Trading book and credit risk : how fundamental is the Basel review ?

In its October 2013’s consultative paper for a revised market risk framework (FRTB), the Basel Committee suggests that non-securitization credit positions in the trading book be subject to a separate Incremental Default Risk (IDR) charge, in an attempt to overcome practical challenges raised by the joint modeling of the discrete (default risk) and continuous (spread risk) components of credit risk, enforced in the current Basel 2.5 Incremental Risk Charge (IRC). Banks would no longer have the choice of using either a single-factor or multifactor default risk model but instead, market risk rules would require the use of a twofactor simulation model and a 99.9-VaR capital charge. Proposals are also made as to how to account for diversification effects with regard to calibration of correlation parameters. The Committee finally advocates disclosure of a desk-level calculation, including a breakdown by individual risk factor. In this article, we analyze theoretical foundations of these proposals, particularly the link with one-factor model used for the banking book and with a general Jfactor setting. We thoroughly investigate the practical implications of the two-factor and correlation calibration constraints through numerical applications. We introduce the Hoeffding decomposition of the aggregate unconditional loss for a systematic-idiosyncratic representation. Impacts of J-factor correlation structures on risk measures and risk contributions are studied for long/long and long/short credit-sensitive portfolios.