On the choice of liquidity horizon for incremental risk charges: are the incentives of banks and regulators aligned?

ABSTRACT The recent incremental risk charge to the Basel market risk framework requires banks to estimate, separately, the default and migration risk of their trading portfolios that are exposed to credit risk. The new regulation requires the total regulatory charges for trading books to be computed as the sum of the market risk capital and the IRC for credit risk. In contrast to Basel II models for the banking book, no model is prescribed and banks can use internal models to calculate the IRC. In the calculation of IRCs, a key component is the choice of the liquidity horizon for traded credits. In this paper we explore the effect of the liquidity horizon on the IRC and, in particular, confirm that the framework for assigning liquidity horizons proposed by regulation is consistent with banks' motivation to conserve the regulatory capital requirement. We consider a stylized portfolio of twenty-eight bonds with different ratings and liquidity horizons to evaluate the impact of the choice of the liquidity horizon for a certain rating class of credits. We find that, in choosing the liquidity horizon for a particular credit, there are two important effects that must be considered. The first effect is that the bonds with short liquidity horizons can avoid further downgrading by frequently trading into a bond of the same initial quality. The second effect is the possibility of multiple defaults. Of these two effects, the multiple default effect will generally be more pronounced for non-investment-grade credits as the probability of default is severe, even for short liquidity periods. For medium investment-grade credits, these two effects will in general offset one another and the IRC will be approximately the same across liquidity horizons. For high-quality investmentgrade credits, the effect of the multiple defaults is low for short liquidity horizons as the frequent trading effectively prevents severe downgrades. Our findings are also supported by empirical results from the credit-spread term structure. Therefore, the liquidity horizon specification in the IRC requirement from the Basel Committee "is consistent with the market reality and banks' incentives in capital requirement conservation". Consequently, it alleviates the concerns in IRCs model validation.