Analysis of the trading book hypothetical portfolio exercise

September 2014

The Basel Committee on Banking Supervision has today issued the results of the trading book test portfolio exercise that was conducted in parallel with the Basel Committee's Basel III monitoring exercise as of 31 December 2013. The report assesses the impact of proposals to revise the internal models-based approach for market risk, as set out in the second consultative paper of the Basel Committee's fundamental review of the trading book (October 2013).

Quantitative impact studies (QIS) are an essential element of the Committee's work to revise the trading book standards. The Committee has planned two such exercises in 2014. The report published today presents the results of the first exercise, which focused exclusively on the revised internal models-based approach and is based on hypothetical portfolios.

The main objective of this exercise was to provide an understanding of the implementation challenges associated with the proposed internal models-based approach, including areas where the draft standards could be made clearer and to provide banks with necessary clarifications. The second QIS exercise focuses on banks' actual portfolios and is being conducted in parallel with the Basel III monitoring exercise that commenced in July 2014.

This report provides preliminary findings on some of the potential effects of the proposed standards on regulatory capital for market risk.

Variability of the new risk measures: The variability of the proposed expected shortfall (ES) and incremental default risk (IDR) measures is similar to the measures in the current regulatory capital framework.

Comparison of the new risk measures to current risk measures: The aggregate impact of the proposed internal models approach would be an increase in capital requirements for all asset classes with the exception of equities. As this exercise was based only on a sample of portfolios specifically designed to test variability, more concrete analysis of the capital impact will be conducted via the second QIS exercise, which will be based on actual portfolios.

Implementation of varying liquidity horizons: Scaling expected shortfall (ES) based on a 10-day or a one-day measure results in consistent median capital outcomes.

Impact of constraining diversification and hedging benefits: Reducing a bank's unconstrained use of correlation factors across asset classes increases the overall level of capital requirements.

Computation of non-modellable risk factors (NMRF) and the incremental default risk measure for equities: Only a small proportion of participating banks properly computed the capital charges for NMRFs and the IDR capital charge on equity instruments. Further specification on the definitions and calculation method for NMRFs and IDR will be provided in the subsequent phase of the QIS.

The findings from this report and the Committee's analysis of the capital impact data derived from the second QIS exercise will inform the Committee's deliberations on the final calibration of the new framework for the trading book capital standard.