"The interlock between FRTB and the LIBOR transition is expected to impact a firm’s current operating model through their pricing and risk modelling, capital requirements and operational activities."
Per the Financial Stability Board, the development of alternative risk-free rates following the cessation of the London Interbank Offered Rate (LIBOR)1 may result in increased market risk capital requirements and create additional operational challenges pertaining to compliance with the Basel Committee on Banking Supervisions’ (BCBS) revised market risk framework.
Minimum Capital Requirements for Market Risk and the LIBOR Transition
To address the structural shortcomings in the Basel II market risk framework, in February 2019, the BCBS published the revised standard minimum capital requirements for market risk.2 The document sets out the minimum Pillar 1 capital requirements for market risk as of January 1st, 2022,3 also known as the Fundamental Review of the Trading Book (FRTB).
Under FRTB, a core feature of the framework includes the Internal Model Approach that relies upon the use of expected shortfall models and sets out capital requirements for risk factors that are deemed non-modellable. The interlock between FRTB and the LIBOR transition is expected to impact a firm’s current operating model through their pricing and risk modelling, capital requirements and operational activities.
The 2019 BCBS revised market risk framework does set out an exemption for extraordinary systemic circumstances and for relief pertaining to the treatment of modellable risk factors that can no longer pass the Risk Factor Eligibility Test (RFET). However, what is not clear is if the LIBOR transition falls within the exemption provision.4
What This Means
There are three key highlights to consider when evaluating the impact of the LIBOR transition on the implementation of the revised market risk framework.
- Modelling Complexity
- Potential Increase in Market Risk Capital Requirements
- Operational Considerations for Implementation
When calculating the Stressed Expected Shortfall under the Internal Model Approach (IMA), the data used should be reflective of market prices observed in a period of stress. This may add to modelling complexity as firms struggle to obtain stress period data for the Alternative Reference Rates (ARRs) and they may be required to reconstruct and/or derive a theoretical historical data set while empirically justifying the methodology applied. When modelling under IMA, banks are required to demonstrate to their supervisory authorities that the principles for modellability of risk factors are being followed, which may be challenging in instances where historical data may not be available.
Banks should consider evaluating their internal models based on a scenario with ARRs and spot potential modelling gaps against the standards’ principles for modellability of risk factors to identify remediation requirements and to demonstrate the application of the principles for risk factor modellability.
Risk Factors that do not meet the RFET based on the number of real price observations and quantitative principles used for calibrating the Expected Shortfall model are deemed as non-modellable, and subject to a stressed capital add-on as a Non-Modellable Risk Factor (NMRF). With the planned discontinuation of LIBOR, there may be a reduction in real-price observations pertaining to associated risk factors given a reduction in market liquidity. This may increase the General Interest Rate Risk (GIRR) linked to instruments and other risk classes that reference LIBOR, based on internal models. In addition, there may not be a significant number of AAR observations to meet the RFET. Risk factors that do not have significant real-price observations may not pass the eligibility tests and would then be subject to a stressed capital add-on unless data can be supplemented through sourcing with external vendors.
Banks should consider evaluating the impact to the risk factors they are exposed to under scenarios of different levels of LIBOR liquidity and limited ARR observations to assess the impact to capital and to evaluate their data sourcing strategy.
To comply with FRTB when considering the complex transition away from LIBOR, banks may be faced with significant operational enhancements to manage. Banks should start to evaluate their FRTB initiative across multiple scenarios and evaluate the impact to modelling requirements and understand the potential impacts to capital requirements in order to develop a modular delivery plan to accommodate the dynamic landscape and to operationalize the standard. As a result of the transition, we may experience changes to the trading desk structure, the integration of external data providers, and enhanced operational requirements, which would have to be permitted to accommodate the transition.
In addition to FRTB, there may be additional initiatives that may be impacted by the transition such as: Model Change Assessments; Minimum Requirement for Own Funds; and Eligible Liabilities, and Securitizations Grandfathering Protection.
Firms should evaluate the impact of the LIBOR transition on interdependencies across key initiatives and develop an integrated LIBOR transition/FRTB implementation strategy. The following key initiatives should be a part of any transition strategy.
- Define and prioritize scenarios and conduct an assessment across the firm against FRTB to evaluate the modellability requirements, capital charge impact and operational requirements to manage the change and provide regulatory compliance.
- Define an Integrated LIBOR Transition/FRTB Implementation Strategy Roadmap to capture product changes and impacts to pricing and modelling across Trading Desks, and identify key enhancements required to data and technology infrastructure.
- Outline details of the changes to the product and operating model, define how the business is to be conducted in the new rate environment and mitigate the impact of the LIBOR replacement on FRTB.
- Implement and test systems to support new products, contracts, risk management disclosures, operations and technology to operate in a post-LIBOR environment.
- “Reforming major interest rate benchmarks,” Financial Stability Board, Progress Report, November 14, 2018. Access at: https://www.fsb.org/wp-content/uploads/P141118-1.pdf.
- “Minimum capital requirements for market risk,” Basel Committee on Banking Supervision, January 2019, revised February 2019. Access at: https://www.bis.org/bcbs/publ/d457.pdf.
- This is the date under BCBS, national jurisdiction dates may vary.
- Minimum capital requirements for market risk,” Basel Committee on Banking Supervision, January 2019, revised February 2019. Access at: https://www.bis.org/bcbs/publ/d457.pdf.
Newsletter Author: Usman Raj
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