fundamental review of the trading book bcbs d352the new market risk capital regulation -fundamental...

May 2016

Fundamental Review of the Trading Book BCBS D352

Minimum Capital

requirements for Market Risk

Agenda

Introduction

1. Trading Book/Banking Book Boundary

2. Revised internal Model Approach� Expected shortfall risk measure to replace

VaR and Stressed VaR� Liquidity Horizons inclusion in the Expected

Shortfall calculation� Internal Models validation at regulatory

trading desk level� Capital Add-on for Non-modellable Risk

Factors� Default Risk Charge� Risk exposure to be measured on an intra-

day basis

3. Revised Standard rules� The sensitivities-based method� The standardised default risk charge� Residual Risk charge

Conclusion

Appendix 1 – Revised Model vs Current Model Impact SimulationAppendix 2 – Revised standardised vs Internal Method Approach Impact SimulationAppendix 3 – Revised Model vs Current Model Impact Simulation for Securitization

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2 | All Rights Reserved – 2016 © CAPTEO - FRTB BCBS D352

Introduction

Scheduled implementation date: 2019 (depending on localjurisdiction) (Art. 44)

The new Market risk capital regulation - Fundamental Review of the Trading Book – BCBS D352 Minimum capital requirements for Market Risk - touches upon a number of complex but pivotal issues –from the design of the basic model used to measure risk, to the process for deciding what sits in the banking and trading books.The FRTB is primarily aimed at consolidating existing measures, reducing variability in capital levels across banks and reinforce the capital framework for trading activities according to the Basel Committee on Banking Supervision.

The January 14th 2016 Basel Committee on Banking Supervision explanatory note to the FRTB estimated that the rules were likely to result in an approximate median capital increase of 22% and a weighted average capital increase of 40% of the market risk capital - compared with the current framework.The norm describes two methods to calculate the market risk, an Internal Model Approach (IMA) and a standardised Approach (SA). The complexity and the constraints associated with the IMA pushes the experts to interpret that the regulator wants a more global use of the SA. Though, BCBS simulations (Appendix 2) are showing a 40% capital overcharge of the SA compared to the IMA. However, the figures are highly depending on the not yet confirmed capital floor issue.

FRTB Timeline

1st 2nd 3rd 4th

Quantitative Impact Study

1st

consultative paper

May Jan.

RCAPMarket

RWA

Oct.

2nd

consultative paper

2012 2013 2017 2018

Apr.

Mar.

Annex to 2nd

consultative paper

3rd

consultative paper

Jan.

FinalizedFRTB

Standards

2016

Rule making

Monitoring and recalibrations

National rule making

Monitoring and approval process

Institutional implementation

Jan.

FinalNational

Standards

Dec.

2019

Latest 1st

reporting date

BCBSNationalInstitutions

Legend :

Dec.

Jul.

2014 2015

Q3Q2

Banks are required to start reporting under the new FRTB standards by year-end 2019. The following timeline illustrates the milestones and tasks that an IMA approved.

3FRTB BCBS D352 - All Rights Reserved – 2016 © CAPTEO |

FRTB at a Glance – ISDA Briefing Notes - April 2015

■ New rules determining the scope of instruments eligible for inclusion in the trading book, and more stringent requirements governing internal risk transfers between the banking and trading book.

■ A revised standardised approach for market risk based on price sensitivities, which is intended to be more risk sensitive compared to the existing standard approach, and therefore reduce the gap between internal models and standard rules.

■ The substitution of value at risk and stressed value at risk with an expected shortfall risk measure to capitalise for loss events in the tail of the P&L distribution.

■ The introduction of liquidity horizons in the expected shortfall calculation to reflect the period of time required to sell or hedge a given position during a period of stress.

■ Replacement of the incremental risk charge with an incremental default risk model, which is designed to capture default risk in the market risk framework.

■ Back-testing requirements of internal models at trading desk level. Failure to meet the validation criteria would force a desk to revert to using the standardised approach.

■ Enhanced public disclosures on market risk capital charges, including regulatory capital charges calculated using both standardised and internal models approaches.

