EBA launched a consultation on the regulatory technical standards on the capitalization of non-modellable risk factors (NMRFs) for institutions using the new Internal Model Approach under the Fundamental Review of the Trading Book (FRTB). These standards specify all technical details that are essential for determining the own funds requirements related to non-modellable risks. They 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 consultation period ends on September 04, 2020.
These draft standards identify two over-arching approaches, upon which EBA is consulting, that may be used by institutions for determining an extreme scenario of future shock. Only one of the two will be kept after consultation. Considering that each approach has its own specific features, EBA has included two versions of the draft regulatory technical standards in this consultation paper to consistently present how the whole framework would work under each of those two approaches:
- The first overarching approach (Option A) requires institutions to identify a stress period for each broad risk factor category and to collect data for non-modellable risk factors on the stress period, with the aim to determine an extreme scenario of future shock. Under this first approach, the draft regulatory technical standards set out that institutions can use a direct method or a stepwise method. The direct method consists of directly calculating the expected shortfall measure of the losses that would occur when varying the risk factor in a way calibrated to the relevant stress period. The consultation paper highlights that this method provides reliable results only where the institution has a significant amount of data in the observation period and requires many loss calculations per risk factor, which leads to a high computational effort. The stepwise method, however, requires significantly fewer loss calculations. In line with this method, institutions approximate the expected shortfall of the losses by first calculating 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 expected shortfall measure.
- The second overarching approach (Option B) recognizes that, for non-modellable risk factors, data availability in a period of stress might be limited and requires institutions to collect data on nonmodellable risk factors on the current period. This approach aims at improving the quality of the data that is used to calibrate the extreme scenarios of future shocks. In accordance with this approach, the extreme scenario of future shock for a non-modellable risk factor is determined by re-scaling shocks calibrated on data observed in the current period. Under this overarching approach, institutions should use the stepwise method. In contrast to the previous overarching approach, however, the direct method is not available under this approach.
Additionally, these draft regulatory technical standards:
- Specify that a regulatory extreme scenario of future shock that should be applied where the institution is unable to determine it based on the above-mentioned methodologies, or where the competent authority is unsatisfied with the extreme scenario of future shock generated by the institution
- Set out 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 set out a specific framework to be used where such maximum loss is not finite
- Institutions may calculate a stress scenario risk measure at regulatory bucket level (that is, for more than one risk factor), where the institution used the regulatory bucketing approach to disprove the modellability of the risk factors within the regulatory buckets
- Set out the formula that institutions should use where aggregating the stress scenario risk measures
The draft regulatory technical standards are one of the key deliverables included in the roadmap for the new market and counterparty credit risk approaches published on June 27, 2019. Given that the capitalization of non-modellable risk factors is a key component of the own funds requirement for market risk, EBA also launched a data collection exercise in June 2019 to fine-tune and calibrate the methodologies that were proposed in the discussion paper on implementation in the EU of the revised market risk and counterparty credit risk frameworks, which was published on December 18, 2017. Thus, the proposed regulatory technical standards are the result of an iterative process where the views of market participants have been sought several times.
Comment Due Date: September 04, 2020
Keywords: Europe, EU, Banking, Market Risk, FRTB, Regulatory Capital, Basel, NMRF, Non-Modellable Risk Factors, Regulatory Technical Standards, Internal Model Approach, CRR2, EBA
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