The Industry conducted a survey to supplement the responses to Questions 1 to Questions 8 of the consultation paper. Collectively 16 firms participated in the survey, however the result of each survey question is based on the number of corresponding responses received.
The industry found the language used for questions 1 and 2 of the consultation paper related to ‘sensitive to market risk’ or ‘market risk sensitive’ too ambiguous to correctly identify appropriate adjustments. This ambiguity could lead to different interpretations on which adjustments are relevant for inclusion for back-testing or for PLAT. While considering the objective behind the questions 1 and 2, the industry structured additional questions as part of the survey to determine the list of adjustments the Industry considered appropriate from a forward looking perspective for both back-testing and PLAT. The details on the survey questions and results can be found in the attachments provided.
The Industry concluded that the requirement of being sensitive to market risk is too broad to correctly identify adjustments relevant for the back-testing of a risk model. The industry suggests using the TRIM definition of “being in scope of market risk” (i.e. measuring something that the VaR model is intended to capture as opposed to any element an exit price would embed). Only the adjustments in line with the TRIM definition would be deemed a valid cause for a back-testing exception.
As noted in the response for question 1, the identification of adjustments which are ‘market risk sensitive’ is too broad and Industry propose using the TRIM definition of ‘being in scope of market risk’.
The majority of the industry survey participants acknowledge the provision as clear and marginally disagree with the provision specified in paragraph 4. The Industry recognises that smoothening is not perfect and can result in unpredictable outcomes as the statistical measures used in PLA tests are not always additive. However, at least this is more realistic than assuming the cumulative market risk effects over the readjustment period (week or month) is imputable to one single day. No smoothening generates a substantial operational burden on Finance (both standalone and allocated adjustments need to be computed), and does not reflect the accounting reality that P&L is additive. In addition, smoothening treatment is consistent with the PRA treatment for Basel 2.5 back-testing - monthly adjustments are in Actual P&L in full on the last day of the month but can be excluded from Hypo P&L.
The industry acknowledges the provision is clear, but disagrees with the provision. The industry recognises that to calculate valuation adjustments at the desk level will create added operational/computational burden to implement the requirements. Stand-alone calculation of adjustments at trading desk level would be possible, but that approach is not deemed suitable, as it would not reflect how business units would economically unwind the risk in practice.
Valuation adjustments are typically calculated at a portfolio level with the understanding that individual adjustments may be required at a more granular level. When considering the appropriate netting level for the close out cost calculation, it is important to use a level which reflects how business units would economically unwind the risk in practice. In most cases this is considered to be at the region/business unit level rather than at the trading desk level.
The industry is concerned that it will be overly burdensome to run the calculation at desk level of granularity in order to isolate specific subsets of positions. In practice many valuation adjustments are excluded from a trading desk's APL on the basis that they meet the criteria in paragraph 5.
To calculate adjustments for each trading desk on a standalone basis instead at the entity" level will considerably deviate from the "fair value" which is the foundation on which P&L is based according to IFRS 13:48:
"an entity shall measure the fair value of the group of financial assets and financial liabilities consistently with how market participants would price the net risk exposure at the measurement date".
The industry suggests that the alternative would be to calculate the adjustment in-line with the risk management, and using an adequate allocation methodology, allocate the adjustments to the desk level."
The industry survey participants strongly agree to the criteria sets out in paragraph 5 allowing institutions to exclude an adjustment from the changes in the trading desk’s portfolio value and also suggest that the provisional criteria should only apply to market risk relevant adjustments.
The industry of the provision in paragraph 5(a)) “that adjustment is computed this way due to its nature” ambiguous or not clear, and seeks more clarity in order to implement in practice. The Industry’s interpretation was that adjustments that aggregate linearly would not meet this criteria (e.g. an IPV adjustment) and adjustments that reflect non-linear effects would meet this criteria (e.g. a delta bid-offer calculation on a portfolio of derivatives).