Key components

NOTE - January 2016 update highlight

The latest FRTB publication, dated January 14th 2016, includes a “modified residual risk charge for exotics and a reduction in the liquidity horizons for some categories of risk factor. However, these have been offset by an increase in the capital multiplier for banks’ internal models, which is now set at 1.5.” (Risk magazine - “Final FRTB is a game of give-and-take, say dealers“ - 18 January 2016)


1. Trading Book Banking Book Boundary

The new regulation lists instruments presumed to be in the trading book (art. 12 to 16), and a bank must receive explicit approval from the supervisor to book any other instrument in the Trading Book. It also has to document any deviations from the presumptive list in detail on an on-going basis (art. 17).The norm imposes also a limit on the movement of instruments between the banking book and trading book (art. 27).

Any movement between books must be approved and documented (art. 29).Policies must be updated, at least yearly (art. 30), and procedures defined and approved by senior management (art. 21).

Stricter limits along with capital disincentives are applied to the booking and transfer of instruments between the banking book and trading book.

Supervisors powers

Finally, supervisors powers over the booking control are extended. They can request a shift from the trading book to the banking book or vice versa if an instrument is deemed to be improperly designated or if the evidence provided is deemed incomplete (art 18 and 19).Banks have also to report on their boundary determination and assessments, as well as document compliance and conduct yearly internal audit of instrument designation (art. 20).

Internal risk transfers

There will be no regulatory capital recognition for internal risk transfers from the trading book to the banking book (art 32); restrictions apply for such transfers from the banking book to the trading book (art 34 to 36)

Trading Book Banking Book

Definition

Instruments comprise financial instruments, foreign exchange, and commodities that are held for the purpose of :

• Short term resale• Profiting from short term price movement• Locking in arbitrage profit• Hedging risks that arise from instruments meeting

previous criteria

Instruments not defined in the trading book

Products

• Instruments in the correlation trading portfolio• Instrument that is managed on a trading desk• Instrument giving rise to a net short credit or equity

position in the banking book• Instruments resulting from underwriting

commitment• Instrument held in the « held for trading » IAS39

section• Instruments resulting from market making activities• Equity investment in a fund (excl BB)• Listed equities• Trading related repo transactions• Options from instruments out of the BB that relate

to credit or equity risk

• Unlisted equities• Instrument designated for

securitisation warehousing • Real estate holdings; • Retail and SME credit • Equity investments in a fund

non daily valuable• Derivative instruments that

have the above instrument types as underlying assets

• Instruments held for the purpose of hedging a particular risk of a position in the types of instrument above


2. Revised internal Model Approach

The Var (99%) and stressed VaR market risk measurements are replaced by the Expected Shortfall (ES(97.5%)) to better take in account “tail risk” and market illiquidity; this according to the following formula (art. 181):

Expected shortfall risk measure to replace VaR and Stressed VaR

where:■ ES is the regulatory liquidity-adjusted expected shortfall;■ T is the length of the base horizon, ie 10 days;■ EST (P) is the expected shortfall at horizon T of a portfolio with positions P = (pi) with respect

to shocks to all risk factors that the positions P are exposed to;■ EST(P, j) is the expected shortfall at horizon T of a portfolio with positions P = (pi) with respect

to shocks for each position pi in the subset of risk factors Q(pi , j), with all other risk factors held constant;

■ the ES at horizon T, EST(P) must be calculated for changes in the risk factors, and EST(P, j) must be calculated for changes in the relevant subset Q(pi , j) of risk factors, over the time interval T without scaling from a shorter horizon;

■ Q(pi , j)j is the subset of risk factors whose liquidity horizons, as specified in paragraph 181(k), for the desk where pi is booked are at least as long as LHj according to the table below. For example, Q(pi,4) is the set of risk factors with a 60-day horizon and a 120-day liquidity horizon. Note that Q(pi , j) is a subset of Q(pi , j–1);

■ the time series of changes in risk factors over the base time interval T may be determined by overlapping observations; and

■ LHj is the liquidity horizon j, with lengths in the following table:

The maximum stress to be calculated can be computed on a reduced set of bank-selected risk factors, provided that these factors explain at least 75% of the variation in the ES model with a full set of risk factors (art.195 to 202).

For a bank that has bank-wide internal model approval for capital requirements for non-securitisationsin the trading book, the total IMA capital requirement would be an aggregation of ES, the default risk charge (DRC) and stressed capital add-on (SES) for non-modellable risks.

