Treliant Takeaway…EBA Assessment Methodology for Market Risk (FRTB) Internal Models

EBA Assessment Methodology for Market Risk (FRTB) Internal Models

• Source: eba.europa.eu

Takeaway:

European Banking Authority (EBA) published its final draft Regulatory Technical Standards (RTS) outlining the assessment methodology for the market risk internal models under the Fundamental Review of the Trading Book (FRTB). The RTS are part of the phase 4 deliverables of the EBA Roadmap on market risk and counterparty credit risk approaches.

Treliant assists firms with the end-to-end design and implementation of FRTB target operating models, including conducting a comprehensive regulatory rule gap assessment covering multiple jurisdictions, prepare supervisory model approval submissions, review risk infrastructure and systems, and provide program management and implementation support for Basel IV capital reforms mandates.

Highlights:

This 164-page document outlines the framework to conducting a regulatory assessment & providing a supervisory approval on the firm’s use of market risk internal model across 3 major themes:

1. Governance
2. Internal risk measurement model covering the expected shortfall (ES) and stress scenario risk measure
3. Internal default risk model

Overarching Governance Requirements

Firms are required to clearly define and document the roles and responsibilities of their management body (including the senior management) for each individual. This should be done in congruence with the assessment of the designated committees of the management body in order to ensure that they provide adequate support function for effective decision-making procedures. In doing so, the firm is expected to document the composition, mandate and reporting lines of the committees responsible for the internal model governance, oversight and decision-making process at the individual trading desk level. Furthermore, it is important to distinctly develop and implement both group-wide and entity specific (i.e., subsidiary level) principles as it relates to the model life cycle (i.e., development, calibration, validation, supervisory approval, implementation in internal processes, application & review of estimates).

It is worth bearing in mind that one of the prerequisites for an institution to use the new internal model approach (IMA) for calculating its own funds requirements for market risk is the approval from its competent authority. To obtain such an approval, the institution is subject to a thorough and comprehensive assessment of its internal model by the competent authority to ensure it complies with the relevant regulatory provisions.

When it comes to internal models’ documentation, the firms are required to document the model methodology, assumptions, limitations, intended usage of the model and adequacy of the IT system infrastructure used for generating risk-figures in such a manner that it allows a qualified 3^rd party to independently validate the associated details in both the development and implementation phase.

It is highly recommended to implement a robust model risk management framework (MRM) that allows the firm to identify, understand and manage the model risk while implementing internal models. The MRM framework at the very least should include:

1. Written model risk management policy.
2. Registry of the firms’ internal models.
3. Roles and responsibilities within the MRM framework.
4. Internal Validation framework that allows for validation staff being separate from the staff involved in the model development process.
5. Detailed approach to
   1. Quantitative and qualitative assessment and measurement
   2. Internal and external model risk reporting
   3. Model life cycle
   4. Identifying and mitigating measurement uncertainty, materiality and model deficiencies
   5. Stress testing, reverse stress testing and ad-hoc stress testing scenarios
   6. Position limits and breaches

Internal Risk Measurement – Mandatory vs Optional

The internal risk measurements have been developed over the last few years that explicitly state the requirements pertaining to the liquidity horizon, back-testing, PnL attribution tests, risk factor modellability, stress scenario risk measure for non-modellable risk factors (NMRF), treatment of FX and commodity risk in the banking book, default probabilities and loss given default (LGD) for the default risk model. While implementing the internal models, the firms are subject to two types of assessment from the supervisory authority.

1. Mandatory assessment that are enforced regardless of the firm type / firm situation.
2. Optional assessments that tend to be more intrusive and generate more burden both for the institution and the competent authority in the investigation phase. They are meant to be used whenever the mandatory assessment methods are not sufficient, and are expected to be used, for example, when the documentation of the institution is not comprehensive or show weaknesses in the analysis performed to validate a modelling aspect.

It is important for the firm to capture sufficient number of risk factors such that they are able to demonstrate to the competent authority by providing an inventory of all market data inputs of the economic PnL and the risk factors used for both Var and stressed VaR (sVaR) models. The firms should be able to provide the results of tests for selected sub-portfolios, business days and selected material proxies i.e., hypothetical PnL used for regulatory back-testing etc.,)

As regards to proxies, the firms are expected to meet the minimum time series requirements alongside demonstrating the ability to identifying the reasons behind poor data quality. The use of beta approximations or regressions could be accepted if they are properly documented and validated regularly that results in consistently good model performance.

For non-modellable risks, the firms are expected to put in place a robust framework to

1. Identify any market risk which is not captured by the model and be able to justify as to why it is not included by supplementing it with product approval process, back-testing etc.,
2. Estimate the potential impact of NMRF’s on the basis that there is no diversification effect (i.e., on a standalone basis)
3. Report the outcomes to the committee responsible by measuring and monitoring the NMRF’s on a frequent basis (i.e., quarterly)

Internal Default Risk Model Assessment

The supervisory authorities expect the firms to establish an inventory outlining how probability of defaults (PD) and loss given default (LGD) have been obtained for the default risk charge (DRC) model i.e., via the external sources or IRB approach? The supervisory assessment also checks on the appropriateness of the VaR number for default-risk including looking through the number of simulations being used to avoiding a sampling error. Furthermore, the firms can expect to be scrutinized on the correlation structure used to model the correlation between issuers’ asset values, appropriateness of the hedging and diversification effects.