Eurozone banks fear market risk capital hike due to Covid-19

Hopes that ECB will fix double-counting as VAR breaches rise on market volatility

ECB-Frankfurt-am-Main

Eurozone banks fear their trading book capital requirements are set to balloon, because current market turmoil will trigger a procyclical effect in the regulatory methodology for calculating market risk. Other jurisdictions are providing ways for their banks to avoid the increase, but eurozone banks are still anxiously awaiting a fix from the European Central Bank’s single supervisory mechanism.

“There are aspects of the current framework that are becoming problematic because of the fact that the current period becomes the stress period in the model, which results in double counting the impact,” says Gregg Jones, a director of risk and capital at the International Swaps and Derivatives Association. “There are a lot of banks in Europe waiting to understand exactly what approach they can take in these instances.”

Currently, banks are calculating their market risk capital requirements according to standards drafted by the Basel Committee on Banking Supervision in 2004 and partly revised in 2010 following the financial crisis.

Under the 2010 revision dubbed Basel 2.5, banks using internal models must add together the results of two measures that estimate losses on their current portfolios to determine their market risk-weighted assets (RWAs).

The first, known as value-at-risk, estimates the losses the bank might face based on market conditions from the past year or a shorter defined time period. The second measure, stressed VAR, estimates losses the bank would face if it had its present-day portfolios over the worst-ever trading days in the bank’s history, which for many occurred during the 2008 financial crisis.

A multiplier is also added onto both VAR and SVAR, which gradually increases the more times losses in a single trading day exceed the results of VAR over the most recent 250 days. This backtesting multiplier ranges from a minimum of three for banks scoring five or fewer breaches and increases to a maximum of four for banks finding 10 or more breaches.

However, due to the current market volatility caused by disruptions to the economy from the coronavirus pandemic, VAR is now increasing to levels last seen during the 2008 crisis, and banks are clocking far more exceptions on their backtesting.

All of the mechanisms that typically work in normal market conditions are now exacerbating problems
Head of market risk modelling at a eurozone investment bank

“[The exceptions] are causing procyclical capital buffers that banks need to set aside when capital is a scarce resource,” says a head of market risk modelling at a eurozone investment bank. “Our Common Equity Tier 1 ratio is already under strain on its own and what is happening is that all of the mechanisms that typically work in normal market conditions are now exacerbating problems.”

The combination of losses eating into capital ratios and models driving an increase in market RWAs is putting pressure on regulatory capital at precisely the time regulators are encouraging banks to bite into their capital buffers in order to keep lending to the real economy.

Risk modellers also see the backtesting exceptions as inaccurate, because the time series on which VAR is based doesn’t have enough volatile days to forecast any future volatility yet.

“The multiplier was conceived to compensate for model deficiencies, so until you fix the model you increase your capital,” says the head of market risk modelling. “Now, models that were fully sound and had no deficiencies will be showing backtesting exceptions simply because the market events that are unfolding these days are unprecedented. Unless you have a time series to which you calibrate your model that has this event, then you cannot expect the risk model to forecast such moves.”

Freeze-frame

Supervisors in Canada, the UK and the US have issued a variety of measures to either avoid or offset the increase. Three sources say the ECB is currently looking into the issue, but banks have yet to hear of any fix.

“The ECB is studying this but we’ve not heard anything yet,” says a senior market risk manager at a second eurozone investment bank. “The multiplier will increase for everyone and that is material. So [an offset] would be welcome.”

The ECB declined to comment for this article.

Two bankers say they and their peers are requesting the ECB to freeze the multipliers to where they were set before the crisis started.

“The VAR and multipliers could increase the capital requirement further if we do nothing,” says a market risk expert at a third eurozone investment bank. “So the request to the ECB is to freeze the multiplier to where it was before the crisis.”

That fix would be similar to the one the Federal Reserve is said to be allowing US banks to take. A market risk expert at a US investment bank says the Fed is allowing them to keep the multipliers frozen until the end of the year. The Fed declined to confirm this.

The head of market risk modelling at the first eurozone investment bank says banks had at first approached their national banking supervisors asking to freeze the multiplier by using a provision in article 366 of the EU’s Capital Requirements Regulation. However, they say national supervisors are waiting for the ECB to decide whether they can do this or not.

“What many banks have been advocating is that there is an article of CRR that gives some discretion to the national competent authorities to consider an exception [as] not deriving from a deficiency in the model and so to neglect it when it comes to increasing the multiplier,” says the head of market risk modelling. “But what I am hearing is that national authorities do not want to operate on their own and they are turning to the ECB to try to get an overall set of directions on how to best use this article or any other article in the CRR.”

Questionable interpretation

The head of market risk modelling believes the hesitation is partly because the article in CRR doesn’t technically allow the multiplier to be frozen. For backtesting, VAR is measured against two different P&Ls, which are known as actual and hypothetical P&Ls.

Actual P&L is the value of a bank’s portfolio at the end of a trading day, whereas hypothetical P&L is the bank’s portfolio from the end of the previous trading day measured using market data at the end of the current trading day. The multiplier is determined by the highest number of exceptions caused by either actual or hypothetical P&L.

The CRR, however, allows competent authorities to set the multiplier to the number of exceptions caused by the hypothetical P&L rather than the actual changes if some exceptions in the latter were not caused by model deficiencies. For example, losses could be caused by intraday changes to the bank’s portfolio composition, which VAR hadn’t been able to account for.

Article 366 therefore doesn’t state that exceptions not caused by model deficiencies can be ignored, but rather that banks must use the hypothetical P&L in those cases.

The head of market risk modelling says in this instance it would make no difference using the hypothetical P&L. Indeed, the measure may cause more breaches, as it won’t take into account traders exiting loss-making positions during the current trading day.

“Typically, I would expect in days of very high volatility that the hypothetical P&L would be more penalised than actual P&L,” says the head of market risk modelling.

But he doubts regulators would feel they had sufficient legal authority to reverse the formulation contained in article 366 and allow banks to ignore a VAR breach of hypothetical rather than actual P&L.

“If you breach on the hypothetical and not on the actual, a national competent authority acting on the basis of article 366 might find itself lacking the legal ground to claim this is not an overshooting, because unfortunately [the article] is very specific.”

Supervisors in the UK and Canada have opted for different fixes. The Prudential Regulation Authority wrote to UK banks on March 30 stating capital increases due to breaches in backtesting resulting from market volatility can be offset by deducting the same amount from requirements held for hard-to-model trading exposures, known as risks-not-in-VAR.

Meanwhile, the Office of the Superintendent of Financial Institutions has allowed Canadian banks to halve the multiplier applied to SVAR at the end of 2019. Therefore, the VAR multiplier will increase with the greater number of breaches resulting from the current market volatility, but this will be offset by a multiplier for SVAR that will be temporarily lower than the minimum of three as set out in Basel 2.5. This reflects the fact that as ‘real’ VAR increases due to market volatility, there is less need to top up capital requirements with the theoretical stress contained in SVAR.

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