EBA published the final draft regulatory technical standards on the capitalization of non-modellable risk factors (NMRFs) for institutions using the Internal Model Approach under the Fundamental Review of the Trading Book (FRTB) implemented in EU as a reporting requirement. The draft standards lay down a methodology for use by institutions to determine the own funds requirements related to non-modellable risk factors in the new market risk regime. The standards set out how institutions are to determine the stress scenario risk measure corresponding to a non-modellable risk factor. The development of these regulatory technical standards fulfills an EBA mandate under the revised Capital Requirements Regulation (CRR2).
The regulatory standards set out methodologies that institutions are required to use to determine the extreme scenario of future shock that, when applied to the non-modellable risk factor, provides the stress scenario risk measure. These standards require institutions to identify a stress period for each broad risk-factor category and to collect data on non-modellable risk factors for the stress period, to determine an extreme scenario of future shock. Once the stress period is identified, institutions can use the following methods:
- The direct method, which involves directly calculating the expected shortfall measure of the losses that would occur when varying the given risk factor as in the relevant stress period
- The stepwise method, wherein institutions approximate the expected shortfall of the losses by first calculating a shock calibrated to an expected shortfall measure on the returns observed for that risk factor and then calculating the loss corresponding to the movement in the risk factor identified by that calibrated shock
The stepwise method requires significantly fewer loss calculations than the direct method. The computation of the calibrated shock for returns under the stepwise method depends on the number of observations available for the stress period. The draft standards also clarify how this has to be done when the number of observations for a non-modellable risk factor is insufficient to obtain meaningful statistical estimates. Additionally, these draft regulatory technical standards specify:
- A regulatory extreme scenario of future shock that should be applied where the institution is unable to determine a scenario based on the abovementioned methodologies, or where the competent authority is unsatisfied with the extreme scenario of future shock generated by the institution
- That the regulatory extreme scenario of future shock is the one leading to the maximum loss that can occur due to a change in the non-modellable risk factor and they set out a specific framework to be used where that maximum loss is not finite
- That institutions may calculate a stress scenario risk measure at regulatory bucket level (that is, for more than one risk factor), where the institution uses the regulatory bucketing approach to assess the modellability of the risk factors within the regulatory buckets
- The formula that institutions should use when aggregating the stress scenario risk measures
These draft standards are one of the key deliverables in the EBA work on implementing the revised market risk framework in EU and as part of the roadmap for the new market and counterparty credit risk approaches that were published on June 27, 2019. EBA had launched, in July 2019, a data collection exercise presenting several stress scenario risk measure calculation method variants. The purpose of the data collection exercise was to apply the EBA non-modellable risk factor methodology proposals that were proposed in the discussion paper toward implementation of the revised market risk and counterparty credit risk frameworks in EU. Post which, in June 2020, EBA had published the consultation paper on which these final draft technical standards are based. Thus, the proposed regulatory technical standards are the result of an iterative process where the views of market participants have been sought several times.
Keywords: Europe, EU, Banking, Market Risk, FRTB, Regulatory Capital, Basel, NMRF, Regulatory Technical Standards, CRR2, Internal model, EBA
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