to be more thoroughly justified and integrated.
- Inclusion of incremental risk capital requirements introduces another infrastructure need.
Our Point of View
The impacts of the changes outlined in this NPR and the Finalized Market Risk Rule can present challenges to a wide range of banking organizations, with large impacts to those organizations required to comply with updated market risk rules. Updated counterparty credit risk guidelines and broader securitization/resecuritization definitions can result in higher capital charges, while the updated market risk rule may lead to significantly larger capital requirements for certain institutions than under previous rules.
What Should Be Your Next Steps?
- Prepare for initial conversations with regulators through the review of current market risk capital calculation models with updated market risk requirements.
- Prepare counterparty risk calculation methodologies for the potential inclusion of CVAand CCP-based capital charges.
- Review and prepare qualitative and quantitative justifications of internal model use for portfolio compositions for compliance with updated market risk rules regarding use. An emphasis should be put on demonstrating that the capital calculation process reflects all risks faced by the bank’s trading portfolio.
- Implement the necessary framework for production of stressed VaR estimates. The process for determination of the stressed period must be robust and repeatable.
- Review internal models for calculating specific risk exposures to ensure compliance with updated market risk rules. An emphasis should be placed on ensuring the use of internal models is appropriate for the product type.
- Implement incremental risk procedures. Close attention should be paid to the calculation of incremental risk, based upon the definition of the bank’s liquidity horizon and the selection of either constant risk or constant composition methodologies.
- Comments on this NPR must be submitted by October 22, 2012. Affected financial institutions should estimate the impact of this NPR on their institution and write a comment letter addressing their concerns to the regulators, if appropriate.
How We Help Companies Succeed
Our Risk and Compliance professionals can help your institution meet the challenges involved with the integration of finalized market risk rules and preparation for future Basel III implementations. Our team has helped a wide range of both regional and national banks to navigate the twists and turns of implementing Basel requirements. Through the use of broadly skilled Basel professionals and specialized modeling and capital management techniques, Protiviti can provide the expertise needed to address the challenges faced by banks due to these evolving requirements.
Protiviti was one of the first firms to lead a top U.S. bank through compliance with anticipated Basel II.5-based market risk capital requirements. We have assisted in the development and integration of stressed VaR and specific risk model components, and have assisted our clients in developing a framework for effective backtesting and outcome analysis. Our model risk professionals have worked directly for both model developers and model validators to ensure compliance with updated regulatory market risk rules.