Banks must calculate, in parallel of IMA and at least monthly, the standardised capital charge for each trading desk as if it were a standalone regulatory portfolio (art. 184). Also, Securitization exposures cannot be calculated with IMA, thus must be calculated using the Standardised Approach.


BCBS illustration of the process and policy design of the internalmodels-based approaches (IMA)

Banks will be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If a bank fails to meet the capital requirements at any time, the national authority shall ensure that the bank takes immediate measures to rectify the situation. (Art. 3)

Risk exposure to be measured on an intra-day basis


Global Expected Shortfall (RS):Equal weighted average of diversified ES and non-diversified partial ES capital charges for specified risk classes

Modelable Non Modelable

Default Risk Change (DRC):Captures default risk of credit and equity trading book exposures with no diversification effects allowed with other market risks (including credit spread risk)

Stressed capital add-on (SES):Aggregate regulatory capital measure for non-modelable risk factors in model-eligible desks

Step 3 Individual risk factor analysis� Risk factors must be based on real,

verifiable prices� Frequency of observables prices

Step 2ii Assessment of trading desk-level model performance against quantitative criteria� Clear thresholds for breaches of P&L

attribution and backtesting procedures

Step 2i Banks nominate which trading desks are in-scope for model approval and which are out-of-scope

Step 1 Overall assessment of the banks’ firm-wide internal risk capital model

The internal Models Approach for Market Risk

Standardised approach for entire trading book

Fail

Standardised approach for specific trading desks

Fail

Out of scope

Securitisation exposures in the trading book are fully out of scope of internal models and capitalised in the revised standardised approach

To take better in account market illiquidity, the BCBS listed the liquidity horizon to take in account in the Expected Shortfall calculation for the different market instruments (see ES formula).“Liquidity horizon” is defined as the time required to exit or hedge a risk position without materiallyaffecting market prices in stressed market conditions, and have been set according to the followingtable.

Liquidity Horizons inclusion in the Expected Shortfall calculation

Liquidity Horizon Table as of January 14th 2016 (art. 181 (k)):

Risk factor category n Risk factor category n

Interest rate: specified currencies - EUR, USD, GBP, AUD, JPY, SEK, CAD and domestic currency of a bank

10 Equity price (small cap): volatility 60

Interest rate: – unspecified currencies 20 Equity: other types 60

Interest rate: volatility 60 FX rate: specified currency pairs 10

Interest rate: other types 60 FX rate: currency pairs 20

Credit spread: sovereign (IG) 20 FX: volatility 40

Credit spread: sovereign (HY) 40 FX: other types 40

Credit spread: corporate (IG) 40Energy and carbon emissions trading price

20

Credit spread: corporate (HY) 60Precious metals and non-ferrous metals price

20

Credit spread: volatility 120 Other commodities price 60

Credit spread: other types 120Energy and carbon emissions trading price: volatility

60

Equity price (large cap) 10Precious metals and non-ferrous metals price: volatility

60

Equity price (small cap) 20 Other commodities price: volatility 120

Equity price (large cap): volatility 20 Commodity: other types 120


Internal Models validation at regulatory trading desk levelInternal Models eligibility is determined and validated at regulatory trading desk level (art. 183).This measure allows regulators to refuse more easily agreement to use internal models, hence impacts capital charge through standardised method, for the risk calculation of specific trading desks.It also does impact banks organization and risk calculation process (potentially intraday). Banks have to be able to answer requirements to calculate ES and P&L accurately at desk level, and also to document and justify the eligibility to IMA at such level.

ES model approval for each desk is premised on two quantitative validation criteria:

■ Profit and loss (P&L) attribution. Atest to determine whether the P&L

Capital Add-on fornon-modellable Risk Factors Within an IMA eligible trading desk, the bank must also identify which risk factors in its model are “modellable” and which are “non-modellable” according to a set of conditions (art. 190). Risk factors that do not meet these conditions are deemed to be non-modellableand must be capitalised individually using a separate stressed capital add-on from the ES approach used for modellable risk factors, the standardised charge (Art. 193)

Default Risk Charge

The DRC replaces the former IRC for trading book positions to capture default risk exclusively (separate from all market risks,including credit spread risk) (art. 186).It must be measured using a VaR model.

