This report presents regulatory technical standards that define the conditions and indicators for determining whether extraordinary circumstances have occurred, which could justify relaxing requirements for the use of internal models in cases of financial market stress. The standards specify that only situations of cross-border financial market stress or regime shifts can be considered extraordinary, provided they…
The document is a final report published by the European Banking Authority (EBA) in June 2024, entitled "Draft Regulatory Technical Standards on conditions and indicators that EBA shall use to determine whether extraordinary circumstances have occurred for the purposes of Articles 325az(5) and 325bf(6) CRR." It is a 23-page regulatory standard establishing a framework to identify extraordinary circumstances enabling competent authorities to relax or exempt certain requirements related to the use of internal models for market risk. The scope covers European financial institutions subject to Regulation (EU) No 575/2013 (CRR), notably Articles 325az and 325bf, and applies to periods of 250 business days preceding the evaluation.
- Subject: The report presents Regulatory Technical Standards (RTS) defining the conditions and indicators the EBA must use to determine whether extraordinary circumstances have occurred, justifying a relaxation of regulatory requirements on internal market risk models (Articles 325az(5) and 325bf(6) CRR).
- Importance: This framework avoids heavy legislative changes in case of major crises by allowing temporary exemptions adapted to exceptional situations affecting multiple institutions.
- Main findings: Only two situations can qualify as extraordinary circumstances: significant cross-border financial stress or a major regime change impacting the validity of back-testing or profit and loss attribution test (PLAT). Key indicators include volatility and correlation levels, as well as the speed of onset of stress or regime change. The application period covers the stress period and an impact period lasting up to 250 business days.
- Conclusions: The proposed framework is flexible, avoiding an exhaustive list of indicators, and relies on a qualitative assessment by the EBA. It aims to preserve the robustness of the prudential framework while allowing an appropriate response to systemic crises.
- Recommendations: The report recommends adopting these RTS, which will be submitted to the Commission, then to the European Parliament and the Council, before official publication. Their application will begin 20 days after entry into force (p. 3-10).
- Context: CRR3 introduces the possibility for competent authorities to grant exemptions to internal model requirements in case of extraordinary circumstances, to avoid heavy legislative changes during crises, as was the case during the COVID-19 pandemic.
- Issue: It is necessary to precisely define what these extraordinary circumstances are and the indicators to identify them, to avoid excessive or inappropriate use of these exemptions that would weaken the regulatory framework.
- Objectives: The EBA must develop Regulatory Technical Standards (RTS) specifying the conditions and indicators to recognize these circumstances, relying notably on Basel Committee (BCBS) principles.
- Scope: The framework applies to European financial institutions using the internal model approach for market risk, particularly for back-testing and PLAT over periods of 250 business days.
- Limits: The framework does not set precise quantitative thresholds for indicators, to maintain flexibility given the diversity of possible crises (p. 4-6, 11-13).
Definition of extraordinary circumstances:
- Only two situations can be recognized: significant cross-border financial stress or a major regime change (e.g., liquidity crisis) affecting multiple institutions in the EU/EEA.
- These situations must impact the validity of back-testing or PLAT results, without these failures being due to internal model defects (p. 3-6, 8-10).
Indicators and factors to consider:
- Volatility: analysis of volatility indices (e.g., VIX, VSTOXX) and realized volatilities, compared to levels observed during the global financial crisis or the COVID-19 pandemic.
- Correlations: assessment of sudden and significant changes in asset correlations.
- Speed of onset: consideration of how quickly the stress or regime change manifests.
- Other possible indicators (non-systematic): liquidity indicators, unusual spread deviations, trading restrictions, number of back-testing overshootings, but these are not included in the mandatory minimum list (p. 8-10, 17-19).
Application period:
- The review period covers 250 business days preceding the evaluation date, including the stress period and an impact period that may last up to 250 business days after the stress ends.
- Exemptions may thus apply during and after the stress period (p. 6).
Evaluation process and role of competent authorities:
- The EBA determines whether conditions are met to recognize extraordinary circumstances.
- Competent authorities then analyze the impact on supervised institutions and may grant tailored exemptions, notably considering known model deficiencies (p. 5-6).
Regulatory options and chosen approach:
- Two options considered: granular and automatic quantitative criteria vs. general and flexible criteria.
- The EBA favors general criteria to maintain necessary flexibility given the diversity of crises, avoiding too frequent or premature triggers.
- This approach promotes qualitative and situation-adapted analysis (p. 12-13).
Public consultation feedback:
- Only one respondent expressed reservations about the restrictive definition of extraordinary circumstances, suggesting inclusion of other crisis types (local, economic, political).
- The EBA maintains its approach, emphasizing that local events or economic cycles are part of normal risk and do not justify temporary relaxations.
- The EBA added correlation indicators to the minimum list of factors to consider.
- The EBA specifies that the assessment focuses on impact at European market level, even if entities outside the EU may be indirectly affected.
- Responses led to minor drafting adjustments but no fundamental changes (p. 14-22).
- Established facts:
- The CRR3 regulatory framework allows exemptions in case of extraordinary circumstances.
- These circumstances are defined as significant cross-border financial stress or a major regime change affecting multiple institutions.
- Key indicators are volatility, correlations, and speed of stress onset.
- The review period covers 250 business days, including the stress period and an impact period.
- Assumptions:
- Future crises will have characteristics similar to past crises (global financial crisis, COVID-19) in terms of volatility and correlation.
- A qualitative and flexible approach is preferable to a rigid quantitative approach.
- Interpretations:
- The EBA interprets that only major systemic crises justify exemptions.
- Local or cyclical events are not considered extraordinary.
- Uncertainties:
- The exact nature of future crises is unpredictable, justifying framework flexibility.
- Differentiated impact on institutions requires case-by-case evaluation by competent authorities (p. 4-6, 11-14, 17-22).
- The EBA recommends adopting the RTS defining a clear but flexible framework to identify extraordinary circumstances justifying exemptions to internal market risk model requirements.
- This framework relies on two cumulative conditions: occurrence of significant cross-border financial stress or major regime change, and the impact of this stress on the validity of back-testing or PLAT.
- Competent authorities have discretion to analyze the impact on each institution and grant tailored exemptions.
- The RTS will be submitted to the European Commission, then to Parliament and the Council, before publication and entry into force 20 days after official publication.
- The chosen approach favors flexibility and qualitative consideration of indicators, avoiding a rigid and exhaustive list that could harm the relevance of exemptions.
- The framework aims to preserve the robustness of the prudential regime while allowing an appropriate response to exceptional systemic crises (p. 3-4, 11-14, 15-22).
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