Shifting to a historical simulation approach to calculating its trading risks added millions of euros to Deutsche Bank’s value-at-risk based capital requirement over the last three months of 2020.

As of end-2020, required capital to cover market risks assessed using its souped-up internal model totalled €2.1 billion ($2.5 billion), up just half-a-percentage point on end-September. However, the VAR-based component of this charge soared 71% to €969 million over the period. The bank said this was caused by changing its Monte Carlo model for a historical simulation-based iteration on October 1.

The new model is “more responsive to extreme tail events such as those experienced in March and April of 2020”, the bank said. It also uses a direct 10-day period return calculation instead of a 10-day scaling from one day, as under the Monte Carlo model.

However, the increased VAR-based charge was offset by a sharp fall in the bank’s SVAR requirement. This stood at €559 million at end-2020, down 46% on the three months prior.

Deutsche’s incremental risk charge, the third component of its market risk capital requirement, increased 43% quarter on quarter to €560 million. The bank said this was the result of it taking on more sovereign exposures over Q4.

Required market risk capital as calculated using the standardised approach hit €224 million at end-2020, up €2 million on end-September. Total required market risk capital made up 9% of Deutsche’s overall capital requirement of €26.3 billion at year-end.

What is it?

Market RWAs are calculated using either the internal models approach (IMA) or standardised approach (SA). The IMA market risk calculation consists of four components: a VAR-based requirement; a SVAR-based requirement; an incremental risk charge; and a comprehensive risk measure for correlation portfolios.

Deutsche Bank received approval from the European Central Bank to alter its internally developed VAR model for capitalising market risks beginning October 1, 2020. This new model uses the historical simulation approach based on full portfolio revaluation, in contrast to the previously used sensitivity-based Monte Carlo model.

Why it matters

Ultimately, the market risk model switch did not change the overall size of Deutsche’s required capital. At least, not yet.

Because the outputs of the historical simulation approach are skewed by extreme tail events, like those witnessed at the height of the coronavirus crisis, higher VAR-based charges are likely to persist for the near future. Since the SVAR-based charge can expand and contract depending on the composition of the trading portfolio, as well as the historical stress period used, it’s possible that down the line Deutsche will have a higher SVAR charge on top of its elevated VAR-based charge, causing its overall market risk capital requirement to balloon.

In fact, this is almost certain to happen. That’s because if a bank’s VAR-based charge is higher than its SVAR-based charge, this should automatically trigger a change in the stress period used. However, Deutsche said it has delayed this switch following guidance from its regulators, who argue the current VAR is already “stressed” because of the coronavirus crisis.

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