The VAR-based approach is insufficient for these types of exposures and needs to be supplemented with a default risk charge. In addition, it is critical that banks conduct rigorous Pillar 2 stress testing of their trading book exposures. They must factor in liquidity horizons and reflect these results in their risk limits, economic capital and concentration management strategies.
Many structured credit products are tailored for individual investors and have a limited or no secondary market. The Basel II framework has guidelines for what should and should not go into the trading book and these need to be reviewed by banks. In the second pillar of the Basel framework, supervisors will be reinforcing the importance of banks’ stress testing practices.