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Needless to say, derivatives business is not just about pricing and trading. Financial risk management and the banking global rule book Basel III play essential and overarching roles. Executives must manage the derivatives business in line with the economic and regulatory capital requirements, and seek to optimize risk-adjusted overall business performance.

Risk Measures and Financial Rule Books

Risk measurement and economic and regulatory capital management are crucial parts of the business. Apart from risk sensitivities for hedging, such as Delta Gamma Vega, a range of other risk measures and quantities are also the essential ingredients of day-to-day risk management activities. Table 3.1 itemizes some of such essential risk measures and quantities:

Table 3.1 Essential risk measures and quantities

The activities on these risk measures and quantities are not only driven by best practices, but also financial regulations including tighter capital adequacy rules and stricter collateral requirements for un-cleared derivative trades. Financial rules and regulations have become key elements in the derivatives business, and they are gaining increasing importance. They are among the key drivers for risk management modernization and more efficient and reliable risk infrastructures. It is therefore vital to understand the relevant regulations and their implications on the derivative business, with a view to optimizing capital usage and risk/return.

Basel III

Basel III (Basel 2010, Basel 2013) is a comprehensive set of reform measures that are designed to strengthen the regulation, supervision and risk management of the banking sector. It was developed by the Basel Committee on Banking Supervision as the global banking rule book, and endorsed by G20 countries. While Basel III sets the international standards and rules, they need to be adopted and implemented by individual countries or jurisdictions. In Europe, Basel III is implemented through the legislative package Capital Requirements Directive IV (CRD IV), and the associated Capital Requirements Regulation (CRR).

Basel III has profound business and quantitative impacts on a number of frontiers:

• Capital: Laying down stricter capital rules for the financial firms, with detailed requirements on the quality of capital, capital loss absorption and minimum capital ratios and buffers. The capital ratio is defined as:

where RWA is a risk-based capital measure and its calculation involves risk models and methodologies designed to capture all key risks. RWAs include credit risk as well as market risk RWAs, linking the capital treatments directly to the financial risks including derivative risks. Operational risks also contribute to RWAs.

• Leverage: Setting prudent leverage ratio limit to avoid excessive leverage in financial institutions and in financial systems. The leverage ratio is defined as:

where Total Assets include on- and off-balance sheet assets, and they are not risk-weighted. Setting a floor to the leverage ratio will force financial institutions to optimize assets and capital, in conjunction with RWAs.

• Liquidity: Setting adequate liquidity standards and defining the important liquidity measures, including short-term Liquidity Coverage Ratio (LCR) and long-term Net Stable Funding Ratio (NSFR).

• Systemic risks: Addressing systemic risks within the financial systems and proposing some regulatory incentives to mitigate them. It covers the topics of counterparty credit risk (CCR), provision of capital incentives for using Central Counterparties (CCP), higher capital requirements for systemic derivative instruments, usage of contingent capital, collateral, trading book, securitization, reputation and operational risks, etc.

• Management and supervision: Addressing management principles and policies, firm-wide governance, supervisory policies and practices, market discipline including transparency and disclosure, and remuneration policy.

Solvency II

The much tightened and refined financial regulations on capital and risk management are not only a theme for the banks, they have also become major business topics for the insurance industry. The Solvency II Directive is an EU Directive aiming to unify and harmonize the regulations for the EU insurers, and reduce their risks of insolvency. Solvency II will impose tough requirements on the amount of capital an insurer should hold, governance, quantitative risk measurement, risk management, reporting and disclosure. Indeed, some of the insurance products in real life (e.g. variable annuities) are quite complex and their embedded hybrid derivative risks can be a major source of instability if not measured and managed properly. Hence an appropriate regulation regime for the insurance industry can serve the purpose of raising general risk management standards and optimizing capital and asset allocation. To this end, insurers can learn from banks in terms of implementing internal models under regulatory directives, and balance sheet and business optimization as a result of regulatory compliance.

Basel III Technical Requirements

The evolution of regulatory regime impacts the banks in such a way that Basel III may determine whether some business is still viable. Banks must pay a great deal of attention to the regulatory changes and requirements of risks and capitals. Compared to the previous Basel accord, Basel III has broadened to a combination of measures including capital, liquidity and funding ratios, in addition to market risks. Banks will have to comply with all the measures and corresponding rules, as opposed to one single narrow measure, hence creating more balanced and stable financial environments and systems. Within this regulatory framework, banks need to optimize the capital usage and efficiency, and carry out appropriate infrastructure projects to comply with the rules.