Perspectives | 6 August 2020
The revised market risk
framework – also known as the Fundamental Review of the Trading Book (‘FRTB’) – not only impacts an institution’s regulatory capital charge
calculation for market risk, but also affects operational, governance and
business strategies.
FRTB brings significant change. With the aim of
harmonising capital standards for market risks across jurisdictions and
preventing significantly undercapitalised trading book exposures, changes
include a revised Trading/Banking book boundary and a revised Internal Models
Approach (IMA) approval process (P&L attribution and back testing) with new
market risk measures (Expected Shortfall, Default Risk Charge, Non-Modellable
Risk Factors). Further changes include a revised Standardised Approach (SA)
with a sensitivity-based methodology and a new role in determining the IMA
floor, as well as more stringent requirements in terms of policies, procedures
and reporting.
After multiple delays, the international Basel
Committee on Banking Supervision (BCBS) finally set the deadline for FRTB
implementation in 2022 – Q1 for SA and Q4 for IMA.
Overview on dependencies and agenda
There exists a cross dependency between FRTB
regulation and IBOR transition requirements defined by central banks. As per
FRTB requirements, the new definition of the trading desk requires institutions
to have a well-defined and documented business strategy. Institutions need to
revise their product strategy to restructure the existing IBOR-based
derivatives portfolio and ensure a switch to the RFR-based strategy. Meanwhile,
IBOR reform raises important challenges for FRTB implementation, in particular
for the risk factor definition and for IMA capital modelling and computation. With
the uncertainty around LIBOR publication beyond 2021 and the insufficient
volumes of RFR-linked transactions, issues arise in terms of Interest Rate (IR)
data and liquidity which may result in material increases in market risk
capital requirement.
With their overlapping timelines, both IBOR and
FRTB projects are of major importance and require close cooperation between all
stakeholders, including front office, market risk managers, IT teams, as well
as quants and risk modellers. Fundamental to ensuring a smooth transition to
RFRs will be communication and coordination so that everyone is aware of the
cross dependencies between these projects. Resources are key. For example, IT
resources need to ensure reliable test environments for both projects. Additional
resources are required by quants and risk modellers to work on the construction
of robust IR models that follow modelling requirements and adhere to the
principles of modellable risk factors as required by FRTB.
Impact on market risk modelling: what are the
challenges and how will the industry and regulators respond?
From a modelling perspective, the capital
requirement computation under SA is less challenging than IMA since all the
price determinants, as well as capital aggregation formulas and parameters, are
defined by the Regulator. Therefore, cross dependencies with IBOR reform should
be limited to an operational challenge: adapting the pricing systems to the new
rate curves.
However, the cross dependencies between IBOR
and FRTB become more significant where a bank gets regulatory approval to
determine its regulatory capital requirements for market risk using IMA.
IR risk factors: definitions and modelling
As defined by the revised market risk
framework, risk factors are variables that affect the value of an instrument,
for example an equity or IR spot rate. Hence RFRs impact the IR risk factor
definition.
By 2022, LIBOR will be less liquid, if not
unobservable, and RFR liquidity will increase as they become the reference IR.
Therefore, all the IR models currently based on LIBOR market data calibration
will need to be amended. At this point in time, the industry is not expecting
material model changes since robust modelling assumptions shall remain the
same. However, RFRs are overnight fixings and RFRs by term structure are
computed by averaging the daily compounded spot rates over the previous months.
This means that the rate is backward-looking and will not be suitable for
structured products such as caps and floors based on forward-looking LIBOR. Until
the regulators provide a final definition of term structure RFRs, this change
might require banks to amend their pricing models. Additionally, IR model
parameters are subject to re-calibration in order to take account of the new
instruments quoted with respect to RFRs, such as Credit Default Swaps (CDS).
Given the tight timeline, as well as the nature
and volume of changes implied by the IBOR transition, market participants –
particularly from the banking industry – are pleading for regulators to be flexible.
