Treatment of trading book positions sensitive to institution’s own credit spread in the internal VaR and stress VaR model

Should institutions include the price risk stemming from its own credit spread in the VaR and stress VaR model?

Examples for positions whose value is sensitive to the own credit spread are structured bonds issued from the trading book or certificate business in the trading book but also from market-making in issuances that were originally issued from the banking book and index positions where the bank itself is part of a broad index that it is trading. The capital impact that inclusion of own credit spread in the VaR and stress VaR model has depends on the position in own debt and the position of the residual trading book. If the residual is credit long which is probably the most common positioning and the own debt position is credit short (e.g. issuance of own bonds) the inclusion of own credit spread could lead to a risk reduction and lower own funds requirements. This question refers solely to the VaR and stress VaR model for the calculation of market risk. For the credit valuation adjustment (CVA) risk Art. 381 CRR clarifies that CVA does not reflect the current market value of the credit risk of the institution to the counterparty, in other words: the own credit spread shall not be considered in the calculation of the CVA risk. The following references to own credit risk can be found in the CRR:  1) According to the prudential filter in Art. 33 CRR institutions shall not include gains or losses on liabilities valued at fair value that result from changes in the own credit standing of the institution in any element of own funds. It is important to notice that the prudential filter does not exclude the effects of changes in the own credit spread altogether as it refers only to liabilities.  2) Paragraph 7 of the EBA Guidelines on IRC (EBA/GL/2012/3) states that both, long and short positions in institutions own debt should be included within the scope of the IRC model but only migration risk should be taken into account. The default risk of long positions may be taken into account (but does not have to) whereas the default risk of short positions is not allowed to be taken into account. Art. 367 (1) CRR requires that the internal model shall capture accurately all material price risks. Applying this requirement to positions sensitive to the own credit spread would lead (where material) to an inclusion of own credit spread as a risk factor in the VaR and stress VaR model. On the other hand, if consistency with the prudential filter is to be achieved in the VaR and stressed VaR calculation, gains and losses excluded according to Art. 33 CRR should also not be taken into account in the modelling as otherwise the measured risk would be affected by a risk factor that is excluded from the prudential determination of own funds.