The FINANCIAL — New Basel market risk rule proposals may reduce trading liquidity further if it results in banks cutting inventory further, Fitch Ratings says. Large European banks have already been reducing their portfolios since the introduction of tougher market risk capital requirements under Basel 2.5 in 2011, according to Fitch Ratings.
The 16 European global systemically important banks (G-SIBs) have reduced trading exposures substantially since 2011, when Basel 2.5 led to a 54% hike in their aggregate market risk capital, according to a recent Fitch analysis. These banks have been able to reduce market risk capital since then, by 24% in 2012 and 12% in 2013.
The reductions partly reflect general efforts by the banks to reduce trading and OTC deriva-tives exposures and hold lower levels of inventory. Several institutions are also strategically scaling back their markets operations in response to expected structurally lower industry-wide revenue in securities businesses, particularly in fixed income, currency and commodities. The easing in market volatility also helped to reduce value at risk (VaR) measures, which drive regulatory capital requirements for traded-market risk, and we expect reported VaR to increase once market volatility reaches higher levels.
Some financial market activities are migrating to the shadow banking system, creating new challenges for regulators. Other activities may just shrink or disappear. Reduced liquidity could exacerbate price volatility in a stress scenario, especially as dealers have reduced inventory holdings and are less likely to accumulate inventory to facilitate trades, according to Fitch Ratings.
The latest trading book capital proposals could put more pressure on banks to reduce market risk exposures, once the rules are finalised and an implementation date set. Basel’s first quanti-tative impact exercise for its proposed new trading book rules, published last month, indicated that market risk capital requirements would increase by between 25% and 52% on average. This incorporates a shift away from VaR models to expected shortfall (ES) models, varying liquidity horizons and constraining diversification benefits. There was an increase in the risk measure for all asset classes with the exception of equities.
The changes appear relatively manageable compared to Basel 2.5, which resulted in an average increase of 224% according to the quantitative impact study conducted in 2009. But the current exercise is only based on a hypothetical portfolio. A second quantitative impact study using real portfolio data is due to be published this year. Nevertheless, the banks have shown they can adapt their operations to reduce market risk capital requirements.
Of the proposed trading book changes, market liquidity had the greatest impact in the hypo-thetical portfolio exercise. The standard two trading week unwind period, used in internal models, is being replaced with a range of more conservative unwind periods for different asset classes. The shift to ES from VaR was also an important driver for the increase in market risk capital because it captures the probability-weighted losses in the tail beyond VaR. Diminished diversification through constrained correlations and the merging of stressed and current market conditions into a single metric (under Basel 2.5, the sum of two components – stressed VaR and current VaR – were used) also increased market risk capital, but to a lesser extent, according to Fitch Ratings.
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