Cutting Edge Analytics
Last updated: 11 July 2022
As a consequence of the global financial crisis in 2007/2008, regulators worldwide put in a place a set of regulations aimed at overhauling the financial industry and preventing a similar crisis in the future. The regulations apply to all aspects of the business, such as trading, accounting, capital requirements, and reporting. They have implications on the structure, legal, the IT infrastructure, and the calculations a bank needs to perform on a daily basis. In addition, regulations are constantly refined and new regulations are added. Banks struggle to keep up with this challenge.
In this publication we will give an overview of the regulatory landscape and assess its impact on computational complexity.
Regulation Overview
Among the regulations impacting the financial services industry, the ones with the highest impact on computational complexity are the capital regulations (Basel III, FRTB, SA-CCR, leverage ratio, etc) and the new rules governing margining requirements (Dodd-Frank, EMIR, SIMM) for new trades. The table below gives an overview of these regulations.
| Context | Name | Scope | Description |
|---|---|---|---|
Trading| Dodd-Frank1 | US |
| |
| EMIR2 | EU | ||
| Bilateral margin requirements (BCBS D3173) | Global | Margin requirements for non-centrally cleared derivatives | |
| SIMM4 | Global | Standardised methodology for computing initial margin (based on sensitivities) | |
| Capital | Basel III (BCBS 1895) | Global | Changes to all aspects of regulatory capital, introduction of CVA charge. |
| FRTB-TB (BCBS 2656, BCBS D3527) | Global | Market risk capital – addition/replacement from Basel 2.5/3 | |
| FRTB SA-CVA (BCBS D3258) | Global | CVA capital, based on CVA sensitivities | |
| CRD IV9 | EU | EU implementation of Basel III | |
| CCAR10 / DFAST11 | US | Annual bank stress tests, mainly for capital | |
| EBA stress tests12 | EU | ||
| SA-CCR (BCBS 27913) | Global | Replaces Basel 2.5/3 CEM and SM methods for CCR capital | |
| IMM removal (BCBS D36214) | Global | Proposal to remove Basel 2.5/3 internal model method for CCR and CVA capital charges | |
| Prudent Valuation15 | EU | Additional capital charge for difference between conservative valuation and value recorded by accounting (Additional Valuation Adjustment) | |
| Leverage Ratio (BCBS 27016) | Global | Risk-independent backstop for capital – sets max ratio of overall capital to overall exposure |
In the following, we zoom in on the margining and capital regulations and detail their impact on computational complexity.
Margining Rules
Dodd-Frank1 in the US and EMIR2 in Europe include an obligation to centrally clear certain classes of OTC derivatives between financial counterparties and large non-financial counterparties. This implies that both initial and variation margin (IM/VM) are required for these trades on a daily basis. While this reduces counterparty risk, and hence CVA/DVA, it introduces the need to fund the additional collateral and hence increases funding costs (FVA/MVA). Hence complex IM calculations are needed, and FVA/MVA should be calculated to manage the full cost of the trades.
Further, the Basel Committee for Banking Supervision requires an initial margin to be posted for more bilateral trades in BCBS D3173, to be phased in from September 2016. Increasing numbers of OTC derivative trades need to post initial margin, in cash, which cannot be rehypothecated. This eliminates counterparty credit risk, but funding the initial margin creates additional costs and risks. Therefore banks are starting to price in MVA, which reflects the funding cost of initial margin over the lifetime of the trade. Calculating MVA requires a complex Monte-Carlo simulation and, if no further algorithmic optimisations and approximations are applied, requires a nested Monte-Carlo simulation. This clearly has a high impact on the calculation requirements of the banks. The figure below compares trading with and without initial margin.
To reduce disputes and legal risk, the ISDA published SIMM4, a mandatory methodology to calculate initial margin. It requires calculating sensitivities of the trades to a large set of market risk factors on a daily basis, which poses a computational challenge to banks. Further, when calculating MVA, these sensitivities need to be evaluated for SIMM in many thousands of Monte-Carlo scenarios for multiple simulation dates.
