6.4 Assessment of Risk-to-Market

Competent authorities should assess Risk-to-Market arising from all types of exposures: for positions that are not subject to clearing (i.e. exposure computed through Net Position Risk methodology), and for positions that are subject to clearing or margining (i.e. exposure computed through Clearing Margin Given methodology).

In assessing Risk-to-Market, competent authorities should take into account the volume, nature and complexity of the investment firm’s activities.

6.4.2 Assessment of inherent Risk-to-Market

Through the assessment of inherent market risk, competent authorities should determine the main drivers of the investment firm’s market risk exposure and evaluate the risk of significant prudential impact on the investment firm. The assessment of inherent market risk should be structured around the following main steps:

• a. preliminary assessment;
• b. assessment of the nature and composition of the investment firm’s positions subject to risk-to-market;
• c. assessment of profitability;
• d. assessment of market concentration risk;
• e. assessment of the prudent valuation framework for trading book positions; and
• f. assessment of the model risk (i.e. models used for regulatory purposes).

Preliminary assessment

To determine the scope of the assessment of risk-to-market, competent authorities should first identify the sources of market risk to which the investment firm is or may be exposed.

As a minimum, competent authorities should consider:

• a. the investment firm’s market activities, business lines and products;
• b. the main strategy of the market risk portfolio within the trading book and the risk appetite in market activities;
• c. the relative weight of trading book positions in terms of total assets, changes over time and the investment firm’s strategy for these positions, if available;
• d. the relative weight of net gains on market positions in total operating income; and
• e. the own funds requirement for Risk-to-Market compared to the total own funds requirement, including the historical change in this figure and forecasts, if available.

In their initial assessments, competent authorities should also consider significant changes in the investment firm’s market activities with the focus on potential changes in the total exposure to market risk. In particular, they may assess:

• a. significant changes in market risk strategy, policies and sizes of limits;
• b. the potential impact on the investment firm’s risk profile of those changes; and
• c. major trends in the financial markets.

Nature and composition of the investment firm’s market risk activities

Competent authorities should analyse the nature of the investment firm’s market risk exposures to identify particular risk exposures and related market risk factors/drivers (including exchange rates, interest rates or credit spreads) for further in-depth assessment.

Competent authorities should analyse market risk exposures by relevant asset classes and/or financial instruments according to their size, complexity and level of risk. For the most relevant exposures, competent authorities should assess their related risk factors and drivers.

While analysing market risk activities, competent authorities should also consider the complexity of the relevant financial products (including products valued using mark-to-model techniques) and of specific market operations (including high-frequency trading). The following points should be considered:

• a. where the investment firm holds derivatives positions, competent authorities should assess both the market value and the notional amount;
• b. where the investment firm is engaged in OTC derivatives, competent authorities should evaluate, where available, the weight of these transactions in the total derivatives portfolio and the breakdown of the OTC portfolio by type of contract (swap, forward), underlying financial instruments (the counterparty credit risk associated with these products is covered under the risk-to-firm methodology);
• c. where the investment firm has implemented hedging strategies, competent authorities should assess the residual market risk after implementation of these strategies.

Where appropriate, competent authorities should assess distressed and/or illiquid positions and evaluate their impact on the investment firm’s profitability.

For those investment firms using internal approaches to calculate their regulatory own funds requirements, competent authorities should also consider the following indicators to identify particular risk areas and related risk drivers:

• a. the split of market risk own funds requirements between the value at risk (VaR), stressed VaR (SVaR), incremental risk charge (IRC) and charge for correlation trading portfolio;
• b. the VaR broken down by risk factors;
• c. the change in the VaR and SVaR (possible indicators could be the day-to-day/week-to-week change, the quarterly average and back-testing results); and
• d. the multiplication factors applied to VaR and SVaR.

Where appropriate, competent authorities should also consider the internal risk measures of investment firms. These could include the expected shortfall, the internal VaR not used in the calculations of own funds requirements or sensitivities of the market risk to different risk factors and potential losses.

When analysing inherent market risk, competent authorities should consider ‘point-in-time’ figures and trends, both on an aggregate basis and by portfolio. Where possible, this analysis should be completed with a comparison of the investment firm’s figures to peers and to relevant macro-economic indicators.

Profitability analysis

Competent authorities should analyse the historic profitability, including volatility of profits, of market activities to gain a better understanding of the investment firm’s market risk profile. This analysis could be performed at portfolio level as well as being broken down by business line, trading desk or asset class (potentially as part of the wider assessment carried out as part of the BMA).

