Fundamental Review of the Trading Book BCBS D352. Minimum Capital requirements for Market Risk

Transcription

1 Fundamental Review of the Trading Book BCBS D352 Minimum Capital requirements for Market Risk May 2016

2 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-modellableRisk Factors Default Risk Charge Risk exposure to be measured on an intraday 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 Simulation Appendix 2 Revised standardised vs Internal Method Approach Impact Simulation Appendix 3 Revised Model vs Current Model Impact Simulation for Securitization How we can help 2 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

3 Introduction Scheduled implementation date: 2019 (depending on local jurisdiction) (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 Banks are required to start reporting under the new FRTB standards by year-end The following timeline illustrates the milestones and tasks that an IMA approved. 1 st 2 nd 3 rd 4 th Quantitative Impact Study Apr. Jul. Jan. Jan. Dec. May Jan. Oct. Mar. Dec. Q2 Q Rule making RCAP Market RWA Annex to 2 nd consultative paper Finalized FRTB Standards Final National Standards Latest 1 st reporting date 1 st consultative paper 2 nd consultative paper 3 rd consultative paper Monitoring and recalibrations National rule making Legend : BCBS National Institutions Monitoring and approval process Institutional implementation FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 3

4 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 capitalisefor 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 14 th 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) 4 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

5 1. Trading Book Banking Book Boundary Stricter limits along with capital disincentives are applied to the booking and transfer of instruments between the banking book and trading book. 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). Definition Products Trading Book 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 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 Banking Book Instruments not defined in the trading book 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 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) 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). FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 5

6 2. Revised internal Model Approach Expected shortfall risk measure to replace VaR and Stressed VaR The Var(99%) and stressed VaRmarket 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): where: ES is the regulatory liquidity-adjusted expected shortfall; T is the length of the base horizon, ie10 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 LHjaccording 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 LHjis 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-securitisations in 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. 6 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

7 BCBS illustration of the process and policy design of the internal models-based approaches (IMA) The internal Models Approach for Market Risk Step 1 Overall assessment of the banks firm-wide internal risk capital model Fail Standardised approach for entire trading book Step 2i Banks nominate which trading desks are in-scope for model approval and which are out-of-scope Step 2ii Assessment of trading desk-level model performance against quantitative criteria Clear thresholds for breaches of P&L attribution and backtesting procedures Out of scope Fail Standardised approach for specific trading desks Step 3 Individual risk factor analysis Risk factors must be based on real, verifiable prices Frequency of observables prices Securitisation exposures in the trading book are fully out of scope of internal models and capitalised in the revised standardised approach Global Expected Shortfall (RS): Equal weighted average of diversified ES and nondiversified partial ES capital charges for specified risk classes 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) Non Modelable Stressed capital add-on (SES): Aggregate regulatory capital measure for non-modelablerisk factors in model-eligible desks Risk exposure to be measured on an intra-day basis 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) FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 7

8 Liquidity Horizons inclusion in the Expected Shortfall calculation 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 materially affecting market prices in stressed market conditions, and have been set according to the following table. 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) 40 Credit spread: corporate(hy) 60 Energy and carbon emissions trading price Precious metals and non-ferrous metals price Credit spread: volatility 120 Other commodities price 60 Credit spread: other types 120 Equity price(large cap) 10 Energy and carbon emissions trading price: volatility Precious metals and non-ferrous metals price: volatility Equity price(small cap) 20 Other commodities price: volatility 120 Equity price (large cap): volatility 20 Commodity: other types All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

9 Internal Models validation at regulatory trading desk level Internal 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. A test to determine whether the P&L based on risk factors included in the trading desk s risk management model captures the material drivers of actual P&L. Backtesting. A test to determine how well the risks in an internal model 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. Capital Add-on for non-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 nonmodellable according to a set of conditions (art. 190). Risk factors that do not meet these conditions are deemed to be non-modellable and must be capitalisedindividually using a separate stressed capital add-on from the ES approach used for modellablerisk 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 VaRmodel. Internal Model expected shortfall to capital charge multiplier set to 1.5 (Jan 14 th 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). 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). 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 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. FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 9

10 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. The standardised approach for Market Risk Sensitivities-based Method: Capital charges for delta, vega and curvature risk factor sensitivities within a prescribed set of risk classes: General interest Rate Risk (GIRR) Credit Spread Risk (CSR): non securitisation CSR: securitisation Foreign Exchange (FX): Risk Equity Risk Commodity Risk Default Risk Charge (DRC) for prescribed risk classes: Default risk: non securitisation Default risk: securitisation Default 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 nonlinear payoffs 10 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

