fundamental review of trading book: new rules for market risk

Fundamental Review of Trading Book: new rules for Market Risk

Arturo Labanda

Risk Unit Director. Market Risk Models

Methodology and Models Construction

Banco Santader

Global Association of Risk Professionals

June, 2016

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

2 | © 2012 Global Association of Risk Professionals. All rights reserved.

Why a fundamental revision?. Timeline

• Recent financial crisis showed debilities in Regulatory Capital

calculation for Market Risk

Financial crisis 2007

BIS 2.5 (julio-09)

First consultive

doc. FRTB

(may-12)

Second consultive

doc. FRTB

(oct-13)

QIS impact

(sep-14)

Third consultive

doc. FRTB

(dic-14)

Final doc. FRTB

(ene-16)


Why a fundamental revision?

• Deficiencies in BIS II para Market Risk

• Insufficicency of Capital for absorve losses

• Models fails: tail risk, basis risk,…2007

• SVaR calculation

• Incremental Risk Charge (IRC): rating migration and default

• Correlation trading portfolio (CRM)BIS 2.5

• Models and standard aproximations

• Fundamental review of market risk standards. BIS 2.5 is not enought

consultive

period

• Reform plan and details for BIS 2.5

• Standard Model Approach (SA)

• Internal Model Approach (IMA)FRTB


Why a fundamental revision?

• Review of boundary between banking book and trading book

• Inadequate capital for credit products (ie. bonds) in the crisis period

• Insufficiency of capital during the stress period. Problems of VaR in tail risk

scenarios

• No liquidity factors in the model

• Standard model fails in complex derivatives

• High dependency of internal models for calculate regulatory capital:

internal models of banks give their own view of risk


Milestones: probably increase of capital requirements

• Review of boundary between banking book and trading book

• Review of trading desk structure and eligibility: PL test for IMA approval

needs a minimal differential between Front office models and Risk models:

models and risk factors

• Definition of Trading Desk with quantitative criteria

• Risk Theoretical PL vs Hypothetical PL:

• Risk PL: engines and risk factors from risk data base

• Hypothetical PL: engines and risk factors from FO data base

• Backtesting



• Capital consumption for Standard Approach (SA):

• Capital at Trading Desk Level

• Input: sensitivities

• RWA, correlations, scenarios, etc., given by regulators

• New Metrics:

• Curvature

• Jump to Default for EQ

• Sticky delta approach

• IMA has a floor at SA. To be determined by BIS

• > 90%: no incentives for IMA. No R+D

• 50%-80%: incentives for IMA

• < 50%: low probability of success. Very difficult for calculate for all TDs



• Impact in capital requirements for Internal Model Approach (IMA)

• Non-Modellable Risk Factors (NMRF). What is a “real price”?

• It is a price at which the institution has conducted a transaction

• It is a verifiable price for an actual transaction between other arms-length parties

• The price is obtained from a committed quote

• The price is obtained from a third-party vendor, where: (i) the transaction has

been processed through the vendor; (ii) the vendor agrees to provide evidence of

the transaction to supervisors upon request; and (iii) the price meets the three

criteria immediately listed above, then it is considered to be real for the purposes

of the modellable classification.

• Risk factor must have at least 24 observable “real” prices per year with a

maximum period of one month between two consecutive observations.

• Use of proxies

• Impacts driven by Expected Shortfall calculations

• Impacts driven by Default Risk Charge calculations (DRC)

• Impacts driven by Stressed capital add-on for NMRF (SES)


Milestones: methodology and models

• Enhance of actuals models for ES, DRC,... Or development of new

models?

• Alignment of FO models and Risk Models?

• Expected Shortfall calculation: no formula provided by BIS

• High number of calculations: optimization process

• New IRC Default Risk Charge

• EQ and Credit deals

• “Only” default (migration is excluded)

• DRC internal approach: 2 factors model

• Look through approach for index and baskets: intensive in calculations



• Non-modelable risk factors definitions: in-house development or third party

vendors?

• Risk Theoretical PL vs Hypothetical PL

• Risk Theo. PL: PL calculated only with risk models and risk factors

included in the risk models.

• Risk Hyp. PL: PL based on MtM with all risk factors

• Align risk and front models?



• Risk Theoretical PL vs Hypothetical PL (cont.)

• PL attribution test: use to determinate IMA model for the TDs

Risk Theoretical PL

PL diario producido por los modelos de valoración,

usando sólo los RF utilizados en el modelo de riesgos

Hypothetical PL

PL producido por los modelos de valoración, usando

todos los RF utilizados en el modelo de riesgos

Unexplained PL

Diferencia entre Theoretical e Hypothetical PL

Metrics

Mean Ratio:

Mean Unexplained PL

Standard Desviation (Hypo. PL)

Variance Ratio

Variance Unexplained PL

Variance (Hypo. PL)

Test



• PL attribution test: use to determinate IMA model for the TDs

Mean Ratio:

Mean Unexplained PL

Standard Desviation (Hypo. PL)

Variance Ratio

Variance Unexplained PL

Variance (Hypo. PL)

Test

Ratio > +/-10%

Ratio > 20%


Milestones: IT architecture and infrastructure

• To be development: Expected Shortfall, DRC, SES, capital agregation,…

• Data base for PL attribution

• Calculator for SA

• Market data information:

• Risk weights, capitalization for EQ, modelable/non-modelable risk

factors,..


Standard Approach in a glance

General Interest Rate Risk (GIRR)

Credit Spread Risk

Credit Spread Risk non Secur (CSR)

Securitizaciones (CSR Sec)

Correlation Trading Portfolio (CSR CTP)

Foreing Exchange Risk (FX)

Equity Risk (EQ)

Commodity Risk (CM)

Default Risk

Default Risk non Secur (CSR)

Securitizaciones (CSR Sec)

Correlation Trading Portfolio (CSR CTP)


Standard Approach in a glance

SA = Sensitivities

(Delta + Vega +Curvatura)

GIRR + CSR + EQ + FX + CM

DRC

Residual Risk

Add on

1% o 0.1% of

the notional

+

Debt & EQ

+


Internal Model Approach in a glance

TD por IMA TD por SA


Internal Model Approach in a glance

3 “times”

Max number of “runs”: 3 x 21 = 63!!!


Default Risk Charge (DRC)

Risk “objetc”

Default and migration

Products in scope

Credit no-securitizations

Incremental Risk Charge (IRC) Default Risk Charge (DRC)

Model

1y @ 99.9%

Risk “object”

Default

Products in scope

Credit no-securitizations and equities

Model

1y @ 99.9%

Liquidity Horizon

Floor @ 3M

Liquidity Horizon

Floor @ 3M for EQ and 1y for Credit

Others

Historical correlations in a 10y time window and

with a stress period. PD floor @ 3pb


BIS 2.5 vs FRTB

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fundamental review of trading book: new rules for market risk

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