The EBA published draft Regulatory Technical Standards (RTS) on the assessment and approval of internal models for market risk on 14 December 2015. The new document sets out far more detail on market risk model requirements than is currently contained in the Capital Requirements Regulation (CRR) or the PRA Rulebook and Supervisory Statements.

In particular, the paper proposes some significant changes and additions to the standards expected of banks in their market risk model applications:

  • The EBA is proposing that market risk model applications should cover 90 to 95% of all trading book positions. This is a significantly greater scope than many of the market risk models currently used by banks and brokerage firms (e.g. many existing CAD 1 and VaR models currently fall far short of this threshold).
  • If the excluded positions grow significantly they must be brought into scope of the model. The EBA say they are including this provision to prevent 'window dressing', whereby banks may shrink certain categories of positions immediately prior to applying for model approval.
  • There would be an exception for securitisation positions and foreign currency positions taken to hedge against foreign-exchange risk, which may be excluded from the scope of the model. The latter category requires regulatory approval.
  • The EBA is considering bringing specific risk of positions in banks' own debt instruments into scope of VaR models. These risks had been carved out of VaR models previously, and remain carved out under the standardised approach.
  • Variable remuneration of staff involved in the assessment of the model must not be linked to the performance of the trading activities covered by the model.

It is not clear if regulators will apply the new requirements retrospectively to existing market risk models, but the PRA could well use any changes as justification to require banks to review their existing market risk models against the new requirements in the near future.

The new standards will also apply to any applications for changes or extensions to existing market risk models.

Interestingly, the EBA state that they have sought to move 'in the direction' of Basel's Fundamental Review of the Trading Book (FRTB) when drafting the new requirements e.g. by requiring more rigorous back-testing. This suggests we may see more examples of the EBA pre-emptively adopting Basel policies when developing European standards.

The RTS also reiterate requirements around internal governance and management of the model. This includes a requirement that where any aspect of the model assessment or validation is outsourced to a third party the firm nonetheless continues to have sufficient in-house knowledge and expertise to operate its model.

As before, compliance with these requirements must reviewed annually by an independent Risk Control Unit or Internal Audit function. In addition the model must be up and running for at least one year prior to submission of the application in order to facilitate rigorous back-testing as part of the approval process.

The EBA will consider comments from the industry as part of a consultation period that runs until 13 March 2016. Following this process the EBA will submit the finalised RTS to the European Commission.

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