In reality, a bank may choose to take adjustments at different levels of reporting hierarchy in a way that reflects how it seeks to manage its business. This may result in adjustments being made at a higher level than the FRTB desk. Requiring banks to calculate the adjustment at a lower level only for the purpose of regulatory back-testing would be an additional process to adjust the actual P&L to include a factor not in the desks' reported P&L. This is undesirable, not just due to the additional process but also due to the lack of business use case that would render this allocation liable to error.
The industry conducted a survey requesting banks to confirm if the client margins and day-one profits/losses are taken into account in the end-of-day valuation process, in the actual P&L and in the hypothetical P&L with the subsequent results shown in the figures above.
The majority of industry respondents confirm that client margins and commissions are taken into account in the end-of-day valuation process and primarily not in the actual P&L. The overwhelming number of respondents confirm Day-one profits/losses are taken into account in both the end-of-day valuation and also in the actual P&L. As a general practice, the industry does not include client margin, commissions or day-one profits/losses in their hypothetical P&L.
The industry acknowledges that client margins corresponds to the P&L generated at the initiation of the transaction. New transactions are part of the EOD Valuation process and Actual P&L but not part of the Hypothetical P&L (CRR Article 366(3)). Currently the margin generated at the initiation of the trade is determined on a declaratory basis. Consequently, day-one profits/losses reserve is computed from the declared client margin.
The industry also recognizes that risk commission is included in the actual P&L for back-testing by some banks. The industry defines the risk commission as a commission on a transaction where a bank agrees to procure an instrument for a client with a price agreed up front. The bank takes on the risk on entering the market (committing capital to fill the order) that the price is different than that agreed with the client.
However, industry members noted that the definition for day-one and client margin P&L may differ across institutions, therefore would urge EBA to retain some level of flexibility in the context of back-testing and P&L attribution. Although current firm-wide definition is subject to ongoing governance and control and often subject to scrutiny by local regulators/supervisors, as part of the Basel II back-testing process. Therefore, industry is in favour of some degree of consistency with the current capital and back-testing regime.
The industry considered the provision to be clear, however the majority of industry survey respondents disagreed with the provision and are concerned that by calculating adjustments only for the trading desks of the Internal Model Approach (‘IMA’) perimeter, without taking into account the netting with Standardised Approach (‘SA’) trading desks, will considerably deviate from the fair value" which is the foundation on which P&L is based according to IFRS 13:48:
“An entity shall measure the fair value of the group of financial assets and financial liabilities consistently with how market participants would price the net risk exposure at the measurement date".
If the bank would need to close all positions it will net off positions across all trading desks (IMA and SA both), before going externally. For example, P&L volatility for the bank is calculated based on net positions across all trading desks. As such a calculation based on all positions should be possible, with allocation to individual desks.
The industry respondents also noted that it will be overly burdensome to run valuation adjustment calculation based on the IMA population only. The industry compute valuation adjustments (VA) not for the purpose of the back-testing, but VAs are calculated to account for factors not explicitly addressed in models to ensure fair value compliance for all relevant products across trading desks, which is not specific to IMA population. There is no economic meaning to calculate valuation adjustment only for the IMA population."
The industry agrees with the provision outlined in paragraph 5 to include in the portfolio’s changes the value of an adjustment stemming from the entire portfolio of positions subject to own funds requirements (i.e. both positions in standard-approach desks and positions in internal model approach desks).
As a practical expedient, and to align the calculation of adjustments with business practice, the industry believes the approach of including all positions subject to own funds requirements for market risk is appropriate.
The provision also leads to the possibility of alignment with the actual calculations in the banks. Some banks might calculate adjustments on a portfolio basis and allocate to individual desks, other banks might calculate on a desk basis and take the diversification centrally.
The industry also notes that computing adjustments on the positions in trading desks that are calculating the own funds requirements using the internal model approach only is overly burdensome because it will deviate from the actual calculations which do not make a distinction between internal model and standardised approach. Valuation adjustment is calculated to account for factors not explicitly addressed in models to ensure fair value compliance for all relevant products across trading desks, which is not specific to IMA population. There is no economic meaning to calculate valuation adjustments only for the IMA population.
