This document presents a draft of regulatory technical standards concerning the assessment of the materiality of extensions and changes to the use of alternative internal models for market risk, in accordance with the CRR2 regulation. It defines the evaluation conditions for material and non-material changes, as well as the notification requirements to competent authorities. The aim is to ensure a consistent and…
- Title: Draft RTS on the materiality of extensions and changes to the use of FRTB IMA and changes to the subset of MRF
- Author/organization: European Banking Authority (EBA)
- Date: 20 June 2024
- Type: regulatory standard (Regulatory Technical Standards - RTS)
- Scope: conditions to assess the materiality of extensions and changes in the use of the internal models approach (IMA) under the FRTB framework, as well as changes in the choice of the subset of modellable risk factors (MRF) according to article 325bc of the CRR
- Target population: financial institutions using the IMA for calculating market risk capital requirements
- Sector: European banking sector
- Period: CRR2 regulatory framework, implementation of FRTB requirements, focusing on post-authorization procedures for IMA use (p. 1-2, 5)
- Subject: This document presents the draft regulatory technical standards (RTS) developed by the EBA to define the conditions for assessing the materiality of extensions and changes in the use of the internal models approach (IMA) for market risk under FRTB, as well as modifications to the subset of modellable risk factors (MRF).
- Importance: CRR2 regulation requires that any material extension or change to the IMA or the choice of the MRF subset requires specific authorization from competent authorities (CAs), while other changes must be notified. However, the CRR does not specify criteria to assess materiality, which may lead to divergent practices and regulatory arbitrage risk.
- Main findings:
- The EBA relies on the previous RTS (based on VaR) to build this new framework adapted to the IMA based on Expected Shortfall.
- The distinction is maintained between material changes (requiring authorization) and non-material changes (requiring notification), the latter being subdivided into changes notified with additional information and with basic information.
- Materiality is assessed through a combination of qualitative criteria (e.g. organizational, methodological, IT changes) and quantitative criteria (impact thresholds on IMA-specific capital requirements: ES, SS, DRC).
- For changes to the MRF subset, the impact on the PEStRC/PEStFC ratio is also considered.
- Quantitative thresholds are precise: for example, a +15% increase or -10% decrease of the IMA OFR qualifies a material change.
- Notification must be made 4 weeks before implementation for non-material changes.
- Conclusions: These RTS provide a harmonized and clear framework for assessing the materiality of changes related to the FRTB IMA, ensuring consistent supervision and better transparency between institutions and authorities.
- Recommendations: Institutions must apply these criteria to classify their extensions and changes, prepare the required documentation (description, quantitative impacts, independent validation, internal approvals) and notify or request authorization from CAs according to the identified category (p. 3-4, 8-19).
- CRR2 introduced the FRTB-based IMA for calculating market risk capital requirements, with a strict authorization regime by competent authorities.
- Article 325az(8)(a) of the CRR mandates the EBA to define technical standards specifying the conditions to assess the materiality of extensions and changes to the IMA and the choice of the MRF subset.
- The objective is to ensure harmonized application across the EU, avoid divergences, and guarantee that authorities have adequate information to supervise these modifications.
- The document clarifies the notion of change or extension, distinguishes automatic changes (not considered changes) from bank-initiated changes (considered changes), and specifies grouping or splitting modalities of changes for assessment.
- Limitations: the document does not cover aspects related to reclassification of positions between trading book and banking book, which are deferred to future developments (CRR3) (p. 5-8).
Notion of change and model extension:
- Material changes involve modifications to methods, processes, controls, data collection, risk management organization, internal validation, and approved IT systems.
- Automatic changes mandated by regulation, if they remain within the approved framework, are not considered changes.
- Examples of material changes: change in valuation methodology, modification of bucketing for risk factor assessment, parametric change of an interest rate curve (p. 6-7).
Materiality assessment methodology:
- Classification into three categories: material changes (requiring authorization), non-material changes with notification and additional information, non-material changes with notification and basic information.
- Qualitative criteria: major organizational changes, inclusion of new desks or asset classes, fundamental modifications of calculation methods (ES, SS, DRC), internal validation, IT, risk management.
- Quantitative criteria: precise thresholds on relative impact on the IMA OFR and its components ES, SS, DRC, calculated over a representative period of 15 business days, with relevance conditions (>5% of OFR) and exemption thresholds (<1% absolute impact).
- For extensions, stricter thresholds (e.g. +10% for OFR) than for changes (e.g. +15%) (p. 8-14).
Assessment of changes to the MRF subset:
- The reduced subset of MRF is defined in approved internal policies.
- Material changes are those significantly modifying the IMA OFR, ES, or the PEStRC/PEStFC ratio (threshold of 80% for this ratio).
- Non-material changes are also categorized according to similar but lower quantitative thresholds.
- Mandatory notification 4 weeks before implementation, except in case of regulatory ratio breach where immediate notification is required (p. 14-16).
General principles and documentation:
- Use of the most recent model configuration and calibration.
- Grouping related changes for a single assessment.
- In case of doubt, obligation to inform the authority with justification, which may reclassify the request.
- Documentation required according to category, including description, justification, quantitative impacts, independent validation, internal approval, version history.
- Validation reports must verify materiality, data representativeness, and propose corrective action plans (p. 17-19).
Regulatory provisions:
- The RTS draft specifies applicable articles and thresholds, calculation methods for ratios and impacts, notification and authorization procedures, as well as documentation requirements.
- Entry into force planned after adoption by the European Commission and publication in the Official Journal (p. 20-33).
Impact and justification:
- The framework aims to harmonize practices, reduce regulatory arbitrage risks, and improve supervision.
- Impact analysis highlights the importance of a clear materiality framework, given fundamental differences between the old VaR approach and the new ES approach of FRTB.
- The RTS rely on best existing practices and public consultation feedback (p. 37-38).
- Established facts:
- Materiality of extensions and changes to the FRTB IMA is defined by precise qualitative and quantitative criteria, with impact thresholds on the IMA OFR and its components ES, SS, DRC.
- Changes to the MRF subset are assessed notably via impact on the PEStRC/PEStFC ratio.
- The 4-week prior notification for non-material changes is a new requirement to enable effective control.
- Assumptions:
- The 15 business days period is representative of normal market conditions to assess impact.
- The chosen quantitative thresholds (e.g. +15% for material) are appropriate to distinguish significant changes.
- Interpretations:
- The distinction between material and non-material changes, as well as the subdivision of non-material ones, allows adapting regulatory burden and supervision.
- Consideration of the PEStRC/PEStFC ratio reflects the importance of the MRF subset in risk calculation.
- Uncertainties:
- Practical application of qualitative criteria may require judgment and interaction with authorities.
- Impact of future regulatory framework developments (CRR3) on these RTS is not yet integrated (p. 8-17, 37-38).
- The EBA proposes a clear and harmonized framework for assessing the materiality of extensions and changes to the FRTB IMA and the choice of the MRF subset, based on precise qualitative and quantitative criteria.
- This framework distinguishes material changes (requiring prior authorization) from non-material changes (requiring prior notification), with an additional subdivision for notifications.
- Institutions must apply these criteria to classify their modifications, prepare complete documentation including independent validation, and respect notification or authorization deadlines.
- Competent authorities thus have an effective tool to supervise these modifications and ensure regulatory compliance.
- The RTS draft will be submitted to the European Commission, then to the Parliament and Council for adoption and official publication.
- Entry into force is planned 20 days after publication in the Official Journal of the EU (p. 3-4, 20-33).
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