A Primer on the European Regulatory Structure

By Dilara Mukhomedzhanova
dilara.mukhomedzhanova@jpmorgan.com

Tightening risk regulation around the world has been the subject of considerable discussion in the last few years, driving financial institutions, pension funds, insurance companies and others to take a more comprehensive approach to risk management. Today, regulators force market players to reassess how they address risk and disclose risk information to their investors and a wider public.

As a response to the 2008 financial crisis that revealed the deficiencies in financial regulation, we have been seeing further scrutiny from regulators around the globe. These new rules are designed to address inadequate risk management and the threat of financial instability as a consequence. In our view, risk management should become an integral part of business decisions (including investment strategy and capital allocation) at most entities.

Global Regulatory Structure: Basel II

Published in June 2004, Basel II is the second of the Basel Accords. Basel represents recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision, which was established by the central banks of the G10 countries in 1974. The 1988 Basel Accord linked minimum capital standards to credit risk, and this was extended to market risks in the 1996 Amendment.

The intention of Basel II is to widen the scope of its regulatory framework to cope with more sophisticated institutions and products and to cover a broader range of risks. Basel II is based on three pillars: minimum capital requirements addressing risk, the supervisory review process and disclosure requirements (market discipline). Minimum capital requirements of the new Basel Accord as with Basel I, consist of three components: definition of capital (no major changes from Basel I), definition of risk-weighted assets (RWA) and minimum ratio (remains 8%).

For measuring market risk, the preferred approach is Value-at-Risk (VaR). The model has to capture all the material risks. It must be computed on a daily basis with a 99% one-tailed confidence interval. An instantaneous price shock equivalent to 10-day movement in prices should be used (i.e., the minimum holding period will be 10 trading days). If shorter holding periods are used, VaR need to be scaled up to 10 days by square root of time. The historical observation period will be a minimum of 1 year. A bank must conduct weekly stress testing, with model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the bank’s portfolio. Both sensitivity and scenario analysis must be considered, depending on the portfolio structure of the entity and its trading strategy. For backtesting regulators recommend using the last 250 days of P&L data to back-test the 1% 1-day VaR that is predicted by an internal model. The model should be backtested against both theoretical and actual P&L. The Committee indicated three possible outcomes: green zone (less than 4 exceptions), yellow zone (between 5 and 9 exceptions) and red zone (10 or more, where the bank’s model would be considered unreliable).

The Basel Committee is also reviewing the need for additional capital, liquidity and other supervisory measures. It started first to reference to Basel III in September 2010. The framework is currently in a development stage and should be fully implemented by January 2019. Some of the propositions are to: 1) raise the quality and quantity of capital (for example, banks must hold 4.5% of common equity by January 2015, up from 2% in Basel II), 2) introduce a leverage ratio (minimum of 3%) and two required liquidity ratios (30-day and 1-year stable funding) and 3) use additional capital buffers.

European Level of Regulation: UCITS IV

In 1985 the European Commission enacted a European Directive called UCITS (Undertakings for Collective Investment in Transferable Securities) in order to establish legislative uniformity throughout Europe. With a number of amendments UCITS III was implemented in December 2001 followed by UCITS IV approved by the European Parliament in January 2009 and implemented in July 2011.

UCITS IV prescribes that funds should be classified as sophisticated or non-sophisticated depending on the portion of derivatives embedded in the fund. Non-sophisticated funds would need to adhere to the “Commitment Approach” whereas sophisticated funds must use an internal VaR model to report on general and specific market risks. Risk limits have been defined as 20% of the total portfolio on an Absolute VaR basis (Absolute VaR is not greater than 20% of its NAV) and two times the benchmark risk on a Relative VaR basis. When risk-return profile of UCITS changes frequently, the Relative VaR method should not be used by the fund.

Thirty Years of Bank Capital Regulation

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European Level of Regulation: UCITS IV

Under the VaR approach the key requirements of UCITS IV are to report daily 99% VaR with a 20-day holding period and an effective observation period of the risk factors of at least 250 days unless a shorter period is justified. Quarterly updates of the data or more frequent when a market is volatile are required. Monthly stress tests are sufficient, but for rapidly changing portfolios more frequent stress tests might be appropriate. If one stress test is changed, both previous and modified stress tests should be done simultaneously at least once and results should be compared. The fund has to have a consistent and appropriate VaR methodology and leverage (“fat-tail” risk) must be monitored. Either dirty (effective) or clean (hypothetical) backtesting must be performed at least monthly. Should the number of “overshooting” for the most recent 250 business days exceed four, the model has to be reviewed by the senior management.

UCITS IV introduced the concept of the SRRI (Synthetic Risk & Reward Indicators) which should be disclosed within the Key Investor Information Document (KIID) for each share class of a UCITS regulated fund. The SRRI is a risk grade based on the volatility of the fund. SRRI is a number between 1 and 7 which allows investors to assess the risk applicable to a potential investment in a UCITS regulated fund (1 – low risk/reward, 7 – high level).

SRRI must be calculated on the basis of the weekly performance of the fund or if daily return data is not available, monthly returns will be used. For a new UCITS, a representative portfolio should be built and a simulation of the projected volatility should be performed.