Internal Model expected shortfall to capital charge multiplier set to 1.5 (Jan 14th 2016)The multiplier factor used in the Capital Charge calculation for a specific desk has been raised from 1 to 1.5 in the latest January 2016 publication of the regulation (Art. 189).

where SES is the aggregate regulatory capital measure for K risk factors in model-eligible desks that are non-modellable. The multiplication factor mc will be 1.5 or set


based on risk factors included in thetrading desk’s risk managementmodel captures the material driversof actual P&L.

■ Backtesting. A test to determinehow well the risks in an internalmodel are captured.

Models must be validated after initial development, after any significant modification, and also periodically “by suitably qualified parties independent of the development process” (art. 182).

After initial validation, in case disrespect of the quantitative validation criteria, the targeted trading desk would have to calculate its capital charge for 6 months, and could then proceed to a new request to IMA, providing 1 year of historical data on the criteria.

“The aggregated charge associated with approved desks (CA) is equal the maximum of the most recent observation and a weighted average of the previous 60 days scaled by a multiplier (mc).

by individual supervisory authorities on the basis of their assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 1.5.”

3. Revised Standard rules

Banks will be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If a bank fails to meet the capital requirements at any time, the national authority shall ensure that the bank takes immediate measures to rectify the situation. (Art. 3)

Revised standard rules

The Standard rules have been revised to be closer to IMA method. It must be calculated by all banks on a monthly basis (Art. 45).Securitization exposures also have to be calculated with the specific standardised method.The calculation approach for this method more complex compared to the previous regulation approach.

It is composed of three main components:■ The sensitivities-based method■ The standardised default risk charge and■ The residual risk add-on.

Sensitivities-based Method: Capital charges for delta, vegaand curvature risk factor sensitivities within a prescribed set of risk classes:

General interest Rate Risk (GIRR)Credit Spread Risk (CSR): non securitisationCSR: securitisationForeign Exchange (FX): RiskEquity RiskCommodity Risk

Default Risk Charge (DRC) for prescribed risk classes:

Default risk: non securitisationDefault risk: securitisationDefault risk: securitisation correlation trading portfolio

Banking book-based treatment of default risk, adjusted to take into account more hedging effects

Residual risk add-on (RRAO):

Risk weights applied to notional amounts of instruments with non-linear payoffs

The standardised approach for Market Risk


The standardised default risk charge

This risk charge aims at taking in account the jump-to-default risk.Securitisation exposures have their own set of rules for DRC calculation.

The framework for default risk requires that positions are allocated to default risk bucket categories (eg corporates, sovereigns, local governments/municipalities for non-securitisation exposures). The calculation is based on given loss given default portion of the notinal amount, weighted according to the counterpart rating.The standardised DRC allows for some limited hedging recognition within each bucket category, but not across different bucket categories.

Residual Risk charge The Residual Risk Add-on is the simple sum of gross notional amounts of the instruments bearing residual risks, multiplied by a risk weight of 1.0% for instruments with an exotic underlying, not taken in the delta, vega or curvature calculation, and a risk weight of 0.1% for instruments bearing other residual risks. (Art. 58).

inputs to a similar aggregation formula as for Delta risks.

■ Curvature: A risk measure which captures the incremental risk not captured by the delta risk of price changes in the value of an option. Curvature risk is based on two stress scenarios involving an upward shock and a downward shock to a given risk factor. The worst loss of the two scenarios is the risk position (defined in paragraph 48) to be used as an input into the aggregation formula which delivers the capital charge.” (Art. 47 (a)).”

The two latest being dedicated to the products with optionality.

Correlation effects are taken in account in the Capital calculation for each risk class. Three scenarii are then applied to these effects: high correlation (125% of the defined factors), medium (100%) and low correlations (75%). The scenario with the highest impact is to be taken in account in the calculation.

The sensitivities-based method


The revised methodology is based on the already existing use of sensitivities but extending it to a broader set of risk factors.The standardised “bucket” risk weights given by the regulation within each risk class have been calibrated using an ES methodology, incorporating the concept of varying liquidity horizons.

“The risk charge under the Sensitivities-based Method must be calculated by aggregating the following risk measures:

■ Delta: A risk measure based onsensitivities of a bank’s trading bookto regulatory delta risk factors.Delta sensitivities are to be used asinputs into the aggregation formulawhich delivers the capitalrequirement for the Sensitivities-based method.

