Mar 17, 2015

The Genesis of Basel IV

In this video blog Satyam Kancharla, Chief Strategy Officer and SVP of the Client Solutions Group breaks down the key components of the Fundamental Review of the Trading Book. Specifically he addresses Expected Shortfall vs. VaR, Liquidity Horizons as well as the overall approach to internal models-based measurement and the revised standardized approach. Satyam also reflects on the overall shift towards looking at PnL from a positions and risk factors perspective, versus entity-level.

Weigh in and continue the conversation on Twitter @nxanalytics or LinkedIn

Video transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog, your expert source on Derivative trends and topics. I’m your host Jim Jockle. As institutions continue to embark on implementing the necessary changes related to Basel III, the distant hum of what many market participants anticipate to be the genesis of ‘Basel IV’ is looming in the background.
From a market risk perspective, all eyes are on the draft proposal of the Fundamental Review of the Trading Book. Ultimately, this revised framework of market risk guidelines could bring significant change to both Internal and Standardized models.
Joining me today to discuss this is Satyam Kancharla, Chief Strategy Officer and SVP of the Client Solutions Group here at Numerix. Satyam, thanks for joining.
Satyam Kancharla (Guest): Hi Jim.  

Jockle: So, quick question, to start with. You provided us a summary of what we believe market participants should be thinking about in the coming months. So, why don’t you take us a little bit through a background of the timeline of some of the issues with FRTB.

Kancharla: That’s exactly the question that a lot of people are now talking about. What’s the timeline, when is this going to be finalized, when is this applicable to different types of institutions. With respect to how it all started, back in 2009, we had what we called Basel 2.5 and at that time it was a reaction to the global financial crisis, it was an immediate set of things the Basel committee felt that it should do in order to put some additional risk controls and additional capital charges in place.

At that point, they also parked certain issues for fundamental review, hence, Fundamental Review of the Trading Book that would be done later and since then, they’ve been doing several versions of consolidated documents to describe what is now being called the Fundamental Review of the Trading Book, also being called as Basel IV.

And there is a general, the philosophical direction is moving towards looking at the entire book from a positions perspective, as well as from a risk factors perspective, to look at what risk factors are at play. Both for the standardized approach, as well as the internal models approach.

Jockle: So there’s really 3 key areas that are new as it relates to FRTB, number one expected shortfall vs. VaR, liquidity horizons and some of the methodologies. Can you give us a little bit more depth on those issues?

Kancharla: Absolutely. One of the changes that we are expecting to see is a move to expected shortfall as a measure of Risk and as a measure that then builds into the capital, as opposed to VaR. Now expected shortfall obviously being a tail measure, seen as something that can more accurately capture the tail risk that exists in a book.

The other factor that we see is a liquidity calculation that’s far more granular than what we saw before, whereas in the past we had a blanket number, which was a multiplier used by Basel. Now we have something that’s more tailored and more granular, based on the specific liquidity profile that we expect to see or that we see in the market for different types of instruments.

And then there’s this whole notion of looking at internal models and standardized models, not at an entity level, but also looking at it at a desk level. So every desk is being examined, or is going to be examined, from a PnL perspective, from a back testing perspective; so the regulator can essentially switch between the standardized approach and the internal models approach at a desk level, as opposed to the entity level.

And then, also different risk factors are being looked at and there is this notion of a non-modelable risk factor, and for that they’re going to apply a different type of approach. But there are certain conditions under which a risk factor is supposed to be modelable.

And then finally, there is the move towards incremental default risk, incremental risk charge, and essentially incremental default risk focuses only on default versus both default and migration risk. And the reason is, the Basel committee felt that migration risk and spread risk had a lot of overlap and they didn’t want to have double counting off that specific measure of risk, so there is a focus to default risk only within IDR, incremental default risk.

And finally, there are a number of changes on the standardized approach and there’s also a sensitivity based approach, which is intermediate between a standardized approach and internal models approach that’s being launched.    

Jockle: So, we’ve had conversations around BCBS 239 with the looming deadlines, and some of the technology challenges, in meeting that principle requirement. What kind of technology issues arise with FRTB? And I’m assuming there’s probably 2 buckets, one being in the realm of quantitative financial innovations, as well as core technologies.    

Kancharla: Absolutely. And, on the methodology side, as we discussed, we’re moving towards expected shortfall, moving towards liquidity horizons. With expected shortfall, being a tail measure, in principle there’s a lot of agreement about expected shortfall being a better metric of risk in the book.

However, there are a number of open issues with respect to how this tail risk has to be measured and how it can be measured reliably. Given that the tail we’re talking about, literally a few scenarios in a typical 250 a day VaR scenario, you’re talking about a small number, a handful of scenarios really determining what the expected shortfall is and therefore, whether we can reliably estimate expected shortfall in this manner, or do we really need to switch to a Monte Carlo based approach or longer time horizon is something that is being discussed at the moment.

Also, liquidity horizons how we calibrate them, how we measure them, how we back test them, these are all important questions that have to be handled. Also, on the standardized approach, what we are going to see is standardized approach is going to be mandated for all institutions and it is also likely going to be used to determine a floor or a surcharge. Which means that institutions have to not only compute internal models, but also standardized. So both have to be computed. And, that again brings a lot of data issues and technological issues that we’re also seeing in BCBS 239.

Jockle: From your opinion, it was clearly advantageous in the past, to utilize a non-standard approach specifically as it related to capital relief. With this change in terms of having to provide both the standard model and the IMM, are banks going to see the same benefit through an advance model?

Kancharla: I think that’s a great question, only time will tell. And there is a quantitative impact study that people are expecting to see. In many cases are being conducted internally within institutions and that will determine how the relative metrics will compare.

But in general, the idea is that the standardized approach will be defined as a common metric that will be derived from any bank, and in some sense it provides regulators with what the capital is going to be on a standardized basis across the industry and therefore there is an attempt to bring these two, the standard metric and the internal models together, so that there isn’t a lot of opportunity for arbitrage, or switching back and forth. So my expectation is that we will see these measures converge more than we have seen in the past.  

Jockle: Well, Satyam thank you so much for joining us and shedding light onto this topic. And of course we look forward to discussing with in the future and we want to hear your feedback going forward. It’s our goal to examine the topics that you want to talk about. So keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Check back soon for the latest industry news, blogs, videos, research and technical papers. Thanks for joining.

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