Market risk regulatory capital expected to rise

A recent Isda study highlights the dangers of failing to implement IDR guidelines

LONDON – The International Swaps and Derivatives Association (Isda) has published the results of its study into the impact of incremental default risk (IDR). Seven international banks contributed information and technical expertise to the study, focusing on the impact of IDR guidelines on banks’ future regulatory capital requirements.

The IDR guidelines will have a big impact on the regulation of banks’ trading books. If regulatory authorities implement the guidelines as expected, market risk regulatory capital is expected to treble on average compared to current levels under the value-at-risk system. The study says that banks’ failure to align IDR guidelines with existing market risk capital rules could have a detrimental effect – firms amid market turmoil might be distracted by the danger of default risk at the expense of addressing more dangerous market risks.

Ed Duncan, head of risk management at Isda, said: “The firms don’t think the increase in capital is reflective of the dominant source of risk in the trading book. This could result in firms switching resources to manage a risk they do not consider a key driver of economic losses. This would not be encouraging prudent risk management of trading book portfolios.”

The new study follows an Isda paper prepared for the Accord Implementation Group Trading Book Working Group. The paper, released in January, recommended a 60-day capital horizon to the Basel Committee for modelling IDR in trading books, and allowing for diversification between default and market risks. Isda aims to increase dialogue between regulators and the firms it represents in an effort to improve technical understanding of IDR modelling, and to provide essential grounding for developing a successful IDR framework by forging solid modelling principles.