- What is XVA?
X-Value Adjustment (XVA) is a collective term for “valuation adjustments” made to derivative trades to reflect various costs related to the trade. The first valuation adjustment was Credit Value Adjustment (CVA); which reflect the credit risk for a given counterparty of a trade. Since the creation of CVA, additional valuation adjustments have been created to capture the cost of funding (FVA), cost of your party defaulting (DVA), cost of collateralization (KVA) and the cost of initial margin (MVA).
- What is SA-CCR?
The Standardized Approach for counterparty credit risk (SA-CCR) is the capital requirement framework under Basel III addressing counterparty risk. The SA-CCR exposure-at-default calculation drives a bank's regulatory capital calculations and is a measure of counterparty credit risk as it calculates the exposure at default (EAD) of derivative trades with counterparties. SA-CCR is calculated as if a counterparty were to default today as the current value of the trade plus an add-on which measures potential future exposure (PFE). The framework replaced both non-internal model approaches (non-IMA): the current exposure method (CEM) and the standardized method (SM).
- What is FRTB?
The Fundamental Review of the Trading Book (FRTB) refers to a comprehensive restructuring of market risk regulatory capital requirements published by the Basel Committee on Banking Supervision (BCBS) between 2016 and 2019 in response to the financial crises. After a few iterations since 2016, BCBS published the final version of the framework in January 2019, and local regulators are starting to release their final translation of FRTB into local law.
With FRTB, banks will have to comply with new rules by 1 January 2023, but a lot of retro planning, implementation and model validation work as well as regulatory approval is required in order to publish official capital numbers by this date. Banks operating trading books will have to confirm to their respective supervisory authorities whether they wish to pursue a Standardized Approach (SA) calculation or obtain approval for an Internal Model Approach (IMA) for each desk in scope.
- What is the difference between FRTB and previous regulations?
FRTB introduces a number of changes for market risk capital requirements including stricter boundaries between the bank’s Trading and Banking Book allocations (i.e. for active trading vs. held to maturity) and fewer possibilities to move trades between them. Instead of a top-of-the-house model approval, banks will have to seek approval at the level of each Regulatory Trading Desk as well as calculating consolidated capital requirements either under the Standardized Approach (SA) or the Internal Model Approach (IMA). Risk Factors to be included in IMA calculations will need to be evidenced as derived from sufficiently observable or liquid instruments (thereby becoming “modellable”), else banks will have to calculate a Stressed Expected Shortfall (SES) add-on for them instead.
The IMA framework also switches from the usual VaR metric to an Expected Shortfall-based risk measure based on the risk type and associated liquidity horizon. In addition, eligible desks will need to demonstrate they pass not only back testing requirements but also a P&L Attribution test designed to reduce any gaps between front-office and risk models which will often increase risk factor granularity compared to existing VaR models. Failing these criteria, desks will have to fall back to the new Standardized Approach which although still based on close-ended sensitivity-based calculations, still increases in complexity and requires implementation changes.
- What is ISDA SIMM?
The International Swaps and Derivatives Association (ISDA) standard initial margin mode (SIMM) is a risk sensitivity-based approach to calculate initial margin (IM) for uncleared derivatives ISDA providing model parameters to calibrate for each product class on historical data considering a period of relevant financial stress. Over-the-counter (OTC) derivatives are categorized into one and only one of the following four Product Classes: RatesFX, Credit, Equity, and Commodity. Under ISDA SIMM, initial margin is calculated using sensitives as inputs. This includes Delta and Vega such that the initial margin would cover 99% confidence given a 10-day margin period of risk. For each product class covered ISDA specifies which sensitivities are required. For Equity, Commodities & FX spot prices are bumped 1% to calculate deltas, and volatility is shifted 1% to calculate vegas. For Interest Rates, curves are bumped at 12 points to calculate deltas.
- What is Scenario Stress Testing?
A bank stress test is an analysis conducted under hypothetical unfavorable economic scenarios, such as a deep recession or financial market crisis, designed to determine whether a bank has enough capital to withstand the impact of adverse economic developments. The importance of robust and rigorous stress testing has moved to the top of the agenda of risk management priorities with many banks having to comply with multiple regulatory regimes i.e. US CCAR & DFA, UK BoE/PRA and ECB/EBA requirements.
In contexts where firms have discretion over the design of scenarios, they must make a large number of subjective decisions around scenario definition. Scenario Stress Testing (SST) allows users to specify hypothetical, historical or regulatory shocks and revalue their portfolio to understand market-market (MTM) loss and changes to counterparty credit exposure. Using Scenario Stress Testing, users can specify shocks to a subset of risk factors which are expanded to all the risk factors in their portfolio through a combination of rules and statistical methods. Banks construct scenarios thus allowing stress testing to be a pro-active process they can use for internal risk and business planning.