The Market Risk Framework
1.
Introduction
Market risk can be
defined as the risk of losses in on-balance sheet and off-balance sheet
positions arising from adverse movements in market prices. The major
constituents of market risks are:
a. The risks pertaining
to interest rate related instruments;
b. Foreign exchange risk
(including gold positions) throughout the bank; and
c. The risks pertaining
to investment in equities and commodities.
(Nepal Rastra Bank Unified Directives, 2019)
Many banks have
portfolios of traded instruments for short term profits. These portfolios
-referred to as trading books -are exposed to market risk, or the risk of
losses resulting from changes in the prices of instruments such as shares, bonds
and currencies. Banks are required to maintain a minimum amount of capital to
account for this risk.
(Basel Committee on Banking Supervision, 2005)
2.
The Main Driver of Market Risk
Fig:
Market Risk: The risk of losses arising from movements in market prices
The prescribed approach
for the computation of capital charge for market risk is very simple and thus
may not be directly aligned with the magnitude of risk. Likewise, the approach
only incorporates risks arising out of adverse movements in exchange rates
while ignoring other forms of risks like interest rate risk and equity risks.
Thus, banks should develop a framework that addresses these various forms of
risk and at the same time perform stress tests to evaluate the adequacy of
capital. The use of internal models by the bank for the measurement of market
risk is highly encouraged. Wherever bank's make use of internal models for
computation of capital charge for market risks, the bank management should
ensure the adequacy and completeness of the system regardless of the type and
level of complexity of the measurement system as the quality and reliability of
the measurement system is largely dependent on the quality of the data and
various assumptions used in the model.
3.
Approaches for Managing Market Risk
A. Net Open Position
Net open position is the
difference between the assets and the liability in a currency. In other words,
it is the uncovered volume of asset or liability which is exposed to the
changes in the exchange rates of currencies. For capital adequacy requirements
the net open position includes both net spot positions as well as net forward
positions. For capital adequacy purposes, banks should calculate their net open
position in the following manner:
·
Calculate the net open position in each of
the foreign currencies.
·
Convert the net open positions in each
currency to NPR as per prevalent exchange rates.
·
Aggregate the converted net open positions
of all currencies, without paying attention to long or short positions.
·
This aggregate shall be the net open
position of the bank.
Out of the various
components of market risk, foreign exchange risk is the predominant risk in our
country. The effects of other forms of market risk are minimal. Thus, a net
open position approach has been devised to measure the capital requirement for
market risk. As evidenced by its name, this approach only addresses the risk of
loss arising out of adverse movements in exchange rates. This approach will be
consolidated over time to incorporate other forms of market risks as they start
to gain prominence. The designated Net Open Position approach requires banks to
allocate a fixed proportion of capital in terms of its net open position. The
banks should allocate 5 percentage of their net open positions as capital
charge for market risk.
B. Computation of Risk Weight
Risk-weighted assets in
respect of market risk are determined by multiplying the capital charges by 10 (i.e.,
the reciprocal of the minimum capital ratio of 10%) and adding together
with the risk weighted exposures for credit risk.
i.
Internal Capital Adequacy Assessment
Process
The internal capital
adequacy assessment process (ICAAP) is a comprehensive process which requires
board and senior management oversight, monitoring, reporting and internal
control reviews at regular intervals to ensure the alignment of regulatory
capital requirement with the true risk profile of the bank and thus ensure
long-term safety and soundness of the bank. The key components are >
·
Board and senior management oversight
o
Bank management is responsible for
understanding the nature and level of risk being taken by the bank and how this
risk relates to adequate capital levels. It is also responsible for ensuring
that the formality and sophistication of the risk management processes is
commensurate with the complexity of its operations. A sound risk management
process, thus, is the foundation for an effective assessment of the adequacy of
a bank’s capital position.