This question has been repeated - see above response for Q8.
Industry welcome EBA’s work to allow alignment of RTPL / HPL due to the differences in the risk factor derivation due to data sources and use of different techniques to derive the risk factors “at source” of this information, as described in particular in the explanatory part of the EBA consultation paper p19. Industry observed however that the text of the article 15 (Section 2) leaves room for interpretation. To clarify, industry suggests to reword the text of the section 2 as follows:
“2. For the purpose of Article 325bg of Regulation (EU) No 575/2013, an institution may replace the value of a risk factor used in the calculation of the theoretical changes in the trading desk portfolio’s value by the value of the same risk factor used in the calculation of the hypothetical changes in the trading desk portfolio’s value (or derived from input data used in the calculation of the hypothetical changes in the trading desk portfolio’s value), where all of the following conditions are met:
(a) the risk factor used in the calculation of the hypothetical changes in the trading desk portfolio’s value does not directly correspond to an input data;
(b) the risk factor has been derived from input data using any techniques of the valuation systems used for the hypothetical changes in the trading desk portfolio’s value;
(c) not all of the techniques of the valuation systems referred to in (b) have been rebuilt in the valuation systems used in the risk measurement model to derive the value of the risk factor used in the calculation of the theoretical changes in the trading desk portfolio’s value.”
The rephrasing will create more transparency on eligible adjustments – e.g. in case where the RTPL is using more risk factors than a particular trading desk marking (example below) it’s not clear if these can be aligned, whereas the alignment would be allowed if the data from vendors are used (as per the example given on the page 19). We also point out to the Article 16 that stipulates the requirement on the documentation and provision of the rational of any adjustment done within article 15 to ensure appropriate control framework. Example:
Risk Factors (Hypothetical): Swaps(1Y, 2Y) (Bootstrapping method used: A)
Risk Factors (Risk Theoretical): Swaps(1Y, 1.5Y, 2Y) (Bootstrapping method used: B)
For theoretical changes in the trading desk’s portfolio, the value of the 1.5Y Swap rate could be derived from FO marks (Swap rate 1Y & 2Y) and the FO bootstrapping method (A).
For the needs of end-of-day valuation, interest yield curve are usually stripped from the most liquid instruments and corresponding market prices. When instruments with fixed maturity date such as IR futures contracts are involved in the stripping for some segment of the curve, it is common practice to transform these market observations into equivalent price of “synthetic instrument” with fixed to maturity to exclude time decay effects in the calibration of risk factors and thus enable consistent shock distributions in the risk engine.
The right hand table shows a situation where an institution uses an outright USD-LIBOR 3M to perform end-of-day valuation but chooses to model this curve as a spread over the OIS curve, in order to get a more orthogonal representation of risk factors in the risk engine.
This transformation may be done by defining synthetic mono-currency basis swaps and derive related price based on the same pricing functions and input data as in the HPL. It also allows transforming data points corresponding to IR futures into equivalent data points with constant time to maturity. This transformation is not meant to reduce the granularity of the market information captured in the risk engine but transform into a tractable format, fit for the purpose of risk modelling.
Here, the 32 equivalent data points would be used as the input of reference price in the risk engine (ie reference price before shock), notwithstanding of how the institution decide to shock the data points (either with direct calibration or using a proxy).
The industry considers that data alignment should be allowed in such situation as long as institutions can justify to the satisfaction of supervisory authorities that these inherent transformations of market data, performed for the purpose of risk modelling, do not distort the representation/dynamic of the PL function and provide documentation thereof as required in Article 16(2).
Of course, allowing data alignment on these transformations would not mean that the institution would be able to disregard the quality of its shock model. If for instance it is chosen in the risk model to use historical data of the 10Y data point (#24) to calibrate the shocks for the longer segment of the curve (data points #25 to #32), then these proxies should inevitably be captured in the PLA test, that will assess the materiality of the approximation.