11:10 | 23/08/2017 Finance - Banking
(VEN) - The State Bank of Vietnam (SBV) has issued Circular 41 in 2016 stipulating the required capital adequacy ratio (CAR) for banks and foreign bank branches in order to apply Basel II standards in Vietnam. Circular 41 will take effect as of 01 January 2020.
|The SBV issued Circular 41/2016/TT-NHNN in order to apply Basel II standards in Vietnam - Photo: Vietnamfinance|
The circular 41 and the Basel II Accord’s requirements in terms of market risk, especially related to capital measurement and valuation methodologies, are outlined below.
The capital measurement for market risk under Circular 41 and Basel II appear to be quite similar in formula, except for some slight differences regarding scope of commodity risk, risk weight for non-rating instruments when identify specific risk.
Under Basel II, the valuation of capital for market risk is the total of capital charges for interest rate risk – with the exception of options (KIRR) in the Trading Book, capital for equity risk – except options (KER) in the Trading Book, capital for foreign exchange rate risk – except options (KFXR) throughout the bank, capital for commodity risk – except options (KCMR) throughout the bank and the capital only for options (KOPT). Meanwhile, for capital calculation purpose, Circular 41 limits the scope of commodity risk to those incurred in the Trading Book.
The capital charge for interest rate risk is expressed in terms of two separately calculated charges. The first applies to specific risk of each instrument arising from issuer – related factors, whether it is a short or a long position. In measuring this type of risk, no offsetting will be permitted between different financial items, even if they are from the same issuer. The second applies to general risk in the portfolio resulted from adverse movement of the market interest rate, where long and short positions in different securities or instruments can be offset.
The capital charge for equity risk is also expressed in terms of two separately calculated charges, including specific risk and general risk. Specific risk is defined as the bank’s gross equity positions, that means the total value of all long equity positions and all short equity positions. The latter one is determined by absolute value of the difference between the sum of the longs and the sum of the shorts. Both charges will be 8 percent, except for index derivatives in calculating general risk, it will be 10 percent.
The capital charge for foreign exchange rate risk is designed to cover the risk of holding or taking position in foreign currencies, including gold. The charge for foreign currencies will be calculated by 8% of the higher of either the net long currency positions or the net short currency positions. And the charge for gold will be 8% of the net position.
The capital charge for commodity risk covers both directional risk arising from a change in the spot price and a variety of other additional risks. The first component - directional risk capital charge will equal 15 percent of the net position of each commodity in the Trading Book. And the second component - other risks charges are set at 3 percent of the bank’s gross position (long plus short) by value in each commodity.
The capital charge for Options is complicated in nature due to the fact that the value of options depends on many different factors, which are difficult to forecast. As such, it should be calculated separately based on the risk of its underlying assets, including interest rate risk, equity risk, foreign exchange risk and commodity risk.
In calculating capital requirement for market risk, it is essential to determine the bank’s position based on market value, which is done by either of the two common methodologies: mark-to-market and mark-to-model methods.
Under Basel II, marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Meanwhile, Circular 41 stipulated that banks must use prices or market data from an official market. This stipulation may cause difficulties for banks in valuation because Vietnamese official market for some financial instruments has not been developed.
However, both are agreed that banks must mark-to-market as much as possible. The more prudent side of bid/offer price must be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. In case mark-to-market method is not possible, banks may mark-to-model where this can be demonstrated to be prudent. Marking-to-model is defined as any valuation has to be benchmarked, extrapolated or otherwise calculated from a market input. Therefore, the result of mark-to-model method cannot be closed to the prices in reality as mark-to-market one.
Banking Book and Trading Book
Both Circular 41 and Basel II mention about the classification of financial instruments/items into either the Trading Book or the Banking Book as an important step to calculate market risk’s capital requirement exactly. Banks should issue suitable policies, processes, criteria and establish functions which make sure separate these two Books clearly and meet the requirement of SBV and Basel II Accord. Besides, it is necessary to have a standard data system from banking transactions to clarify which transactions belong to Trading Book or Banking Book.