Regulatory Capital
Regulatory capital is determined as a sum of three main capital charges:
- Market risk charge:
To compensate for risk from daily movements in market parameters - Counterparty Credit Risk (CCR) charge (default risk):
Related to losses in case of defaults of a counterparty - CVA charge:
Capitalise the risk of future changes in the CVA component of the derivative prices
The regulator defines two approval levels for banks, which determines how the can compute their capital charges: standardised or internal models. The table below summarises the regulations for the capital charges.
| Approval Level | Period | Market Risk | CCR | CVA |
|---|---|---|---|---|
| Standardised | current | Basel 2.5/3 VaR, IRC, CRM (BCBS 15817) | Basel 2.5/3 SM / CEM (BCBS 1895) | Basel 3 CVA (BCBS 1895) |
| new | FRTB SBA (BCBS D3527), Jan 2019 | SA-CCR (BCBS 27913), Jan 2017 | FRTB SA-CVA / BA-CVA (BCBS D3258), issued for comments Oct. 2015 | |
| Internal Models | current | Basel 2.5/3 VaR, IRC, CRM (BCBS 15817) | Basel 2 IMM | Basel 3 IMM CVA (BCBS 1895) |
| new | FRTB-IMA (BCBS D3527), Jan 2019 | to be removed with BCBS D36214 (issued for comments Jun. 2016) | to be removed with BCBS D36214 (issued for comments Jun. 2016) |
As we can see, many changes are on the horizon and banks are facing increasing calculation requirements.
FRTB SBA7 market risk capital approach is based on sensitivities to a large number of market risk factors, which need to be calculated efficiently. FRTB-IMA7 requires up to 63 expected shortfall calculations, compared to two VaR calculations in the previous regulation.
For CCR capital, the SA-CCR13 method is a more complex method than the previous standard or current exposure methods (SM / CEM), which is also more risk-sensitive and takes into account hedges better.
The proposed FRTB SA-CVA8 regulation requires calculating CVA sensitivities to a wide range of market risk factors. As CVA is calculated in a complex Monte-Carlo simulation, adding sensitivities is no simple matter.
The BCBS D36214 consultative document, issued for comments in June 2016, proposes to remove internal models based approaches for CCR and CVA capital, in favour of more standardised and comparable calculations between banks. Future discussions will show whether this proposal becomes a regulation.
Indirectly, all new regulations on the capital requirements have an impact on KVA, which reflects the cost of capital over the lifetime of a portfolio. Banks are implementing and constantly adapting their KVA calculations to keep up with the regulations. The leverage ratio16 and prudent valuation15 regulations also have an impact on KVA calculations.
The European stress tests and CCAR10 / DFAST11 in the US also have an indirect impact on the computational complexity. With these annual stress tests, banks have to evaluate, among other things, their capital under various macroeconomic stress scenarios. This involves repeatedly calculating XVAs and capital charges – all complex calculations that take considerable time and IT resources.
1Dodd-Frank Wall Street Reform and Consumer Protection Act, July 2010.
2Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR), European Banking Authority, July 2012.
3Margin requirements for non-centrally cleared derivatives (BCBS D317), Basel Committee on Banking Supervision, March 2015.
4ISDA WGMR Implementation Initiative, International Swaps and Derivatives Association (ISDA), Sep 2016.
5Basel III: A global regulatory framework for more resilient banks and banking systems,(BCBS 189) Basel Committee on Banking Supervision, June 2011.
6Fundamental review of the trading book: A revised market risk framework (BCBS 265), Basel Committee on Banking Supervision, Consulative Document, October 2013.
7Minimum capital requirements for market risk (BCBS D352), Basel Committee on Banking Supervision, January 2016.
8Review of the Credit Valuation Adjustment Risk Framework (BCBS D325), Basel Committee on Banking Supervision, Consultative Document, July 2015.
9Capital requirements regulation and directive – CRR/CRD IV, European Banking Authority, legislative texts, 2013.
10Comprehensive Capital Analysis and Review, US Federal Reserve Board, 2016.
11Dodd-Frank Act Stress Tests, US Federal Reserve Board, 2016.
12EU-wide stress testing, European Banking Authority, 2016.
13The standardised approach for measuring counterparty credit risk exposures (BCBS 279), Basel Committee on Banking Supervision, April 2014.
14Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches (BCBS D362), Basel Committee on Banking Supervision, Consultative Document, March 2016.
15EBA FINAL draft Regulatory Technical Standards on prudent valuation under Article 105(14) of Regulation (EU) No 575/2013 (Capital Requirements Regulation — CRR), European Banking Authority, January 2015.
16Basel III leverage ratio framework and disclosure requirements (BCBS 270), Basel Committee on Banking Supervision, January 2014.
17Revisions to the Basel II market risk framework (BCBS 158), Basel Committee of Banking Supervision, July 2009.