Assessment of inherent market risk
Through the assessment of inherent market risk competent authorities should determine the main drivers of the institution’s risk exposures and evaluate the risk of significant prudential impact on the institution. To develop such an understanding, competent authorities should first identify the market risks to which the institution is or may be exposed and focus their attention on the subcategories and drivers deemed the most material for the institution.
To support this analysis, competent authorities should consider, as a minimum, the products, activities and business lines of the institution. They should compare the own funds requirements for market and CVA risk and the additional valuation adjustment deducted from the institution own funds, against the total own funds requirements. Where relevant they should compare the internal capital allocated to those risks by the institution against the total internal capital. They may also consider the relative weight of market risk positions in terms of total assets, the relative weight of net gains on market risk positions to total operating income and the historical changes in these figures and forecasts. Also, the strategy of the institution as regards market activities and the related risk appetite should be taken into account. When considering market activities, competent authorities should refer to the risks mentioned in paragraph 161 which may encompass the trading and non-trading book.
Nature and composition of the institution’s risk activities
The first step in assessing the nature of the inherent market risk of an institution is to identify its market risk exposures consistently and comprehensively. Competent authorities should use available regulatory reporting templates, such as COREP and FINREP, internal reporting, insights gained from the assessment of other SREP elements (such as the BMA) or prior supervisory activities, and comparisons with the institution’s peers, where available.
Competent authorities should base their assessment primarily on the most significant identified sources of risk, evaluating their materiality for the institution from a prudential perspective. To assess the nature of market risk, competent authorities should consider at least the following subcategories(39):
interest rate risk (trading book);
credit spread for non-securitisation, credit spread for securitisation (trading book);
equity risk (trading book);
default risk (for business subject to a default risk charge);
foreign exchange risk, including translation risk (both in the trading and banking book);
commodities risk (trading and banking book);
CVA risk (trading and banking book);
valuation risk (fair-valued instruments in the trading and non-trading books).
Competent authorities should also consider:
the complexity of financial products (e.g. products valued using mark–to-model techniques, products bearing non-delta risks and basis risks). Competent authority may assess this by using as an indicator the add-on resulting from residual risks as per Article 325u of Regulation 575/2013/EU;
the liquidity of the institution’s exposure. The competent authority can do so by assessing whether the institution is exposed to subcategories with high liquidity horizons in accordance with table 2 of Article 325bd of Regulation 575/2013/EU;
the concentration of market risk towards specific names, sectors, economies, risk-classes;
the employment of specific market operations the risk of which may not be fully represented by the market risk own funds requirements (e.g. high-frequency trading).
When appropriate, competent authorities should also consider the internal risk measures of institutions. These could include the internal VaR or expected shortfall not used in the calculations of own funds requirements or sensitivities of the market risk to different risk factors and potential losses.
Competent authorities should also assess the institution’s ability to form a comprehensive view on the degree of market concentration risk to which it is exposed, either from exposures to a single risk factor or from exposures to multiple risk factors that are correlated, thereby paying specific attention to concentrations in complex and illiquid products. They should review the firm’s own assessment of concentrations and illiquid positions. Competent authorities should require institutions to reduce exposure towards a given CCP in case of excessive concentration risk, or to realign exposures across their clearing accounts in accordance with Article 7(a) (opens EUR-Lex in a new tab) of Regulation 648/2012 (opens EUR-Lex in a new tab).
When determining whether P2R should be imposed for the market risk to which the institution is exposed, in line with paragraph 300, competent authorities should consider whether the Pillar 1 methodology adequately captures the risk, taking into account that:
institutions employing the alternative standardised approach are required under Pillar 1 to calculate an add-on (residual risk add-on) for the risks inherent in complex financial products that are not sufficiently captured in the sensitivity-based method and the default risk charge;
institutions employing the internal model approach or the alternative internal model approach are required to capture all material risks in those internal models;
the risk-weights provided in the alternative standardised approach, the expected shortfall measures referred to in Article 325bb of Regulation 575/2013/EU and the stress scenario risk measures referred to in Article 325bk of Regulation 575/2013/EU in the alternative internal model approach are designed to cater for the positions’ liquidity in line with liquidity horizon referred to in table 2 of Article 325bd of Regulation 575/2013/EU.
Competent authorities should identify and analyse in relation to market risk positions and the corresponding governance arrangements, any transfer pricing arrangements between institutions established in the Union that are part of a third-country group and other entities of that group established outside of the Union and not consolidated by the EU parent undertaking. The analysis should include:
a quantitative component to identify the materiality of the transfer pricing arrangements relative to the trading book total P&L and the own funds of the institution;
a qualitative component to assess if the effect of these arrangements is transparent to the institution’s management board and appropriately reflected in the risk management governance;
a qualitative component to assess how the transfer pricing arrangement affects the business decisions of the institution, including how the dynamics of the transfer pricing arrangement potentially affect the decisions of front-office desks, and the potential conflicts of interest that the arrangement may create.
Competent authorities should identify the materiality of the transfer pricing in the context of trading book items by focusing on the transfer pricing arrangements that meet the following conditions:
they involve at least one entity of the group that is established outside of the Union and for which the highest level of consolidation is outside the Union;
they are based on a transaction profit method (TPM) – or any similar practice that would be economically equivalent – in accordance with which the profits and losses relating to positions owned by several entities are re-distributed across those entities on the basis of the marginal contribution ‘m’ of each entity towards key-metrics set out in the pricing arrangement.
For institutions under paragraph 1733, point (a), where the profits and losses, re-allocated as a result of transfer pricing arrangements based on transaction profit methods, are material (e.g. account for more than 5% of the P&L generated by the institution) and this risk is not covered or fully covered by P1R, competent authorities should:
consider this risk for the determination of P2R;
consider the results of the components listed in paragraph 1722, such as the materiality of the transfer pricing arrangements, in relation to the market risk capital requirements of the portfolio whose profits and losses are used to determine the amount to be transferred to the institution as well as potential weaknesses in the related governance arrangements;
determine P2R that sufficiently cover the market risks not captured under P1R which are generated under the transfer pricing arrangement. To that end, competent authorities may use the calculation method as laid down in Annex V or an alternative methodology that provides accurate measurement of the risk not covered in P1R and identifies the consequent P2R, considering as a reference the methodology in Annex V.
Profitability analysis and stress testing
Competent authorities should analyse the historic profitability, including volatility of profits, of market activities to gain a better understanding of the institution’s risk profile for market risk. This analysis could be performed at portfolio level as well as being broken down by business line, asset class or desk depending on the materiality and complexity of the institution’s exposures (as emerging from the BMA or other supervisory insight).
Competent authorities should distinguish between trading and non-trading revenues (such as commissions, clients’ fees, etc.) on one hand and realised and unrealised profits/losses on the other hand.
For those asset classes and/or exposures generating significant profits or losses, competent authorities should assess profitability in comparison to the level of risk assumed by the institution (e.g. VaR/net gains on financial assets and liabilities held for trading) to identify and analyse possible inconsistencies. Where possible, competent authorities should compare the institution’s figures to its historical performance and its peers.
Competent authorities should assess whether an institution has implemented adequate stress tests that complement its risk measurement system. For this purpose, they should take into account the following elements: