What the latest Basel 3.1 update means for market risk

On 12th September, The Prudential Regulation Authority (PRA) released its much anticipated second set of Basel 3.1 rules. As expected, market risk was in the spotlight, especially the implementation of Fundamental Review of the Trading Book (FRTB) as a binding capital requirements framework.

On top of this, the update provided rules concerning the internal transfers of positions between the trading and banking book, a more risk sensitive approach in the Standardised Approach (SA) and a coherent capital framework for the Internal Model Approach (IMA).

We’ve already written a general summary covering the main changes and implications of the latest Basel 3.1 update, as well as a deep dive on Credit Risk and Operational Risk. In this blog, we’ll take a closer look at what it means for those with responsibility for managing market risk, and what you need to do next.

Why is Basel 3.1 relevant to market risk?

One of the main aims of Basel 3.1 is to introduce stricter capital requirements and improve the risk sensitivity of banks’ market risk models. The framework builds on the FRTB, which better captures risks arising from market volatility and complex financial instruments. 

By refining the methods used to calculate risk-weighted assets (RWAs), Basel 3.1 ensures that banks hold adequate capital to cover potential market losses, thereby increasing resilience to market shocks and systemic instability.

Under Basel 3.1, banks must use either the SA or IMA to calculate market risk capital. The SA offers a simpler, transparent method for smaller institutions, while the IMA requires advanced risk modelling techniques for larger banks, subject to stringent regulatory approval. This distinction ensures that market risks are properly captured regardless of bank size, while also encouraging robust model validation and risk management practices (and ultimately reducing the likelihood of significant losses during periods of market stress).

What does the latest Basel 3.1 update mean for market risk?

The main change to be aware of is the implementation of FRTB as a binding framework for capital requirements. The PRA’s update also delves into the specific sensitivity definitions and treatment for securitisations, non-securitisations and alternative correlation trading portfolios (ACTPs).

Key highlights include:

1. Strict trading book/banking book boundary.
2. For the SA — More risk sensitive capital requirements for Delta, Vega and Curvature risk. A standardised Default Risk Charge (DRC) measure and a Residual Risk Add-on (RRAO) is now prescribed, and a simplified standardised approach is available for banks with small trading books.
3. For the IMA — There will now be a more coherent capital framework calibrated to a stress period with liquidity horizons ranging from 10 days to 120 days. Expected shortfall, Non-Modellable Risk Factors (NMRF) and the Default Risk Charge (DRC) will all be used.

Other important changes to note:

1. Institutions cannot use the IMA for instruments like ACTPs or CIUs, and the usage is restricted to reduce inconsistencies. It must operate at the desk level with increased controls on performance, through P&L attribution and back-testing. It also focuses on reducing variability in RWAs across firms by limiting the use of internal models where inconsistencies in calculations may arise.
2. For an Advanced Standardised Approach (ASA) — Sensitivity definitions and risk factors for each asset class have been clearly defined. Calculations for default risk basis gross and net jump to default definitions have been added for non-securitisations and securitisations (including and not including ACTP). Residual Risk Add-ons are to be considered for instruments with exotic underlying.
3. For a Simplified Standardised Approach (SSA) — Calculations for positions, specific and general risk (including netting) are explained. Clear demarcation between funds requirement for FX and commodity positions is expected.
4. Firms are to use Basic or the Standard approach (on permission) for Credit Valuation Adjustment (CVA). For SA-CVA, firms are required to calculate on a monthly basis, with the capability to calculate it daily and at the counterparty level. Non-zero losses must be expressed as positive values, ensuring a clear representation of potential losses.

In the spotlight: gap analysis and senior management training

The key thing to know is that banks should complete self-assessments against the Basel 3.1 rules to identify any gaps in data management processes, model development, model validation, management/regulatory reporting, performance monitoring and documentation. It’s crucial that you formulate an effective roadmap for timely gap remediation, and even more important that you socialise this with senior management.

Doing so will ensure proactive communication with the regulator, as well as helping you to achieve FRTB regulatory compliance in a timely manner.

It’s also vital that you have a strong training programme in place to ensure that internal staff have a good grasp of market risk fundamentals, including FRTB regulatory requirements, measurement methodologies, risk management strategies and processes used to generate internal and regulatory metrics.

The challenge for senior management is often to understand the technical nature of FRTB capital models that drive strategic decisions. Ensure that everyone possesses an adequate level of technical knowledge (in strategic levers like portfolio composition, hedging, risk management activities and model life cycle) to form a judgement on the suitability of material modelling decisions.

What does that mean for me?

As a bank, proactively preparing for the Basel 3.1 changes will help you stay compliant and optimise capital efficiency. You may need to assess and potentially restructure business strategies and portfolios to ensure compliance without compromising profitability, given higher capital charges.

As a general rule, we would suggest:

1. Ensuring accurate distinctions between the trading book and banking book.
2. Adjusting market risk measurement processes to align with revised standards for capturing tail risks and NMRFs.
3. Upgrading risk management systems to meet the more complex data requirements for stress testing, back-testing, and capital calculation.
4. Adjusting capital reserves in response to Basel 3.1’s higher capital charges for market risk exposures, under the revised SA and stricter model validation requirements.
5. Preparing for more frequent regulatory reviews, especially for firms using internal models. Regulatory approvals will require demonstrating that the models are robust and meet the new standards.

Basel 3.1 and market risk — our thoughts?

The Basel 3.1 changes for market risk are a game changer for the industry in terms of market risk capital requirements. Remember, the framework was put in place to address key shortcomings in the Basel 2.5 framework. 

Banks have a choice between the IMA and the SA, with banks that have small trading portfolios able to opt for an SSA (if permitted by the regulator). For those who choose this option, it’s important to carefully consider factors such as risk management sophistication, RWA impact, implementation/maintenance costs and complexity.

In achieving FRTB compliance, banks should:

• Conduct timely gap analysis.
• Ensure robust data and model governance is in place.
• Enhance model, policy/procedure and process documentation.
• Agree with senior management on capital and risk management decisions.
• Effectively train resources on regulations, methodologies and processes.

What’s next?

For more guidance, you can read our general summary of the latest Basel 3.1 update, as well as what it means for…

• Credit Risk
• Operational Risk

To find out how 4most can help your business respond to the Market Risk implications of Basel 3.1, complete our short contact form, and we’ll get straight back to you.