While assessing profitability, competent authorities should pay specific attention to the main risk areas identified during the examination of market risk activities. Competent authorities should distinguish between trading revenues and non-trading revenues (such as commissions, clients’ fees) on the one hand and realised and unrealised profits/losses on the other hand.

For those asset classes and/or exposures generating abnormal profits or losses, competent authorities should assess profitability in comparison to the level of risk assumed by the investment firm (including VaR/net gains on financial assets and liabilities held for trading) to identify and analyse possible inconsistencies. Where possible, competent authorities should compare the investment firm’s figures to its historical performance and its peers.

Market concentration risk

Competent authorities should form a view on the degree of market concentration risk to which the investment firm is exposed, either from exposures to a single risk factor or from exposures to multiple risk factors that are correlated.

When evaluating possible concentrations, competent authorities should pay special attention to concentrations in complex products (notably structured products), illiquid products (including collateralised debt obligations (CDOs)) or products valued using mark-to-model techniques.

Prudent valuation of the trading book positions

Competent authorities should form a view on the prudent valuation framework of the investment firm, as a flawed valuation process may lead to errors in the calculation of the exit value of financial instruments leading to an underestimation of potential losses of the investment firm. While performing this analysis, competent authorities should pay particular attention to the calculation of reserves (notably fair value reserves, model reserves) and their potential impact on the capital position of the investment firm.

Competent authorities should assess whether the investment firm’s trading book positions are valued at a prudent value that achieves an appropriate degree of certainty having regard to the dynamic nature of trading book positions. The level of certainty referred to in Commission Delegated Regulation 2016/101²⁰ should be considered to achieve an appropriate degree of certainty for this purpose.

²⁰ Commission Delegated Regulation (EU) 2016/101 of 26 October 2015 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for prudent valuation under Article 105(14) (OJ L 021 28.1.2016, p. 54).

Competent authorities should assess whether investment firms have robust prudent valuation methodologies and that they consider the following valuation adjustments:

• a. unearned credit spreads;
• b. close-out costs;
• c. operational risks;
• d. market price uncertainty;
• e. early termination;
• f. investing and funding costs;
• g. future administrative costs; and
• h. where relevant, model risk.

Competent authorities should assess whether:

• a. the governance arrangements, processes and procedures related to valuation adjustments are sufficiently sound, especially with regard to less liquid positions, and consistent with the investment firm’s strategy;
• b. the IT systems and processes linked to the valuation framework are robust;
• c. the adequacy of the adjustments performed by the investment firms is periodically reviewed.

Model risk

Competent authorities should assess the risk relating to the underestimation of own funds requirements by regulatory approved internal models used, notably internal ratings-based (IRB) approach, IRC, models used for the purpose of credit risk mitigation, VaR and sVaR.

6.4.3 Assessment of Risk-to-Market management and controls

To achieve a comprehensive understanding of the investment firm’s market risk profile, competent authorities should review the governance and risk management framework underlying its market activities. To this end, competent authorities should assess the following elements while taking into account the volume, nature and complexity of the investment firm’s activities:

• a. the investment firm has a sound, clearly formulated and documented market risk strategy, approved by their management body;
• b. the investment firm’s market risk strategy properly reflects the investment firm’s appetite for market risk and is consistent with the overall risk appetite;
• c. the investment firm has an appropriate organisational framework for market risk management, measurement, monitoring and control functions, with sufficient (both qualitative and quantitative) human and technical resources;
• d. the investment firm has clearly defined policies and procedures for the identification, management, measurement and control of market risk, including limits reflecting the risk appetite approved by the management board;
• e. the investment firm has an appropriate framework for identifying, understanding and measuring market risk, in line with the investment firm’s size and complexity, and that this framework is compliant with relevant requirements in accordance with the relevant EU and national implementing legislation; and
• f. the investment firm has a strong and comprehensive control framework and sound safeguards to mitigate its market risk in line with its market risk management strategy and risk appetite.

6.4.4 Summary of findings and scoring

Following the above assessment, competent authorities should form a view on the investment firm’s market risk. This view should be reflected in a summary of findings, accompanied by a risk score based on the considerations specified in Table 6. If, based on the materiality of certain risk factors, competent authorities decide to assess and score them individually, the guidance provided in this table should be applied, as far as possible, by analogy.

Competent authorities should consider all these factors in parallel and not in isolation and understand the drivers behind Risk-to-Market.

Table 6. Supervisory considerations for assigning a market risk score

Risk Considerations in relation to inherent Supervisory view adequate management and score risk