Brexit, hedging costs and the SMA

BREXIT puts spotlight on political risk

NSFR rules threaten spike in hedge costs

SMA comes under fire again

COMMENTARY: The art of the possible

The UK referendum on European Union membership this week has produced a political upheaval in what had been one of the EU's more politically stable members. The financial sector has not been immune. And over the past few weeks, banks in the UK, the EU and elsewhere have been taking a new look at the issue of political risk.

This hasn't been an easy process. Pricing in highly significant binary events such as Brexit is causing headaches – and high volatility and skew on major indexes. The rates and credit markets have become similarly unnerved, with some dealers conceding largely one-way client trades in these asset classes have been hard to recycle.

All the problems that apply to operational risk modelling – lack of historical loss data, dominance of tail risks, diversity of causes and event types – apply to political risk, but more so. The idea of modelling political risk at the level of detail and reliability expected for market and credit risk belongs to science fiction – 'psychohistory' is still merely imaginary. For this reason, many banks are turning to political risk insurance to cover the dangers of future political upheaval elsewhere in the world.

At present, the Advanced Measurement Approach allows them to reduce their regulatory capital for operational risk by taking out insurance – but the AMA's successor, the Standardised Measurement Approach, may not be so accommodating. The final version of the rules has yet to be decided, and lobbying to include insurance has been intense. Ironically, one of the most significant political risks banks face may revolve around the rules for managing political risk.

STAT OF THE WEEK

SPX one-month at-the-money forward implied volatility was at the 79th percentile level for the past three years as of June 21, and one month 95-105% skew at the 99th percentile.

QUOTE OF THE WEEK

"Model risk management has become a board-level process. Now the chief risk officer or the chief model risk officer has to go to the board and not only talk about market risk, credit risk and operational risk, he also has to talk about model risk. It is a huge organisational change" – New York-based model risk manager

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