1.  Entry into force of FRTB-based capital requirements

1.1.   Transition from the FRTB reporting requirement in CRR2 to the FRTB-based capital requirement in CRR3

In 2016, the BASEL COMMITTEE issued the FRTB to address identified deficiencies in the market risk capital requirements framework for trading book positions. In monitoring the impact of the FRTB standards, the BASEL COMMITTEE identified a number of issues with the FRTB standards and, as a result, issued revised FRTB standards in January 2019.

In November 2016, the Commission had initially proposed to introduce binding capital requirements based on the FRTB standards under CRR2 to address the shortcomings of the market risk framework. However, given the subsequent decision of the BASEL COMMITTEE to revise these standards, with timeframes incompatible with the steps in the CRR2  process, the European Parliament and the Council agreed to implement FRTB standards in CRR2 for reporting purposes only. The introduction of capital requirements based on the FRTB standards has been postponed until later, through the adoption of a separate legislative proposal.

CRR3 therefore introduces binding capital requirements for market risk in line with the revised FRTB standards.

1.2.   Deduction of own funds items

CRR3 includes a waiver allowing banks to reduce total supplementary value adjustments in exceptional circumstances, based on advice provided by the EBA, to address the inherent procyclicality of supplementary value adjustments deducted from CET1 capital.

1.3.   Clarification of the trading book vs. banking book boundary and overriding options

CRR3 introduces the FRTB approaches for the calculation of capital requirements. Thus, the criteria for allocating positions to the trading book or the banking book are revised. CRR3 also introduces a waiver that allows a bank to allocate to the banking book, specific instruments that would otherwise be allocated to the trading book. This derogation is subject to very strict conditions and to an approval of the bank’s competent authority.

CRR3 further clarifies the conditions that must be used to reclassify an instrument between the two books. It introduces a derogation that allows banks to create dedicated trading desks to which banks can exclusively allocate non-trading book positions subject to foreign exchange and commodity risk.

CRR3 also clarifies the treatment of foreign exchange hedges in capital ratios, allowing banks to exclude, under certain conditions, certain positions from the calculation of capital requirements for foreign exchange risk.

Finally, it clarifies the existing provisions on internal risk transfers.

1.4.   Framework for calculating capital requirements frtb

CRR3 introduces binding capital requirements for market risk based on the FRTB approaches. These are:

  • The alternative standard approach or A-SA.
  • The alternative internal model approach or A-IMA.
  • The simplified approach or SSA and the conditions of eligibility for this approach.
  • Conditions for the use of the different approaches.
  • The frequency of calculation of capital requirements.

An exemption for banks from the calculation of capital requirements for positions subject to foreign exchange risk that are deducted from their capital is also introduced.

Finally, the CRR3 clarifies the calculation of capital requirements for market risk on a consolidated basis.

1.5.   The alternative standard approach

CRR3 introduces additional qualitative requirements related to validation, documentation and governance of A-SA.

1.5.1.    Clarification of the A-SA methodology for OPC exposures

Thus, CRR3 clarifies certain elements regarding the treatment of investments in funds (i.e. collective investment schemes or UCIs) and introduces targeted adjustments in the calculation of capital requirements for these positions. These changes ensure that the treatment of mutual funds under the Standardised Approach does not disproportionately increase the complexity of the calculation and is less punitive for mutual fund exposures. This is very important as mutual funds play a crucial role in facilitating the building up of personal savings, whether for large investments or for retirement. These objectives are achieved by specifying that banks must apply the look-through approach with a monthly frequency for positions in mutual funds covered by this approach, and by allowing banks, under specific conditions, to use data provided by relevant third parties in the calculation of capital requirements under the look-through approach. In addition, under the mandate-based approach, CRR3 requires EBA to further specify the technical elements that banks must use to constitute the hypothetical portfolio used in the calculation of capital requirements.

1.5.2.    Evolution of methods for calculating sensitivities

The RRC3 makes the following series of changes:

  • Clarification of the treatment of vega currency risk factors.
  • Adjustment of the formula for vega risk sensitivities.
  • Alignment of sensitivities used for the calculation of capital requirements with those used for the bank’s risk management.
  • Clarification of the treatment of exposures to traded non-securitized credit and equity derivatives
  • Clarification of the treatment of the inflation risk factor and the cross currency risk factors.
  • Clarification of risk weights for covered bonds (both externally rated and unrated).
  • Clarification of the methodology for determining the value of the correlation parameters.
  • Clarification of risk weights for vega risk factor sensitivities.

