Market risk is the risk of losses in on- and off-balance sheet risk positions arising from movements in market prices. Under the Capital Requirements Regulation (CRR), credit institutions are required to hold own funds for market risk to cover foreign exchange risk and commodities risk in their non-trading and trading books as well as position risk (risk of positions in debt and equity instruments) in their trading book. They can use either the standardised approach or internal risk models to calculate their market risk.
The capital requirements under the standardised approach are regulated by Articles 326 to 361 of CRR. These provisions describe the calculation methods used to determine the capital charge for instruments of every risk category. Furthermore, there are regulatory technical standards, implementing technical standards, and guidelines for individual topics (see below).
Internal Market Risk Models
The rules for the capital requirements for internal market risk models can be found in Articles 362 to 377 of CRR. Only with permission from the competent authorities may institutions use internal risk models for one or more risk categories alongside or instead of the standardised approaches.
Model changes or extensions
Material extensions or changes to internal models require the permission of the competent authority. If a non-material change or an extension needs to be made to an approved risk model, the authorities must be notified and separate permission by the competent authorities may be necessary. The procedure to be followed when models are changed or extended is set forth in a regulatory technical standard.
Own funds requirements under an internal model approach
The own funds requirements under an internal model approach are composed of various elements which each have to be determined according to certain calculation rules. Credit institutions are always expected to calculate Value-at-Risk (VaR) and stressed VaR figures (stressed VaR). Institutions that model the specific risk of debt instruments are additionally required to calculate the capital charge for default and migration risk (incremental risk charge, or IRC). They can choose to include all listed equity positions and derivatives positions based on listed equities in the calculation of the capital charge for default and migration risk. Institutions also have the option of determining their capital charge for the correlation trading portfolio using an internal model (comprehensive risk measure, or CRM).
The introduction of Stressed VaR and the modelling of default and migration risk (IRC, see above) were part of a more comprehensive overhaul of the framework for measuring market risk (“Basel 2.5”) introduced by the Basel Committee on Banking Supervision 2009 in response to the financial crisis.
Institutions are required to add a multiplication factor on the VaR and the stressed VaR risk figures. The multiplication factor is at least 3 and can also assume higher values in the case of qualitative deficiencies (qualitative multiplication factor). Institutions are required to carry out daily back-testing on hypothetical and actual changes in the portfolio value and count the overshootings as described in Article 366 of CRR. The number of overshootings is used to generate a quantitative addend on the multiplication factor for the VaR and stressed VaR figures (quantitative multiplier). The addend derived from the number of overshootings identified during back-testing takes a value between 0 and 1 as defined per Table 1 in Article 366 of CRR.
To mitigate the effects of the COVID-19 crisis on the banks, the ECB, EBA and EU Legislator introduced extraordinary measures. In particular an update of the CRR (Quick Fix) gives competent authorities discretion to exclude overshootings from the calculation of the quantitative multiplier, provided that those overshootings do not result from deficiencies in the internal model and provided that they occurred between 1 January 2020 and 31 December 2021 (Regulation (EU) 2020/873 of 26 June 2020 in the Official Journal of the European Union).
Targeted Review of Internal Models (TRIM)
In February 2017, the ECB initiated a project for a targeted review of internal models (Targeted Review of Internal Models, or TRIM). Goal of TRIM is to assess adequacy of internal models used within the SSM with a consistent guide and to reduce the non-risk driven variability of model-based capital requirements. After the planned investigations in the area of market risk models had been conducted, the guide was adjusted to reflect insights, publicly consulted and published in its final version by ECB on 8 July 2019. Since 1 October 2019, a consolidated version (including general and risk-specific chapters) is available renamed to ECB Guide to internal models.
Fundamental Review of the Trading Book (FRTB)
The Basel Committee has fundamentally revised the concepts and methods in both the standardised approach and the internal models-based approach and refined the trading book definition. The new Basel framework for market risk – the Fundamental Review of the Trading Book (FRTB) – was adopted and published after final modifications in January 2019. In the EU, the new FRTB regulations will be implemented in a phased manner. In the context of the COVID-19 crisis, the original schedule for the gradual implementation of the FRTB regulations (Art. 461a and 430b (3)) had to be postponed. On 30 September 2021, the reporting obligation for the FRTB standardised approach became effective.
The reporting phase for the internal model approach is scheduled to begin three years after the (still outstanding) publication of the last of the four "Core RTS" in the EU Official Journal.
For the calculation of own funds requirements, the draft CRR3 submitted by the EU Commission on 27.10.2021 defines the starting date of 2025 for the new approaches (FRTB standardised approach and model approach). Until this date, banks will continue to calculate their own funds requirements according to the rules of the current framework. If the planned start date at the beginning of 2025 and the above-mentioned specifications regarding the IMA "Core RTS" are not adjusted in the EU trilogue process, an earlier reporting phase would not be applied for the IMA.
The current CRR3 draft, which is still under discussion, grants the EU Commission the option of a further postponement of the application of requirements for the calculation of own funds by 2 years under certain conditions (cf. Art. 461a(b) CRR3). Furthermore, this option also provides a scaling possibility for own funds requirements at different levels (cf. Article 461a(a) CRR3). The background to these options is to support a globally consistent implementation of the Basel rules. At the same time, the new Article 325c CRR3 strengthens the implementation quality of the new FRTB standardised approach and its supervisory review process.