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Trading book and credit risk: How fundamental is the Basel review?

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  • Laurent, Jean-Paul
  • Sestier, Michael
  • Thomas, Stéphane

Abstract

Within the new Basel regulatory framework for market risks, non-securitization credit positions in the trading book are subject to a separate default risk charge (formally incremental default risk charge). Banks using the internal model approach are required to use a two-factor model and a 99.9% VaR capital charge. This model prescription is intended to reduce risk-weighted asset variability, a known feature of internal models, and improve their comparability among financial institutions. In this paper, we analyze the theoretical foundations and relevance of these proposals. We investigate the practical implications of the two-factor and correlation calibration constraints through numerical applications. We introduce the Hoeffding decomposition of the aggregate unconditional loss to provide a systematic-idiosyncratic representation. In particular, we examine the impacts of a J-factor correlation structure on risk measures and risk factor contributions for long-only and long-short credit-sensitive portfolios.

Suggested Citation

  • Laurent, Jean-Paul & Sestier, Michael & Thomas, Stéphane, 2016. "Trading book and credit risk: How fundamental is the Basel review?," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 211-223.
    • Handle: RePEc:eee:jbfina:v:73:y:2016:i:c:p:211-223
    DOI: 10.1016/j.jbankfin.2016.07.002
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    Cited by:

    1. Angelo D. Joseph, 2023. "Emerging Market Default Risk Charge Model," JRFM, MDPI, vol. 16(3), pages 1-18, March.
    2. Frédéric Vrins, 2018. "Sampling the Multivariate Standard Normal Distribution under a Weighted Sum Constraint," Risks, MDPI, vol. 6(3), pages 1-13, June.
    3. Matheus Pimentel Rodrigues & Andre Cury Maialy, 2019. "Measuring Default Risk For A Portfolio Of Equities," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(01), pages 1-21, February.
    4. Ballotta, Laura & Fusai, Gianluca & Marazzina, Daniele, 2019. "Integrated structural approach to Credit Value Adjustment," European Journal of Operational Research, Elsevier, vol. 272(3), pages 1143-1157.
    5. Ripamonti, Alexandre, 2020. "Financial institutions, asymmetric information and capital structure adjustments," The Quarterly Review of Economics and Finance, Elsevier, vol. 77(C), pages 75-83.
    6. Ioannis Anagnostou & Tiziano Squartini & Drona Kandhai & Diego Garlaschelli, 2020. "Uncovering the mesoscale structure of the credit default swap market to improve portfolio risk modelling," Papers 2006.03014, arXiv.org, revised Apr 2021.
    7. Bonollo Michele & Persio Luca Di & Prezioso Luca, 2018. "The Default Risk Charge approach to regulatory risk measurement processes," Dependence Modeling, De Gruyter, vol. 6(1), pages 309-330, December.

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    More about this item

    Keywords

    Fundamental review of the trading book; Portfolio credit risk modeling; Factor models; Risk contribution;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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