1.5.3.    Better supervision of carbon trading systems

CRR3 introduces a lower risk weighting for the delta risk factor of commodities related to carbon trading. According to the finalization of Basel III, emission allowances are equated with electricity contracts, which could be considered too conservative given the historical data relevant to the European emission allowance market. Indeed, the creation of the Market Stability Reserve by the Commission in 2015 has stabilized the volatility of the price of allowances in the Emissions Trading Scheme. This justifies the creation of a specific risk category for carbon trading system allowances under the A-SA, separate from electricity, with a lower risk weight equal to 40% to better reflect the actual price volatility of this EU-specific product.

1.6.   The alternative approach of the internal A-IMA model

CRR3 introduces several changes to the alternative internal model approach. These include:

  • Clarification of the conditions that banks must meet in order to be allowed to use A-IMA to calculate market risk capital requirements.
  • Introduction of the aggregation formula for capital requirements calculated under A-IMA.
  • Introduction of an RTS mandate for the EBA to specify the criteria for the use of input data in the risk measurement model.
  • Clarification of new powers for competent authorities with respect to the assessment of risk factor modeling potential by banks using A-IMA.
  • Introduction of new powers for competent authorities to remedy model and/or backtesting deficiencies.
  • Introduction of binding requirements on P&L allocation.
  • Introduction of adjustments for the calculation of market risk capital requirements for mutual fund positions under A-IMA, in particular to ensure that more mutual funds could be eligible under the approach. Similar to the changes to the treatment of mutual funds under A-SA, banks are permitted, under specific conditions, to use data provided by relevant third parties in the calculation of capital requirements under the look-through approach, and are required to apply the look-through approach with a minimum weekly frequency.
  • Clarification of the responsibilities of the risk management and model validation teams.
  • Clarification of when banks are permitted to use an IRB model to estimate probabilities of default and losses given default for the calculation of the capital requirement for default risk.

1.7.   Use of internal models to calculate capital requirements

The current Internal Model Approach (IMA) used to calculate market risk capital requirements is replaced by the A-IMA.

2.  Credit Valuation Adjustment (CVA) Risk Framework

2.1.   Definition and objectives of the CVA

The credit valuation adjustment (CVA) is an accounting adjustment to the fair value of the price of a derivative transaction, intended to cover potential losses due to the deterioration of the creditworthiness of the counterparty to that transaction. During the 2008 financial crisis, several systemically important banks incurred significant CVA losses on their derivatives portfolios due to the simultaneous deterioration of the creditworthiness of several of their counterparties. As a result, in 2011, as part of the first round of Basel III reforms, the Basel Committee introduced new standards for calculating capital requirements for CVA risk to ensure that banks’ CVA risk would be covered by sufficient capital in the future.

2.2.   The need for a new CVA calculation framework

However, banks and supervisors expressed concern that the 2011 standards did not adequately address the actual CVA risk to which banks were exposed. In particular, three specific criticisms were made of the standards:

  • The approaches outlined in these standards lack risk sensitivity.
  • The approaches do not recognize CVA models developed by banks for accounting purposes.
  • The approaches described in these standards do not take into account the market risk inherent in derivative transactions with the counterparty.

To address these concerns, the Basel Committee issued revised standards in December 2017 as part of the final Basel III reforms and further adjusted their calibration in a revised publication in July 2020. CRR3 aligns with the Basel Committee’s new standards.

2.3.    Clarifications made by the CRR3

CRR3 clarifies the definition of CVA risk to capture both the credit spread risk of a bank’s counterparty and the market risk of the trading book relating to transactions negotiated by that bank with that counterparty.

CRR3 also specifies which securities financing transactions are subject to the CVA capital requirements.

In addition, a new provision requiring banks to report the results of the calculation of the CVA risk capital requirement for exempt transactions is introduced. It is further clarified that banks that hedge the CVA risk of such exempt transactions have the discretion to calculate the CVA risk capital requirement for such transactions, taking into account the relevant eligible hedges.

Finally, EBA will have to write guidelines to better identify excessive CVA risk and specify the conditions for assessing the materiality of CVA risk exposures arising from securities financing transactions measured at fair value.

CRR3 defines the new approaches that banks must use to calculate their capital requirements for CVA risk, as well as the conditions for using a combination of these approaches.

 

References

https://ec.europa.eu/finance/docs/law/211027-proposal-crr-2_en.pdf

 

Abbreviations and glossary

A-IMA: Alternative Internal Model Approach

A-SA: Alternative Standardardized Approach

CVA: Credit Value Adjustment

SSA: Simplified Standardized Approach