·
Sound capital assessment
o
Policies and procedures designed to ensure
that the bank identifies, measures, and reports all material risk
o
A process that relates capital to the
level of risk
o
A process that states capital adequacy
goals with respect to risk, taking account of the bank’s strategic focus and
business plan
o
A process of internal control, reviews and
audit to ensure the integrity of the overall management process
·
Comprehensive assessment of risks
o
All material risks faced by the bank
should be addressed in the capital assessment process. Nepal Rastra Bank recognizes
that not all risks can be measured precisely. However, bank should develop a
process to estimate risks with reasonable certainties.
o
In order to make a comprehensive
assessment of risks, the process should, at minimum, address the different
forms of risk. They are credit risk, operation risk, market risk and
liquidity risk.
·
Monitoring
and reporting
The
bank should establish an adequate system for monitoring and reporting risk
exposures and assessing how the bank’s changing risk profile affects the need
for capital. The bank’s senior management or board of directors should, on a
regular basis, receive reports on the bank’s risk profile and capital needs.
·
Internal
control review
The bank’s internal
control structure is essential to a sound capital assessment process. Effective
control of the capital assessment process includes an independent review and,
where appropriate, the involvement of internal or external audits. The bank’s
board of directors has a responsibility to ensure that management establishes a
system for assessing the various risks, develops a system to relate risk to the
bank’s capital level, and establishes a method for monitoring compliance with
internal policies. The board should regularly verify whether its system of
internal controls is adequate to ensure well-ordered and prudent conduct of
business.
ii.
Supervisory
Review
Central Bank shall
regularly review the process by which a bank assesses its capital adequacy,
risk positions, resulting capital levels, and quality of capital held by a
bank. Supervisors shall also evaluate the degree to which a bank has in place a
sound internal process to assess capital adequacy. The emphasis of the review
should be on the quality of the bank’s risk management and controls and should
not result in supervisors functioning as bank management. The periodic review
can involve any or a combination of
·
On-site examinations or inspections
·
Off-site review
·
Discussions with bank management
·
Review of work done by external auditors
(provided it is adequately focused on the necessary capital issues)
·
Periodic reporting
iii.
Supervisory
Response
Central Bank expects
banks to operate above the minimum regulatory capital ratios. Wherever, NRB is
not convinced about the risk management practices and the control environment,
it has the authority to require banks to hold capital in excess of the minimum.
D. Disclosure
The purpose of disclosure
requirements is to complement the minimum capital requirements and the review
process by developing a set of disclosure requirements which will allow market
participants to assess key pieces 34 of information on the scope of
application, capital, risk exposures, risk assessment processes, and hence the
capital adequacy of the bank. It is believed that providing disclosures that
are based on a common framework is an effective means of informing the market
about a bank’s exposure to those risks and provides a consistent and
comprehensive disclosure framework that enhances comparability. The importance
of disclosure is more pronounced in cases of bank that rely on internal
methodologies in assessing capital requirements.
4. Conclusion
The instability associated
with the market dynamics draw the attention of banks upon the market risk management.
In the respect, banks improve and developed new methods in order to counter
these effects and also in order to better estimate interest rate risk, exchange
rate risk, and other types of risk. The effects generated by the external
shocks were a warning signal for the authorities to increase their capital as a
strong need for a correct covering of these risks.
5.
References
·
Milanova, E. (2010). Market risk management
in banks – models for analysis and assessment. FACTA
UNIVERSITATIS Series: Economics and
Organization, 7(4), 395-410.
Retrieved from http://facta.junis.ni.ac.rs/eao/eao201004/eao201004-04.pdf
(1) (PDF) Regulatory assessment of the bank market risk: International
approaches and Ukrainian practice.
·
Basel
Committee on Banking Supervision. (2005). Trading book survey: a summary of
responses. Retrieved August 10, 2013, from www.bis.org:
www.bis.org/publ/bcbs112.htm
·
Nepal Rastra Bank Unified Directives (2019).
Retrieved from https://www.nrb.org.np/contents/uploads/2019/12/Directives-Unified_Directives_2076-new-1.pdf
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