16 August 2013

ISDA, GFMA & IIF response to the consultative document, 'Fundamental Review of the Trading Book Rules on Liquidity Risk'

On August 15, ISDA, GFMA and IIF sent a covering letter and further response to the Trading Book Group of the BCBS on the Fundamental Review of the Trading Book Rules, studying the measurement of liquidity risk.

There are clearly opportunities to introduce double-counts with stress-calibrations of expected shortfall models, and more broadly for fair-value risks currently in the trading book of today and likely in the non-trading book of tomorrow. The industry believes that the liquidity horizons approach may provide the opportunity to integrate the two concerns, to the extent that the overall aggregation issues can be solved.

The industry believes that fundamentally, portfolio hedging and diversification of idiosyncratic risks are the attributes that carve-in client activities in a capital efficient way. When that same mechanism is used to leverage up the fundamental capacity of the market and beyond, then we precisely run the risk of illiquidity in a stressed scenario. Looking at the alternatives discussed and analysed in the appendix, it is not clear which reacts correctly as that leverage becomes unsupportable, and none of these proposals necessarily reduce pro-cyclicality.

While the industry continues to support the FRTB initiative and fully accepts the need to adequately capture liquidity risk in the capital framework, it believes that, in the spirit of BCBS 258, the benefits of additional Pillar 1 adjustments for liquidity are more than outweighed by the costs in terms of additional complexity. Given the practical challenges of having a single prescribed measure of liquidity and the added difficulties of back testing model performance when there are liquidity adjustments, the industry believes that liquidity adjustments in Pillar 1 will further complicate the already difficult problems of a more granular model approval process - constraining diversification benefits and reducing comparability between the standardised and the internal model based approach. In the previous communications with the Trading Book Group on these topics, the industry presented a framework with different cuts of risk (by products, risk factors, desk etc.) to fit the different purposes and most importantly, to include a weighted average of internal model approach and standardised approach based on model performance. Liquidity adjustment will take us further away from a unified framework.

The industry believes that liquidity risk will be adequately captured for Pillar 1 by stressed expected shortfall over a single standard liquidity horizon. Any incremental liquidity risk not captured within the stressed expected shortfall framework, which is likely to be idiosyncratic by nature, is better captured under Pillar 2. The supervisory review process should be trusted to ensure that each firm adequately identifies incremental risk and treats it in a way that is consistent with its own management strategies and its own particular market access.

Full response

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