Solvency II

On April 22, 2009, the European Parliament approved the Solvency II framework directive, due to come into force from January 1, 2013. Solvency II introduces a comprehensive risk management framework that defines required capital levels and implements procedures to identify, measure, and manage risk levels for insurance firms that operate in the European Union. Similar to Basel II, Solvency II is based on three pillars: Quantitative requirements, Supervisor review and Market discipline.

While Solvency I requirements concentrated mainly on the liabilities side (i.e., insurance risks), Solvency II takes account of the asset-side risks. The new regime is a “total balance sheet” type (a “delta NAV” approach) where all the risks and their interactions are considered. Insurers will now be required to hold capital against market, credit and operational risks (Solvency I did not cover these). Insurers must have available resources sufficient to cover both a Minimum Capital Requirement (MCR) and a Solvency Capital Requirement (SCR). The SCR is based on a Value-at-Risk measure calibrated to a 99.5% confidence level over a 1-year time horizon, calculated and reported to the supervisory authorities at least once a year. The SCR may be calculated using either a new European “Standard Formula” (where capital charges are standardised by asset class) or an “Internal Model” (whereby insurers calculate their capital requirements using a bespoke model) validated by the supervisory authorities. When assessing the market risk inherent in collective investment vehicles, pooled funds or other “packaged” investments, a “look through” approach should be applied where possible to avoid punitive treatment and higher capital charges. Hedge funds, private equity, commodity, infrastructure and similar investments should be sufficiently transparent to have a lower charge. The standard calculation of the SCR involves six modules with market risk having the highest weight. Market risk in its turn has seven sub-modules covering interest rate, equity, credit spread, property, currency and concentration risks, with the first three being the main components. Correlation matrices, term structures and individual risk shock scenarios are all specified in the EU Directive. Assets should be valued at market value including any currently held at amortised cost. A swap curve with an added illiquidity premium should be used to discount liabilities (which will be the same for all the firms in the EU).

Country specific/National level

The Netherlands. The nFTK (nieuw Financieel Toetsingskader) regulation was introduced in January 2007, requiring pension funds and insurers to test the adequacy of their financial position by maintaining a minimum funding ratio, performing a risk-based solvency calculation for investment risks and carrying out a long-term continuity analysis. The regulation draws attention to any mismatch between assets and liabilities, in particular the interest rate risk (duration match), which arises when the duration/cash flow profile of assets does not equal the average term of liabilities.

Germany. BaFin was formed on Mary 1, 2002 with the passing of the Financial Services and integration Act on April 22, 2002. The aim of this legislation was to create one integrated financial regulator that covered all financial markets. BaFin is a uniform national supervision of banks, credit institutions, insurance companies, pension funds, financial service companies, brokers and stock exchanges. Because the funding rules in Germany are relatively strict, pension funds and insurance companies are required to be fully funded at all times with an additional solvency buffer of 4.5%, which gives a minimum funding level of 104.5%. If the funding level falls below 100%, the pension fund, for example, is declared insolvent. BaFin also defines the investment universe and imposes limits for the maximum investment per asset class or group of classes (diversification rules).

Sweden. In 2006 Finansinsektionen (FI), the Swedish prudential supervisor, introduced the Traffic Light Model. The aim of the model is to identify insurance companies and pension funds that could encounter problems if equity prices, real estate prices, or interest rates, change sharply. The supervisory tool identifies with great accuracy companies with exposure to financial risk that is excessive in relation to their capital buffer. All insurance companies and occupational pension funds must use the traffic light-light model in their reporting.

Norway. Norwegian Finanstilsynet laid out general risk reporting requirements for the local players that involve calculation of the capital buffer and maintenance of an adequate cover for liabilities, risk limit settings, measurement of potential loss, stress testing and backtesting. The risk system should include all positions and be updated at a minimum on a daily basis.

Denmark. In July 2001, The Danish Financial Supervisory Authority (Finanstilsynet, FSA) introduced new financial regulations. The centre piece of the financial reforms was the introduction of marked-to-market valuation of pension liabilities. The FSA also raised the required standard of risk management, risk assessment, and transparency. The key element was the requirement to conduct resilience tests, or Traffic Lights. The net effect of this new procedure was to tighten the overall solvency requirements for all Danish financial institutions.

Conclusion

We live in an environment of constantly changing and demanding regulation that requires the market players to develop advanced risk management systems and have consistent methods, processes and data availability across the firm for risk reporting. J.P. Morgan’s Investment Analytics & Consulting (IAC) Group continues to make significant development to the services we can provide to clients. Our group is committed to provide risk measurements which comply with industry-wide regulation including those mentioned in this article.

J.P. Morgan IAC provides a full security-level ex-ante risk package which includes VaR, stress testing and backtesting. We have identified optimal risk solutions and formed partnerships with leading firms whose innovative methodologies are proven to be effective in meeting our clients’ risk management needs. Our service is customer focused, allowing the client to choose appropriate reporting frequency (daily, weekly or monthly); core risk methodology (Monte Carlo, Historical, and Parametric); confidence interval; historic analysis period and sampling frequency; the look forward period and exponential weighting factor. We can define asset breakdowns at account or fund level in accordance with both regulatory and client bespoke requirements.

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