What We Understand About MCRMR-2016 (FRTB)
The MCRMR-2016 is the result of the FRTB. The BCBS have been quite lucid about the requirements of MCRMR-2016, and they are quoted as follows:
• Revised boundary: The boundary between the banking book and trading book has been revised to reduce incentives for a bank to arbitrage its regulatory capital requirements between the two regulatory books, while continuing to respect banks’ risk management practices. Notably, stricter limits along with capital disincentives are applied to the transfer of instruments between the banking book and trading book.
• Revised standardised approach: The standardised approach for market risk has been revised so that it remains suitable for banks with limited trading activity while also sufficiently risk sensitive to serve as a credible fallback for, as well as a floor to, the internal models approach. This is particularly relevant for banks whose internal models are found to be inadequate in certain areas by their supervisors and, as a consequence, are not permitted to be used to determine regulatory capital requirements. A key change to the standardised approach is the greater reliance on risk sensitivities as inputs into capital charge calculations. This means that a common risk data infrastructure would be able to support both the revised internal model and the standardised approaches, thus facilitating the use of the standardised approach as a fallback and floor to internal models.
• Revised internal models approach: The enhancements to the internal models approach for market risk have three main aims: (i) more coherent and comprehensive risk capture that takes better account of “tail risks” and market illiquidity risk; (ii) a more granular model approval process whereby internal models are approved for use at the trading desk level; and (iii) constraints on the capital-reducing effects of hedging and portfolio diversification.
However, as expected for such a wide-ranging change of regulatory scope, the detailed requirements are rather more complex:
• The Revised Boundary is subject to stricter guidelines regarding the division of trades – it is primarily intended to discourage arbitrage between the banking and trading books. The regulator also has the authority to switch trades between the books if they deem that any positions have been inappropriately booked.
• The revised Standardised Approach (RSA) requires new calculation and reporting processes compared to the current SA – it requires a much more sophisticated use of sensitivities to derive a closer calibration with the Internal Models Approach (IMA). The required sensitivities (time horizons, buckets and weightings) are provided by the BCBS.
• The RSA approach derives its risk charge by aggregating the calculated sensitivities (delta, vega and curvature), the Default Risk Charge (DRC) and the Residual Risk add-On (RR). A synopsis of each component is covered in the following 3 points:
• For the revised SA sensitivities, 3 correlation scenarios are required for each risk class to reflect market volatility – these scenarios are based on the correlation between risk factors within a bucket and the risk factors across buckets in a risk class. The weightings are supplied by the BCBS along with the risk factors for General Interest Rate Risk (GIRR), various classifications (securitised, non-securitised, correlation) of Credit Spread Risk (CSR), Equity Risk (ER), Commodity Risk (CR) and FX Risk.
• The DRC is derived from the Jump to Default (JTD) risk (calculated as a function of the nominal and market value of an asset and the prescribed LGD), netting (via specified offsetting rules) and the application of bucketing rules against prescribed risk weightings.
• The RR add-on is to be calculated for all instruments bearing residual risk separately and is applied in addition to other components of the capital requirement under the standardised approach for market risk.
• For IMA, a new daily risk measure called Expected Shortfall (ES) replaces VaR – ES is intended to incorporate tail risk, inclusive of liquidity risk at a quantile of 97.5%. A series of horizons have been specified by the BCBS (10, 20, 40, 60 & 120 days) and ES reporting needs to be calibrated to use the most severe 12-month stress period for the risk factors required. Another requirement is the availability of at least 75% of the relevant historical risk factors for the last 10 years.
• Calculating Default Risk under IMA requires an regulatory-approved internal model, with correlations based on credit spreads or officially-listed equity prices. Netting is permitted between the same obligor, and PD is floored at 0.3%. A challenge is the need to model the effect of issuer and market concentrations, along with qualitative and quantitative validation of the DRC – backtesting may not necessarily be suited due to a quantile requirement of 99.9%, a liquidity horizon of 1 year and a correlation calibration period of 10 years. In summary, DR requires a multi-step approach – JTD loss, offsetting long and short positions from the same obligor, net short positions discounting by a specified hedge benefit ratio and application of default risk weights to arrive at the final DRC. Note that the JTD loss is calibrated and calculated differently for various asset classes.
• Capitalisation of the IMA risk factors involves taking the weighted average of the bank-wide diversified (unconstrained) ES figures with the undiversified (constrained) individual risk factors for GIRR, EQ, FX, CR and CSR – the risk for each factor will then be summed up to derive the aggregated capital risk charge for modellable risk factors. This then needs to be multiplied by 1.5 to arrive at the regulatory capital requirement.
• The capitalisation for non-modellable risks requires a calibrated stress scenario no less prudent than those used for modellable risks. However, the liquidity horizon must be the larger of the largest prescribed horizon for the product and two consecutive price observations.
• Regardless of whether IMA is adopted or not, it is always required to report the revised SA.