11 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 on sensitivities of a bank s trading book to regulatory delta risk factors. Delta sensitivities are to be used as inputs into the aggregation formula which delivers the capital requirement for the Sensitivitiesbased method. Vega: A risk measure that is also based on sensitivities to regulatory vegariskfactorstobeusedas 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 scenariiare 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 standardised default risk charge This risk charge aims at taking in account the jump-to-default risk. Securitisationexposures have their own set of rules for DRC calculation. The framework for default risk requires that positions are allocated to default risk bucket categories (egcorporates, sovereigns, local governments/municipalities for nonsecuritisationexposures). The calculation is based on given loss given default portion of the notinalamount, weighted according to the counterpart rating. The standardiseddrc 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, vegaor curvature calculation, and a risk weight of 0.1% for instruments bearing other residual risks. (Art. 58). Exotic exposures include longevity risk, weather, natural disasters and when used as an underlying for a swap future realised volatility. Carbon emissions, which were considered exotic in an earlier document, have been removed in the January 14th 2016 publication. FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 11

12 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. 12 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

13 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) FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 13

14 How wecanhelp 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 PROGRAM MANAGEMENT Impact assessment on organization, models, IT, processes and businesses Project Management Office (PMO) to coordinate FRTB streams IT data framework rationalization: golden source, reorganization DATA MANAGEMENT IT diagnostic: as-is, target, opportunities for change Data management optimal IT framework design SUPPORT IN DECISIONS Provide decision-making solutions by simulating impacts, projecting strategic and business related items Manage & facilitate communication with Top Management MODEL DESIGN & VALIDATION Risk modeling and quantification Cartography and optimal validation process definition (Validation and documentation) OPTIMIZATION & CAPITAL Assess cross-impacts & implement synergies: quantitative, IT, organization, process FRTB Arbitrages Design optimal book structure, parallel runs, cost efficient processes Q4 Q Q IMPLEMENTATION FRTB OBSERVATION & TEST DESIGN ROADMAP & OPERATIONAL SET-UP DESK ELIGIBILITY & BOUNDARY ASSESSMENT TB/BB MODELDESIGN SA -IMA & RISK CAPITAL ASSESSMENT FRTB HOMOLOGATION & REPORTING DESK VALUATION ASSESSMENT Sensitivity-based Risk charge + Default Risk charge + Residual Risk Add-On REDACTION DOSSIER HOMOLOGATION SA RISK FRONT PRODUCT PnL Attribution Process DESK ELIGIBILITY ANALYSIS & BOUNDARY IMA VALIDATION INTERNE DOSSIER HOMOLOGATION CONTROL ACTIVITES PORTEFEUILLE TRADING STRATEGY IMPACTS TRADING DESK & HEDGING PREPARATION REPORTING DESK & PROCESS Trading Portfolio Position Analysis & Valuation INTERNAL RISK TRANSFERS NM RF COMPOSITION TRADING BOOK BACKTESTING PROCEDURES MONITORING PROCESS & PLAN CONTRÔLE RISK REQUIREMENTS MONITORING PROCESS CALIBRATION FRTB - CVA LIMITS & ALLOCATION RISK CAPITAL ASSESSMENT 14 All Rights Reserved 2016 CAPTEO - FRTB BCBS D352

15 Contacts Gabriel LETHU Directeur Risk & Finance Mobile : glethu@capteo.com Rodolphe RANCE Risk Manager Mobile : rrance@capteo.com Richard TEUSCHER Directeur Général Mobile : rteuscher@capteo.com 11 Avenue de l Opéra PARIS Tel : Fax : Web site : CAPTEO est un cabinet de conseil en Stratégie, en Organisation et en Management, dédié à l'industrie financière et aux marchés financiers, et spécialisé en Risk Management. Cabinet de référence dans le secteur financier, nous accompagnons nos clients depuis 10 ans dans leurs réflexions stratégiques, dans la mise en œuvre de leurs projets de transformation et l'amélioration de leurs performances. Notre sphère d'influence et nos expertises métiers se développent autour de 4 segments : - Les Banques de Financement et d'investissement - Les Sociétés de gestion d'actifs, les Asset-Managers et les Banques privées - Les Services dédiés aux investisseurs et la chaine Titres - Les compagnies d'assurances, Mutuelles et Organismes de Protection Sociale Grâce à un accompagnement sur-mesure, nos offres de conseil permettent de répondre aux principaux enjeux du secteur des marchés financiers : - Définir et mettre en œuvre des stratégies de croissance - Améliorer la performance opérationnelle et le coefficient d'exploitation - Conduire les projets de transformation complexes et transversaux - Gérer les risques et la liquidité des établissements financiers - S'adapter aux évolutions règlementaires du secteur financier - Manager la connaissance et le Capital Humain - Maitriser les données et dimensionner le Système d'information dans la transformation Digitale CAPTEO apporte également son expérience et sa vision de l'évolution du secteur des marchés financiers en réalisant des études et des benchmarks pour le compte de ses clients. CAPTEO publie régulièrement des études et des travaux de recherche, notamment sur les problématiques risques et règlementaires. Pour plus d'information, visitez FRTB BCBS D352 - All Rights Reserved 2016 CAPTEO 15

16 Fundamental Review of the Trading Book BCBS D352 Minimum Capital requirements for Market Risk All Rights Reserved CAPTEO - FRTB BCBS D352