It is of the utmost importance that institutions can properly review their
models and prioritize the changes consistently with their materiality. For
example, changes that would be qualified with different levels of priority
include:
- The switch to euro short-term rate (ESTER) discounting by central counterparties (CCPs) on July 27th, 2020: this is considered an important change which requires pricing systems to be adapted by this date.
- RFR data quality and backfilling: this should be considered as a top priority as the computation of risk measures will depend on the reliability of RFR quotes.
- Model re-calibration requiring RFR market liquidity should come later in the agenda. Indeed, credit models based on the CDS spread currently quoted with respect to LIBOR, will be subject to re-calibration when the CDS spread is quoted with respect to RFRs. As published by the FED mid-July 2019[1]: the publication of pre-production estimates of the Secured Overnight Financing Rate (SOFR) going back to 1998 allows banks to study SOFR data characteristics and make comparisons with other rates such as the US repo and the effective federal funds rate (EFFR). For further examples of data proxies, please refer to our article[2] .
Expected Loss: Data quality challenges and risk factor
proxies
The Expected Shortfall (ES) computation involves
three calculations: ES on the reduced set of risk factors during the current
period, ES on the reduced set of risk factors during the stressed period, and
ES on the full set of risk factors during the current period. The reduced set
of risk factors needs to explain 75% of the fully specified ES model.
On the one hand, while RFRs are important risk
factors, banks may want to include them in the reduced set of risk factors.
However, the lack of data on RFRs during the 12-month stressed period raises
the challenge to find the appropriate proxy for RFRs during this stressed
period. On the other hand, with LIBOR becoming increasingly illiquid, IBOR
benchmarks will also suffer poor data quality problems and will therefore need
to be proxied during the current period.
Expected impacts on regulatory capital requirements
The
latest FAQ published by the BCBS[3] in June 2020 provided some relief regarding the forbearance on regulatory
capital requirements:
- Both IBOR and RFR price observations can be used in the Risk Factor
Eligibility Test (RFET) for a period of time that should not exceed 12 months
after LIBOR discontinuation date.
- Regarding the computation of the ES: the RFRs deemed modellable risk factors,
can be used to compute the ES on the current period for full and reduced set of
risk factors. IBOR benchmarks can be used to compute the ES on the reduced set of risk factors during the stressed period.
Therefore,
the RFRs seem to be fully modellable. However, they remain subject to RFET and
the reduced set must be approved by the regulator and meet the data quality
requirements. For example, the identified reduced set of risk factors must be
able to explain a minimum of 75% of the variation of the full ES model. In case
a RFR is to be considered as non-modellable or in case one of these conditions[4] is not met, banks would have to compute Non-Modellable Risk Factors (NMRF),
which may have a material impact of the capital increase.
External cross
dependencies impacting the future of both projects
The COVID19 crisis might
have an impact on the IBOR transition agenda and on FRTB implementation: the
market turmoil in March 2020 has led to increased doubts on the market
liquidity of RFRs. The current situation begs the question whether the end of
2021 is an appropriate date to switch to a new rate world and cease IBOR
benchmark publications? Particularly as no one can guarantee transition in the
current situation. Plus, RFR trading volumes are still low and the market
players are waiting for a catalyst from the Regulators to highly improve to
liquidity if the RFRs.
Officially, the agendas are not subject to any changes. But if we want to keep to these deadlines, more coordination is required to ensure RFR market liquidity and to align supervisory strategy and banking industry competence.
Article written by Mariem Bouchaala.
[1] https://www.federalreserve.gov/econres/notes/feds-notes/historical-proxies-for-the-secured-overnight-financing-rate-20190715.htm
[2] https://financialservices.forvismazars.com/ibor-transition-modelling-of-sofr-risk-factors/
[3] https://www.bis.org/bcbs/publ/d503.pdf
[4] For further details,
refer to articles 31.12 to 31.25 of the FRTB final rules: https://www.bis.org/bcbs/publ/d457.pdf
