LO 59.2: Explain the process of calculating the incremental risk capital charge for

LO 59.2: Explain the process of calculating the incremental risk capital charge for positions held in a banks trading book.
Prior to the financial crisis, the capital charge for exposures in the banks trading book (i.e., bonds, marketable equity securities, commodities, foreign currencies, and most derivatives that are held by the bank for the purpose of trading) was generally lower than the capital charge for exposures in the banking book (i.e., instruments the bank intends to hold for investment purposes including loans and some debt securities). A one-year, 99.9% confidence level VaR was required for calculating capital for the banking book while a multiplier was applied to a 10-day, 99% VaR for capital to back the trading book.
The Basel Committee proposed an incremental default risk charge (IDRC) in 2005 to correct the problem. The proposal required a 99.9% confidence level, one-year time horizon VaR for instruments in the trading book that are sensitive to default risk. This change had the affect of requiring roughly the same capital for trading book instruments as banking book instruments. However, because much of the 20072009 losses in the financial sector were due not to defaults but instead to downgrades, widening credit spreads, and losses of liquidity, the Basel Committee revised the IDRC to become an incremental risk charge (IRC). Instead of instruments sensitive to default, it is now credit-sensitive instruments. Banks must consider ratings change sensitivities in addition to default sensitivity. Banks are expected to rebalance the portfolio through the year to lessen default risk.
As part of the IRC calculation, banks are required to estimate a liquidity horizon for each instrument in the portfolio. For example, assume an AA-rated bond in the portfolio has a liquidity horizon of 6 months. If at the end of 6 months the bond has defaulted or has been downgraded, it is assumed that the bank will replace the bond with an AA-rated bond comparable to the one held at the start of the period. This rebalancing is assumed at the end of each six-month period (or three months, nine months, etc., depending on the estimated liquidity horizon). The Basel Committee set the minimum liquidity horizon at three months.
This assumption of rebalancing to the beginning of the period position is known as the constant level of risk assumption. Small losses occur as bonds are downgraded and the portfolio is rebalanced, but the likelihood of default is lessened. Generally this assumption reduces the one-year, 99.9% VaR. As discussed in the previous topic, the specific risk charge (SRC) captures changing credit spreads.
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