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The issue centers on the elevated number of value-at-risk (VaR) back-testing exceptions that banks are currently experiencing, caused by severe market volatility due to the coronavirus pandemic. Under the current regime introduced as part of Basel 2.5, banks are required to add a multiplier to their capital calculations if actual or hypothetical P&L over the course of a single trading day exceeds VaR estimates more than four times in a year – with the multiplier increasing as the number of exceptions continues to climb.
However, this measure has proved to be highly pro-cyclical. The multiplier is meant to compensate for model deficiencies, but extreme volatility in recent weeks has put VaR models – which are calibrated based on historical data – under pressure, resulting in higher numbers of exceptions. This means banks are having to apply multipliers because of market volatility rather than shortcomings in their models, causing market risk capital requirements to balloon during a period of stress.
This is happening at a time when regulators are taking measures to encourage banks to use excess capital and liquidity to continue to provide intermediation services and support the economy. The pro-cyclical nature of the VaR multiplier could end up having the opposite effect, putting pressure on capital requirements.
Regulators in Canada, Switzerland and the UK have recognized this issue and have taken action to smooth the volatility induced procyclical effect of the multiplier. For example, Swiss regulators have opted to freeze the multiplier used by banks as of February 1 until July 1.
The European Central Bank has also looked to address the problem, announcing on April 16 that it is temporarily reducing the ‘qualitative market risk multiplier’, a measure set by supervisors that is intended to address weaknesses in a bank’s risk management, controls and governance framework.
While this action is welcome, we would urge the European authorities to go further. The qualitative multiplier isn’t directly linked to the number of back-testing exceptions that is causing the problem. It’s also individual to each bank, meaning the potential level of relief could differ between firms and be limited in some cases.
We think a more effective course of action would be to revise the EU’s Capital Requirements Regulation to bring it in line with Basel Committee on Banking Supervision standards by giving national competent authorities the flexibility to take appropriate action when exceptions are not caused by deficiencies in the model. That would allow national authorities to intervene where necessary to temporarily suspend the automatic effects of the multiplier until the extreme effects of the coronavirus outbreak are over.
It’s important that banks have sufficient capital to weather the current crisis, and the more than €2 trillion in Tier 1 capital that internationally active banks have added to their balance sheets since 2011 means they are more resilient to stress. But pro-cyclical market risk capital measures give banks less leeway to act as intermediaries, hindering firms from accessing the financing and risk management services they need.