Understanding Market Risk Capital Charge — Part 1 (Fixed Income)
For any business, capital happens to be key component from the point of view of growth and stability. An organization that is well capitalized is better positioned to pursue new business opportunities, enhance customer experience, and most importantly stay robust in times of market stress; all of which lead to growth in both top line and bottom line of the business. Banking organizations also need capital for a host of reasons, some of which are mentioned above. A bank that is well capitalized boosts customer confidence thereby attracting more customer savings that would be used for further lending which the bank does to its borrowers. Also, the surplus funds generated by banks may be used for other revenue generating activities like trading, investments etc.
Background:
Lets understand the crux of the term capital adequacy. Capital Adequacy is a regulatory requirement that is to be satisfied by banks globally. The Basel Committee of Banking Supervision has published the Basel III guidelines that are adopted by banking regulators around the world. Most regional regulators take the Basel guidelines and subsequently make a few modifications to the same (as necessary) based on the respective jurisdictions that come under their regulatory purview. For instance, the banking regulator in India may modify a portion of the original Basel guideline to make it more applicable to the Indian market. Regulators in other countries may do something similar too based on their respective markets.
Capital Adequacy requires banks to allocate a specific portion of their capital for regulatory purposes. Ultimately, the idea that the Regulator is trying to convey through the capital adequacy guideline is simple — Regulators say, banks are allowed to take risks, however, they need to allocate a certain portion of their capital that is commensurate to the risk that the bank is bringing on its books. A well capitalized bank can tide over market stresses and is also well equipped to handle any potential systemic risks and thereby continue to be a going concern.
In this article we will focus on the capital adequacy calculation called as the market risk capital charge that gets applied for positions that the bank is holding as a part of its Trading Book. Further, the trading division of a bank (also called as the Front Office) engages in trading activities across a variety of financial products including fixed income, derivatives, equity etc.
As every asset class has a separate approach that gets used for calculation of the relevant capital charge, we will publish a series of articles to discuss the approach for capital charge computation of various asset classes. In this Part 1 of the article, we will focus on Fixed Income (i.e. T-bills, bonds, commercial paper, certificate of deposits etc.) product type. Another reason behind starting with Fixed Income is that a significant portion of market risk capital charge is contributed by positions that banks hold in fixed income assets.
I have included different types of fixed income products in the portfolio, so that we can discuss the calculation for each of them.
Before we begin our analysis, understanding a few terms will be helpful
1. GR: General Risk Charge — Representative of market risk for a product. Every fixed income product will carry a GR charge
2. SR: Specific Risk Charge — Representative of un-systematic risk. This is specific to a certain issue/issuer. Therefore, only non-Treasuries will carry a SR charge
3. Market Value — The market value of the position based on the current market price
4. M-Duration — Modified Duration — This explains the interest rate sensitivity of the product to the market yields. For our discussion we will assume that we have a separate calculator for computing modified duration of the fixed income product.
5. Credit Rating — Rating assigned by a credit rating agency.
6. TTM — Time to maturity of the product
7. Assumed Change in Yield — This is a quantity that can be looked up in the Basel capital adequacy guideline basis category of the issuer and TTM
8. SR Weights — Specific Risk weights again are a looked up from Basel guideline and are a function of category of the issuer and credit rating
Let’s jump in to analyze our portfolio
1. Treasury Bond (T-bond) and T-bill
Treasury bond also called as a G-sec is issued by the central bank of the country. This bond attracts only GR. (we generally don’t see central governments defaulting on payment commitments, unless in very rare cases as observed in history 😊). GR is calculated as a product of: Market Value X Assumed Change in Yield X M-Duration. There will be no SR for a T-bond.
2. Corp Bond
This is a corporate bond i.e. non-treasury. This bond will attract both GR (i.e. systematic risk) and SR (i.e. idiosyncratic risk). GR is calculated similar to T-bond as a product of Market Value X Assumed Change in Yield X M-Duration. Whereas, SR is calculated for HFT and AFS. For this, we again refer to the Basel guideline and look up the SR weights to be applied for the calculation. Subsequently, SR is calculated as product of Market Value X SR weight
3. CD/CP
These are a type of discount products. The coupon on such products is zero. The GR and SR methodology remains similar to as mentioned for Corp bonds above.
The above approach can be applied for other fixed income products on the bank’s portfolio. The GR and SR that are calculated above gets used in calculation of the overall market risk capital charge on a bank-wide (i.e. enterprise wide) level.
In this article, we understood the methodology used for calculation of Capital charge for fixed income product type. In the next part of this article series we will talk about the capital charge approach for equity, and derivatives.
