The long-term effect of Covid-19 on market risk capital

Covid-19 has replaced the global financial crisis in some banks’ stressed VAR calculations

The feral markets that accompanied the start of the coronavirus pandemic may be a thing of the past, but they continue to affect banks’ capital charges – and will do so for some time to come.  

Trading book capital requirements are set using a series of risk indicators, one of which is stressed value-at-risk (SVAR). A bank measures this by calculating how much its current portfolio would fall in value if subjected to a 12-month period of historic stress.

Most banks anchor this stress period to the global financial crisis. But the record-breaking moves witnessed earlier this year have compelled some to instead use a 12-month period that includes the coronavirus outbreak.

Royal Bank of Canada is one example. In fiscal Q3, the firm said it had switched to using a stressed period that included the coronavirus outbreak. This pushed its SVAR-based capital requirement up 30%, or C$64 million.

US banks change the historical period used for SVAR dynamically as their portfolio changes. A capital manager at one large dealer tells the Covid shock would have been included in many banks’ calculations during the second quarter.  

On its own, SVAR makes up just a fraction of a bank’s overall market risk capital charge. But the ‘regular’ VAR-based requirement – calculated using the most recent 12 months of historical market data – has also rocketed, as banks’ internal models have factored in the wild swings earlier this year.

Some banks have therefore been hit with a double whammy as VAR- and SVAR-based charges jumped higher in tandem. JP Morgan has seen its VAR- and SVAR-based charges climb 377% and 39%, respectively, since the end of 2019. Together, they made up almost half of its total market risk capital requirement at end-June, up from 31% six months prior.

‘Regular’ VAR-based charges will stay elevated at most banks for at least a year, after which time the Covid shock will start rolling out of the observation data. But for those banks that have to retain the Covid period for their SVAR-based charge, market risk capital requirements may remain stuck at a higher level for many, many years.

This may affect capital-allocation decisions across trading desks. For example, a trading desk that did particularly poorly during the first quarter of this year – say, equity derivatives – may be more capital-intensive under an SVAR measure that incorporates the Covid shock than under the global financial crisis stress.

To paraphrase William Faulkner, “the (market) past is never dead. It’s not even past”.

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