■ Vega: A risk measure that is alsobased on sensitivities to regulatoryvega risk factors to be used as

Exotic exposures include longevity risk, weather, natural disasters and – when used as an underlying for a swap – future realisedvolatility. Carbon emissions, which were considered ‘exotic’ in an earlier document, have been removed in the January 14th 2016 publication.

Conclusion

The Fundamental Review of the Trading Book –Minimum capital requirements for Market Risk – is an extensive review of the Market risk capital allocation and calculation.

It will definitely have a major impact on banks’ processes, organization, activities and capital amounts to cover Market Risk.

Experts expect a move from current advanced methodology to the new standardised one, though based on the Basel Committee for Banking Supervision, this would imply a non-negligible capital cost compared to the new Internal Method Approach. However this last issue is highly depending on the implementation, or not, of the standardised approach capital floor for the internal model approach, that is still under discussion at the time of the redaction of this document.


Appendix 1 – Revised Model vs Current Model Impact Simulation (src BCBS)

Appendix 2 – Revised standardised vs Internal Method Approach Impact Simulation (src BCBS)

Appendix 3 – Revised Model vs Current Model Impact Simulation for Securitization (src BCBS)


■ Risk modeling and quantification■ Cartography and optimal validation process definition (Validation

and documentation)

How we can help

BUSINESS IMPACTS & STRATEGY

■ Provide decision-making solutions by simulating impacts, projecting strategic and business related items Risk modeling and quantification.

■ Comparative impact analysis between market risk IMA and SA approaches + Impact of FRTB new publications

■ Impact assessment on organization, models, IT, processes and businesses

■ Project Management Office (PMO) to coordinate FRTB streams■ IT data framework rationalization: golden source, reorganization

■ IT diagnostic: as-is, target, opportunities for change■ Data management optimal IT framework design

PROGRAMMANAGEMENT

DATA MANAGEMENT

SUPPORT IN DECISIONS

MODEL DESIGN & VALIDATION

■ Provide decision-making solutions by simulating impacts, projecting strategic and business related items

■ Manage & facilitate communication with Top Management

OPTIMIZATION & CAPITAL

■ Assess cross-impacts & implement synergies: quantitative, IT, organization, process – FRTB Arbitrages

■ Design optimal book structure, parallel runs, cost efficient processes


VALUATION ASSESSMENT

DESK ELIGIBILITY ANALYSIS & BOUNDARY

STRATEGY IMPACTS TRADING DESK & HEDGING

INTERNAL

RISK TRANSFERS

BACKTESTING

REQUIREMENTS MONITORING

PROCESS

DESIGN ROADMAP& OPERATIONAL SET-UP

DESK ELIGIBILITY & BOUNDARY ASSESSMENT TB/BB

RISK CAPITAL ASSESSMENT

CALIBRATION

FRTB - CVALIMITS &

ALLOCATION

MODEL DESIGN SA - IMA& RISK CAPITAL ASSESSMENT FRTB

Sensitivity-basedRisk charge

Default Riskcharge+ Residual

Risk Add-On+

NMRF

IMPLEMENTATION FRTB OBSERVATION & TEST

HOMOLOGATION& REPORTING DESK

REDACTION DOSSIER

HOMOLOGATION

VALIDATION INTERNE DOSSIER HOMOLOGATION

PREPARATION REPORTING DESK

& PROCESS

COMPOSITION TRADING BOOK

PROCEDURES MONITORING

PROCESS & PLAN CONTRÔLE RISK

2016 2016

Q42017

Q42019

IMA

SA

Q12018

Trading Portfolio Position Analysis &

Valuation

FRONT

RISK

PRODUCTCONTROL

ACTIVITES PORTEFEUILLE TRADING

PnLAttribution

Process

Richard TEUSCHERDirecteur GénéralMobile : 06 17 35 85 51E-mail : [email protected]

11 Avenue de l’Opéra75 001 PARIS

Tel : 01 40 40 10 10Fax : 01 40 40 10 11Web site : www.capteo.com

Gabriel LETHUDirecteur – Risk & FinanceMobile : 06 77 56 69 22E-mail : [email protected]

Rodolphe RANCERisk ManagerMobile : 06 73 63 15 07E-mail : [email protected]

Contacts

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