The Model Risk Management (MRM) function faces significant challenges due to changes in regulation and the industry. The pressure to reduce costs and the tight labor market for quants forces banks to transform their MRM by implementing a holistic framework and increasing the level of automation. The following interconnected challenges need to be addressed in tandem:
- Develop and implement an integrated “IBOR meets FRTB” strategy to utilize overlapping resources in an optimal way
- Define an integrated IBOR & FRTB implementation strategy roadmap capturing product changes, pricing and modelling considerations across trading desks, data requirements and IT infrastructure
- In developing an integrated strategy and plan, enough time needs to be considered for user acceptance testing, validation and potential finding remediation
In the following, the two challenges and implications for banks are discussed in more detail:
Validation of the alternative standardized approach
After entry into force of the CRR II at the end of 2019, the timeline for implementation is set. To meet the reporting requirements as of September 2021, banks are currently finalizing the implementation of the alternative standardized approach (A-SA). Due to its high complexity and ambiguities in the regulation, the implementation is not straightforward and prone to errors such as rounding errors, inconsistent data for mapping to the buckets or errors in the sensitivity input files. Therefore, some banks decided to involve the validation unit in the process to make sure the implementation adheres to the regulatory requirements and industry standards, where the regulation is ambiguous. Since the methodology for the A-SA is prescribed by the regulation, the validation process is not assessing the conceptual soundness, but centers around analysis and quality of the input data and the correctly implemented aggregation. This allows for a high degree of automation and an efficient use of resources since the validator only needs to investigate the differences identified.
Supervisory permission regarding the application of alternative approaches for the alternative standardized approach
In certain cases the CRR II allows institutions to use an alternative approach deviating from the regulatory prescribed approach. However, this requires supervisory permission and institutions must submit the appropriate supporting documents to the supervisor to obtain the permission.
Use of alternative Delta & Vega sensitivities (Cf. Art.325t)
For the purpose of calculating the Delta and Vega risks, institutions could use sensitivity formulas different than those prescribed. To obtain supervisory permission, the prescribed conditions must be satisfied, and institutions should justify its rationale and demonstrate the materiality of its impact on the capital charge.
FX curvature – scalar approach (Cf. Art.325q)
If institutions would like to apply the scalar 1.5 consistently for all FX risk factors subject to curvature risk, including shifting simultaneously any FX risk factors based on the institution’s reporting currency (or base currency), institutions should be able to justify its rationale for using this approach and its materiality on the capital charge in terms of FX curvature risk.
Base currency approach (Cf. Art.325q)
Institutions could choose another currency than its reporting currency to express the Delta and Curvature FX risk factors. For using this approach, institutions should demonstrate that the prescribed conditions are satisfied.
CIU treatment – Mandate-based approach (Cf. Art 325j) & Tracked index benchmark approach (Cf. Art 325j)
Upon supervisory permission, the Mandate-based approach could be used under the condition that the institution has sufficient knowledge of the mandate and other information about the investment strategy. For using the Tracked index benchmark an institution may, subject to supervisory permission, use an annualized return difference from a period shorter than 12 months for CIUs with less data available.
Consolidated requirement (Cf. Art.325b)
For the purpose of calculating the capital requirement at the consolidated group level, the positions across subsidiaries or undertakings could be offset. In order to apply this approach, institutions must identify and aggregate risk positions at a homogeneous granular level across subsidiaries or undertakings that fulfil certain legal and regulatory requirements.
Impacts to Models from the IBOR transition
The enterprise-wide impact of transitioning away from LIBOR onto alternative risk-free rates (RFRs) like €STR and SOFR is coupled with a tight timeframe. By the start of 2022, all remaining dependencies to LIBOR should be removed. This transition has pervasive impacts on the bank’s products, operations as well as models & risk landscape.
Overall, regulators have consistently stressed that the final deadlines will not be pushed back. Market participants can expect more scrutiny on their model validation and governance by regulatory bodies. Recently, JSTs and the ECB have reached out to several banks collecting responses on the impact of LIBOR on models and how the banks are preparing for the transition.
Given the urgency of focusing on other aspects in the IBOR transition, the implications for models have only become a major focus in the past few months. Addressing and preparing for the remediation of models is a high-volume and business-critical task that could overload your potentially already stressed resources and depends on internal set ups, timing and external milestones. A significant number of banks’ current models involve IBOR, meaning they will need to be remediated, recalibrated and revalidated. This will impact all lines of defence (LoD) front-to-back in the following way:
We believe taking a proactive approach now will realise a more fluid transition program for model work streams to the end of 2021 and beyond. To be prepared for the challenges ahead, you need to consider the following points:
- Challenge: Aligning your model strategy closely to your IBOR product strategy
- The product strategy will need to consider the plan for instruments currently incompatible with the nature of the proposed fallbacks.
- New products based on RFRs need to be considered in model development, implementation and validation.
- Challenge: Underestimating the volume of necessary model work
- While some aspects of the LIBOR reform may mirror the LIBOR to OIS discounting transition, the challenges are much deeper with reference index updates and an increasing number of new products to maintain that also will need to be validated.
- Plan and budget resource efforts as soon as possible as model work on the transition will occur at the same time as other initiatives like FRTB resulting in efforts likely to be in excess of normal BAU.
- Challenge: Anticipating future needs to ensuring flexibility in infrastructure
- Many recent updates in the cash-world for example seem to break consistency with their derivative counterparties and the final conventions are not yet set in stone.
- Model infrastructure should be suitably adaptable to accommodate alternative conventions to aid a quick and efficient entry to markets.
- Challenge: Preparing for regulatory scrutiny on transition impacted models
- Regulation requires an impact analysis (e.g. material or immaterial impact) on capital requirements before implementing a change (e.g. change of discounting methodology, inclusion of fall-back rates etc.) on the total market risk Pillar I regulatory capital, Pillar II, Banking Book and Trading Book models, separately.
- Whether LIBOR transition makes ex-ante notification or model change necessary, regulators are certainly looking for well documented impact assessment and model changes.
Understanding the impacts from the IBOR reform on your model inventory is key and a timely preparation is essential to overcome the IBOR reform challenges for model implementation, remediation and validation. PwC has developed Model Edge as a platform to help you prepare and minimize the involved risks.
For more information on this topic do not hesitate to contact us.