EU Capital Requirements Regime: Market risk under CRR III

Background and sources

• Market risk is associated with the risk of losses in on- and off-balance sheet risk positions, as a result of movements in market prices.
• In the context of market risk, the Capital Requirement Regulation (CRR II), requires credit institutions to retain capital to cover market risk in their trading and non-trading portfolios, as well as position risk in their trading book. To calculate their market risk, these entities may use a standardised approach or internal risk models.
• However, the Basel Committee on Banking Supervision (BCBS) fundamentally reviewed the concepts and methods of the standardised approach and internal risk models, and redefined the notion of trading book. The new Basel framework for market risk, known as the Fundamental Review of the Trading Book (FRTB), has been adopted and published after final amendments in January 2019. CRR II has already introduced these FRTB standards, but only as reporting requirements.
• The new Capital Requirement Regulation (CRR III) will amend the existing CRR provisions relating to market risk, with a particular focus on the implementation of the Fundamental Review of the Trading Book (FRTB), notably in order to introduce the new FRTB standards as binding capital requirements. (Articles 325 and seq. CRR III; and Article 104 CRR III for the inclusion in the trading book).

Key changes

• Against this background, the main change introduced by CRR III is the establishment of binding capital requirements for market risk, based on the final FRTB standards.
• In order to calculate capital requirements for market risk, the provisions relating to the approaches to be used by credit institutions are also amended, and the boundary of the trading book is refined.
• However, the European Commission is being granted with the power to adopt delegated acts to amend the approaches for calculating capital requirements for market risk and to change the date of application of these approaches, in order to address potential disparities in the application of FRTB rules in different jurisdictions and to ensure a fair and balanced market environment.

Requirements

Approaches to calculate capital requirements

CRR III amends the provisions of CRR II by requiring credit institutions to calculate the own funds requirements, for market risk for all their trading book positions and non-trading book positions that are subject to foreign exchange risk or commodity risk, in accordance with the following approaches:

• The Alternative Standardised Approach (A-SA), applicable as the principal approach to be used by institutions. Under this approach additional qualitative requirements are introduced, relating to validation, documentation and governance for institutions employing this model. The Alternative Standardised Approach (A-SA) has been designed to be more risk-sensitive than the previous approach adopted under CRR II, the combination of risk sensitivities and stress scenarios making this new model significantly more responsive to risks;
• The Alternative Internal Models Approach (A-IMA), applicable only with permission from the competent authorities. This model may be used instead or in combination with the alternative standardised approach, if "the total own funds requirements for market risk calculated using the alternative internal model approach represent at least ten per cent of the total own funds requirements for market risk". The Alternative Internal Models Approach (A-IMA) will replace the Internal Models Approach (IMA), in order to remedy the weaknesses of the current CRR II rules. For instance, the standards relating to data quality criteria will be more stringent, particularly when modelling risk factors; and
• The Simplified Standardised Approach (SSA), applicable to institutions that maintain smaller or simpler trading books. To take into account the principle of proportionality, this approach will be an option for institutions with medium-sized trading books (i.e. less than EUR 500m and ten per cent of its total assets).

Trading books provisions

• The implementation of the final FRTB standards regarding the boundary between the trading and non-trading book is crucial, as they have a significant impact on the calculation of the own funds requirements for market risk. It has been considered that changing the trading book boundary is likely to have a greater capital effect than changes in modelling approaches.
• CRR III therefore proposes a revision of the provisions concerning trading books, and includes the lists of instruments to be assigned to the trading book or non-trading book. For instance, institutions should assign positions in the following instruments to the trading book: (i) instruments that meet criteria for the inclusion in the alternative correlation trading portfolio (ACTP); (ii) instruments that would give rise to a net short credit or equity position in the non-trading book; (iii) instruments resulting from securities underwriting commitments, where those underwriting commitments relate only to securities that are expected to be actually purchased by the institution on the settlement date; (iv) instruments classified unambiguously as having a trading purpose under the accounting framework applicable to the institution; (v) instruments resulting from market-making activities; (vi) collective investment undertakings held with trading intent; (vii) listed equities; (viii) trading-related securities financing transactions; and (ix) options, or other derivatives, embedded in the own liabilities of the institution in the non-trading book that relate to credit or equity risk.
• CRR III also provides for details on the derogation to allow institutions to assign, subject to the approval of the competent authority, certain instruments usually held in the trading book, to the non-trading book, where positions in those instruments are not held with trading intent or do not hedge positions held with trading intent.
• There are also additional provisions concerning evaluation of the trading books, CRR III stipulating in particular that each institution "shall have in place an independent risk control function which shall evaluate, on an ongoing basis, whether its instruments are being properly assigned to the trading or non-trading book".
• In addition, banks will have the option of separately reporting calculations relating to positions in the trading book and the non-trading book, which are subject to foreign exchange and commodity risks.

Power of the European Commission to adopt delegated acts

• CRR III provides the European Commission with the power to act by way of delegated acts to postpone by up to two years the date from which institutions shall apply the own funds requirements for market risk, or any of the approaches to calculate the own funds requirements for market risk.
• These delegated acts will also allow the European Commission to mitigate potential distortions resulting from the divergent application of FRTB rules in different jurisdictions, and to align with forthcoming international developments. As a result, the Commission will be able to adjust capital calculation approaches for market risk in the event of major divergences with other jurisdictions, in order to maintain an international level playing field.