1. The context of the establishment of the FRTB in the EU
In January 2016, the Basel committee published the minimum capital requirements for market risk FRTB. It has aligned the start date of the revised market risk framework with the start date of the finalization of Basel III reforms.
In order to address the issues identified during the monitoring of the implementation and impact of the FRTB framework, the Basel Committee published a consultative paper in March 2018 on proposals for revising the FRTB standards on targeted areas, as well as a proposal for a simplified standardised approach for market risk.
Following this, the Basel Committee published a revised version of its Minimum Capital Requirements for Market Risk in January 2019.
2. The context of the FRTB roadmap
In 2017, EBA set out its thoughts on the issues surrounding the implementation of the new market risk approaches in its discussion paper “EU implementation of the revised market and counterparty credit risk frameworks”. Based on the answers from industry, EBA defined a roadmap of deliverables in the area of market risk to ensure the proper implementation of the new approaches in the EU.
EBA envisages finalising its market risk deliverables in four phases, starting with the implementation of the core parts of the framework and ending with regulatory texts that require some experience or feedback from the early stages of implementation of the framework for their development.
In addition to the work on its mandates, EBA is strongly committed to working on the implementation issues that may arise as supervisors and the industry begin to prepare and implement the new FRTB framework.
3. ANTICIPATION OF OPERATIONAL DIFFICULTIES IN IMPLEMENTING THE FRTB INTERNAL MODEL APPROACH
As part of this process, EBA has taken into account industry concerns about the operational difficulty of implementing the new Internal Market Risk Model (IMA) approach and the related supervisory approval processes. Therefore, clarification of the IMA framework will be addressed as a priority in the early stages of implementation. This should also provide institutions with the legal certainty to make the investments and improvements to their current systems and processes that the new IMA framework requires.
4. FAST implementation of frtb regulatory reporting
CRR2 introduced, as a first step towards the implementation of the FRTB framework in the EU, a reporting obligation. The reporting requirement will only apply to banks with a trading book size above a threshold of EUR 500 million or 10% of total assets. Banks below this threshold are exempt from the reporting requirement. The reporting requirement will cover all positions in the trading book and for all positions outside the trading book that are subject to foreign exchange (FX) or commodity risk. Reporting will be phased in:
- The results of the calculations based on the use of the alternative standard approach ;
- The results of the calculations based on the use of alternative IMAs.
Thus, the EBA’s roadmap also aims to rapidly materialize the specific reporting requirements for market risk, which are the first step towards full implementation of the FRTB in the EU.
5. A set of 11 eba rts projects to accompany the entry into force of the frtb
A set of 11 RTS specifies the key aspects of the Internal Model Approach (IMA) under the FRTB and represents an important contribution to a smooth and harmonised implementation of the FRTB in the EU. This regulatory package includes:
5.1. The RTS on liquidity horizons for the IMA
5.1.1. Background to the drafting of the RTS
In accordance with CRR2, banks are required to map each risk factor to one of the risk factor categories and one of the risk factor sub-categories in order to identify the relevant liquidity horizon under the Internal Model Approach (IMA). In this context, EBA is mandated to develop RTSs to specify:
- How banks should associate the risk factors of trading book positions with each risk factor category and sub-category of risk factor ;
- The list of currencies that are the most liquid currencies for interest rate risk ;
- The list of currency pairs that are the most liquid pairs for foreign exchange (FX) risk over a 10-day liquidity horizon;
- The definition of small and large caps reflecting the specificities of the EU equity market.
5.1.2. A RTS structured in four distinct axes
- The first section deals with the mapping of risk factors to risk factor categories and subcategories. Ad hoc treatments for specific risk factors are provided. Although the vast majority of risk factors will clearly be mapped to a single dedicated subcategory, a general approach covering less obvious cases of mapping is also provided.
- The second section of the draft RTS specifies the definition of the most liquid currencies for interest rate risk. In particular, the most liquid currencies are defined by considering ECB and BIS studies on OTC interest rate derivative volumes.
- In their third section, the RTS specifies the most liquid currency pairs for FX risk, defining them based on ECB and BIS study of OTC FX derivatives volumes by currency pair.
- In their fourth section, the RTS provides a definition of large cap for equity risk, based on both an absolute threshold and the STIs specifying the major indices and recognized stock exchanges.
5.2. The RTS on backtesting and profit and loss attribution (PLA) requirements
5.2.1. Background to the RTS
CRR2 issues a key requirement on the conditions that must be met for an institution to be approved to use an Internal Model Approach (IMA) to calculate capital requirements for market risk. The IMA must produce reliable capital requirements related to the bank’s P&L.
One way to assess whether or not a model produces reliable capital requirements is through the regulatory backtesting framework. Under the revised market risk framework, backtesting will continue to rely on actual and hypothetical P&L (APL and HPL, respectively). Therefore, clarifying the definition of APL and HPL for backtesting purposes is a prerequisite for the successful implementation of the new IMA under the FRTB.
