Trading On margin

Webinar rewind: How can banks reduce regulatory risk capital in volatile markets?

by Stuart Nield, Ph.D. and Allan Cowan, Ph.D.

Regulatory capital is an ongoing challenge for most banks, from Tier 1 to regional institutions. Each bank faces its own challenges, but there’s no denying that current market conditions, including high inflation, rising interest rates, falling equities and widening credit spreads, have rekindled concern. market players.

In a recent webinar, we looked at which part of the capital framework is most affected and why, as well as the strategies banks are using to maximize capital efficiency. Here is an overview of what was discussed in the webinar.

What are the different elements of capital that should be considered when considering regulatory risk?

Stuart Nield, Ph.D.

We continuously review metrics that influence investment banking capital and measure those that respond to market volatility. Specifically, we look at counterparty credit risk, market risk, and credit valuation adjustment (CVA) risk.

If we look at the diagram of a typical investment banking setup (Figure 1), at the top are the trading desks, which do business with clients and then hedge the mark-to-market risk of those derivative transactions with other brokers or centres. counterparties through hedging. And it is usually this activity that is covered by the capital framework for market risk and the capital framework for counterparty credit risk.

Figure 1 – Generic Investment Bank organization. Source. S&P Global Market Intelligence. For illustrative purposes only.

One of the main aspects to consider is where banks place these hedges in different capital frameworks.

Under current capital frameworks, credit hedges are included in the CVA venture capital framework. But all market risk hedges are currently under market risk capital. This changes as part of revisions to the CVA venture capital framework due to come into force in January 2023, which introduces two new types of risk models: the basic approach (BA-CVA) and the standard approach (SA -CVA) which is based on CVA sensitivities. Under SA-CVA, market risk hedges of CVA risk will be included in the CVA risk capital framework.

What aspects of the capital structure are affected by market volatility?

Allan Cowan, Ph.D.

Own funds for counterparty credit risk have remained stable for some EU banks over the past two years. Compared to market venture capital, it has been relatively immune to the shocks of COVID-19. This is driven by the design of the counterparty credit risk framework, where the risk weight used in these calculations depends on the historical probability of default, which will not react quickly to market volatility. There are other downgrades you could make to your internal ratings-based (IRB) approach to capital requirements for credit risk. And in the EU, all but one of the banks are Internal Model Method (IMM) approved banks.

Thus, exposure to default is motivated by the simulation of exposures. But these simulations are, again, calibrated on historical volatilities, which will not react quickly to current market changes because these parametric values ​​will only change gradually. Moreover, their volumes can only be updated quarterly or even semi-annually.

At this point, we don’t see much impact on capital from counterparty credit risk. But there are still a few things to remember when assessing counterparty credit risk. Currently, the probability of default is likely to increase for counterparties based in Russia or Ukraine. This risk weighting could therefore change in the coming quarters.

And finally, an undiversified portfolio is, of course, always a concern. With rates our wallets haven’t seen in a long time, plus inflation, the replacement cost duration could increase.

What options do banks have? And what are banks doing to minimize the impact of market volatility on capital requirements?

Stuart Nield, Ph.D.

We start by looking at the different risk frameworks and some of the steps you could take to mitigate capital size and regulatory volatility now and in the future. One of the strategies we see banks adopting is trying to have a large portion of their trading book under the Internal Models Approach (IMA) rather than splitting it between IMA and SA. This way, they get the most out of the diversification between positions in their trading portfolio.

But when we move on to the future capital requirements of FRTB, banks consider different strategies to minimize their capital. Banks often hedge against a risk factor correlated to the risk exposure factor. Generally, the more risk factors banks have that can be modelled, the lower the capital requirement. So, researching data pools and providers is a great avenue to explore here.

A final way for banks to minimize capital under FRTB is to optimize which of their trading desks is put on SA versus IMA. So you see a diversification benefit among the risk factors, and there is no diversification between the two approaches. This means that there is an efficient frontier.

Let’s move on to counterparty credit risk. Within the framework of the standardized approach to counterparty credit risk (SA-CCR), now in force, it is quite penalizing for directional portfolios, even more than the old method of current exposure (CEM). If banks can balance their portfolios, they can save capital. And then, for the standardized approach in the internal model method, the improvement of the robustness of the credit support annex agreements (CSA) and the improvement of the quality of the guarantee which minimizes the risk of deviation collateral versus margin risks are ways to reduce capital requirements.

How do we see our customers ensuring the sustainability of their books?

Allan Cowan, Ph.D.

One of the essentials we mentioned is having diversified portfolios and understanding the impact of your trade. We see banks moving towards analyzing their capital at the time of the transaction. This helps to understand the incremental change in capital due to the transaction. It also allows traders to more aggressively pursue capital depleting trades or bypass trades that are not capital beneficial.

So if you were to enter into a new transaction considering SA-CCR, for example, replacement costs, you have full net benefit. However, within the potential future exposure (PFE) term, there are regulatory prescribed slices, and the correlations between these slices dictate the extent to which you can achieve diversification benefits.

For SA-CVA, the capital is calculated using the sensitivity-based approach. You must therefore recalculate the sensitivities of your portfolio with the impact of the new trade. If you can calculate this at trade time, you can begin to quantitatively understand what the benefit of your new trade is.

The other element, of course, is the total cost of capital or return on capital. And this is measured by the Capital Valuation Adjustment (KVA) calculation. This allows you to understand not only the evolution of your current capital, but also the capital requirements associated with holding this transaction until maturity. This calculation therefore requires you to forecast future capital needs at each time step and at each exposure date in your simulation. This requires you to understand the portfolio’s future exposure with new trade, future variation or initial margin requirements.

Learn more about our Financial Risk Analytics solutions for XVA, Counterparty Credit Risk and FRTB.

About the authors:

Stuart Nield, Ph.D., Global Product Manager, Financial Risk Analytics, S&P Global Market Intelligence

Stuart Nield is global head of financial risk analysis at S&P Global Market Intelligence. He has worked on many aspects of risk during his career and has held senior positions in risk management, quantitative analysis and systems development. Over a 15-year career, Dr Nield has worked for Barclays Capital, UBS Investment Bank and Detica (a data analytics consultancy). He has a passion for developing risk management software that solves business problems in a simple and elegant way.

Allan Cowan, Ph.D., Global Head of Data Analytics, Financial Risk Analytics, S&P Global Market Intelligence

Allan Cowan is Global Head of Financial Engineering for Financial Risk Analytics at S&P Global Market Intelligence. He is responsible for R&D initiatives for the Financial Risk Analytics team. He oversees the research and development of the quantitative libraries and methodology used in the group’s counterparty credit risk and xVA solutions. With over 13 years of experience, he is an expert in the field of derivatives valuation, regulatory risk and xVA management.

IHS Markit provides industry-leading data, software and technology platforms and managed services to meet some of the toughest challenges in financial markets. We help our clients better understand complex markets, reduce risk, operate more efficiently and comply with financial regulations.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.