EBA plans reboot of FRTB’s P&L test

The European Banking Authority (EBA) will start from first principles as it draws up a crucial test for banks that want to model their market risk capital requirements – an opening that will delight critics of the international version of the rules.

Banks have claimed the P&L attribution test is too sensitive and will be nearly impossible to pass without a painful systems revamp. It aims to make sure bank capital models are in line with those used to price and value trades, but a discussion paper from the EBA – due later this year – will explore a variety of ways to achieve this outcome, including the fundamental question of what measures should be compared.

Isabelle Vaillant, director of regulation for the EBA in London, says the ground-up approach is required because of inconsistencies in the Fundamental review of the trading book (FRTB) – the year-old international standards on market risk capital – and because the industry has no experience with the new test. Work also continues at the international level.

It is not all good news for banks, though. A deliberative approach from the EBA might leave European banks with no way to obtain modelling approval before the regime’s 2020 start date, potentially forcing them to apply the sensitivities-based approach (SBA) – a standardised formula that generates higher capital levels.

“We have to be pragmatic. We already have a backstop in the form of the SBA – that’s life. We’ll observe two or three years of practice and will then try to incorporate it into our standards,” says Vaillant in an interview with Risk.net.

The full interview will be published online on April 4. 

The FRTB was finalised by the Basel Committee on Banking Supervision in January last year, and now has to be transposed into domestic regulation by the committee’s members. In the European Union, the vehicle for that is a set of proposed amendments to the Capital Requirements Regulation (CRR II), issued by the European Commission in draft form on November 23, 2016.

In more than three-dozen places, the commission calls upon the technical expertise of the EBA to flesh out the rules – the level one text – with regulatory technical standards (RTS), known as level two. Crucially, it tells the authority to specify in a draft RTS the technical criteria for the P&L attribution test, which acts as the gateway to the use of internal models, and lighter capital requirements. 

We have to be pragmatic… We’ll observe two or three years of practice and will then try to incorporate it into our standards

Isabelle Vaillant, European Banking Authority

The end result of the EBA’s work is generally intended to mirror the substance of the Basel standards, but problems in the way the FRTB text currently describes the test make that impossible, Vaillant says. At the Basel level, work to address these issues is also in train.

“Comparing the Basel text and CRR, you have different difficulties. Basel is not even consistent from one piece to another – so there we still have to push for some aspects to be closed, and we are doing that. CRR offers some clarity on the P&L attribution test, but it’s obviously a goal of ours to make sure any progress in Basel is achieved in parallel with the CRR.”

The P&L attribution test is supposed to ensure a bank’s risk models, which would be used to calculate capital, are not missing any significant sources of actual P&L, but the FRTB contains two contradictory descriptions of the test. In one place, it tells banks to compare the outputs of their front-office and risk management models; in another, it says the different inputs to both sets of models should be fed into the front-office model and the outputs compared.

Banks see the first approach as more demanding. Quants at Italy’s Banca Intesa calculate it would require an effective correlation of 97% between the two models – too high, according to the industry, which claims the only way to pass would be to spend time and money trying to remove underlying differences in data and timing. 

CRR II uses the tougher definition when describing the test – leading FRTB specialists at some banks to conclude the official line is now set – but the EBA’s Vaillant says the authority has more latitude than that. 

“I have no doubt that this is open and that’s what we want to contribute with the discussion paper. The legislative proposal is a starting point and then the negotiations take place,” she says.

The EBA aims to publish the paper in around six months. 

Range of alternatives

A range of alternatives will be considered – Vaillant sees “several possible solutions”. She agrees with the draft of CRR II that the detail should not be baked into the final version of CRR II, which could then only be changed with the approval of the EU’s three legislative bodies. Instead, the level one text will give the outline of the test, with the detail added later in the form of an RTS or guidelines.

“[The level one text] would give the principle – what you have to compare. So, whether it is your risk management model being compared to your front-office model, or something else – there are several possible solutions. And then there will be technical standards to specify it,” she says.

As negotiations on the level one text continue, the EBA will use the findings of its discussion paper to deliver an opinion to the Council of the European Union – one of the EU’s three legislative bodies.

Fundamentally, the EBA believes capital should be risk-sensitive, says Vaillant – so one way to judge the appropriateness of the test would be to monitor the pass rate – but she says the authority will not design the test with a target pass rate as the sole criterion.

“It’s not a mystery that the EBA has been defending models with the idea I mentioned earlier – that risk sensitivity is crucial. Of course, it depends whether the modelling is robust, otherwise you stop talking about risk sensitivity and start calling it undue variability, so this is what we have to sort out,” Vaillant says.

“What we face with the P&L attribution test is that it’s not yet very well settled – so we are not facing years of practice, where banks know how to deal with it and are very sure they have stable practices. We don’t want to be advisers to the banks, but we have to push for practices to settle down,” she adds.