5.2.2. Objective of the RTS
This RTS specifies:
- the technical elements that banks must take into account when calculating hypothetical, actual and theoretical P&L (HPL, APL and RTPL respectively) for the purposes of back-testing and PLA testing
- the criteria for ensuring that the RTPL is sufficiently close to the HPL
- the consequences for banks whose desks show misalignments between the RTPL
- the HPL, the frequency with which PLA testing must be performed.
- the aggregation formula that banks must use to aggregate capital requirements.
5.2.3. A first part of the RTS on the definition of real and hypothetical P&L
The first part of the RTS sets out the definition of real and hypothetical P&L in the context of backtesting carried out both at the trading desk level and above.
Another way to assess whether or not a model produces reliable capital requirements is the P&L Attribution test (PLA). The P&L attribution requirement ensures that the theoretical changes in the value of the trading book, based on the risk measurement model and the bank’s risk factors in the risk measurement model, are sufficiently close to the hypothetical changes in the value of the trading book. This assessment is made on the basis of the pricing methods used by the bank in the end-of-day portfolio valuation processes. It includes all the risk factors of these valuation methods.
5.2.4. A second part of the RTS on the definition of P&L Attribution
The second part of the RTS deals with the P&L attribution test and is divided into five subsections:
- The first subsection defines, in the light of international standards, the criteria for ensuring that theoretical changes in the value of a trading portfolio are sufficiently close to hypothetical changes.
- The second subsection outlines the consequences for a bank with one (or more) trading desk(s) with a theoretical and hypothetical evolution of the value(s) of the portfolio(s) that are not sufficiently close.
- The third subsection sets out the frequency with which the P&L Attribution test must be performed.
- The fourth subsection provides the definition of hypothetical P&L and theoretical risk P&L (RTPL) for the purposes of the P&L attribution test.
- The fifth sub-section specifies how institutions using the IMA for certain trading desks should aggregate the total market risk capital requirements of all positions in their trading book and non-trading book positions carrying foreign exchange or commodity risk taking into account the consequences of the P&L attribution test.
As part of the implementation of the FRTB framework in CRR2, being able to meet the PLA requirement becomes a necessary condition to be met in order to calculate market risk capital requirements using the IMA.
5.3. The RTS on the criteria for assessing the modellability of risk factor in the IMA
5.3.1. background to the writing of the rts
Under the FRTB framework defined in CRR2, an important new element is the assessment of the modelability of risk factors, referred to as the risk factor eligibility test (RFET) in the Basel standards. The purpose of the modelability assessment is to ensure that the risk factors that institutions include in their Expected Shortfall (ES) model are sufficiently liquid and observable.
The methodology for assessing modelability is consistent with the Basel Committee’s work in recent years on the requirements for identifying risk factors eligible for the ES model.
5.3.2. Objective of the RTS
This RTS defines the criteria for identifying risk factors that are modelable. The assessment of modelability is intended to ensure that only risk factors, which are sufficiently liquid and observable, are included in the ES calculations so that reliable risk measures are calculated. The technical standards also set out the frequency with which the assessment of modelability should be performed by banks.
5.3.3. Two different criteria to assess the modelability a risk factor
The methodology proposed by EBA is based on two different criteria to assess the modelling potential of a risk factor:
- Identification of a minimum of 24 verifiable prices representative of the risk factor over the past 12 months. Over a period of 90 days or more, there must always be at least four verifiable prices representative of the risk factor.
- Identification of a minimum of 100 verifiable and representative prices for the risk factor over the past 12 months.
For the purposes of this assessment, EBA specifies in the RTS the requirements that a price must meet to be verifiable and the requirements under which verifiable prices can be considered representative of risk factors.
In addition, the RTS specifies how the possibility of modelling risk factors belonging to curves, surfaces or cubes should be assessed, as well as the bucketing approaches that are available in this context.
6. Terms of entry into force
The adoption of these RTS should, under CRR2, trigger the three-year period after which banks authorised to use FRTB internal models are required, for reporting purposes only, to calculate their capital under the market risk requirements with these internal models.
In view of the COVID-19 situation, these RTS will not impose an immediate burden on the industry. EBA believes that providing early information to all market participants on key aspects of the EU implementation of the FRTB framework will be beneficial to ensure a smooth and harmonised process.
Abbreviations and glossary
EBA: European Banking Authority
IMA: Internal Model Approach
FRTB: Fundamental Review of Trading Book
PLA: Profit & Loss Attribution
RTS: Regulatory Technical Standard
HPL: Hypothetical P&L
APL : Actual P&L
RTPL: Risk-Theoretical P&L
ITS: Implementing technical standard
RFET: Risk Factor Eligibility Test
ES: Expected Shortfall