This document presents the regulatory technical standards regarding the exemption from the own funds requirements related to the residual risk add-on for certain hedging instruments. It specifies that only hedging positions can benefit from this exemption, while the hedged positions must always be capitalized with a residual risk add-on. Institutions are required to establish detailed internal policies to…
This document is the final report of the European Banking Authority (EBA) dated 17 December 2024, entitled "Draft Regulatory Technical Standards on the exemption from the residual risk add-on own funds requirements for certain type of hedges" (EBA/RTS/2024/20). It concerns the Regulatory Technical Standards (RTS) on the exemption from regulatory capital related to the "residual risk add-on" (RRAO) for certain types of hedges under Regulation (EU) No 575/2013 (CRR), amended by CRR3. The scope covers financial instruments exposed to residual risks within the Fundamental Review of the Trading Book (FRTB) and targets European financial institutions subject to prudential requirements. The document is 30 pages long and includes impact analyses and feedback from the public consultation (p. 1-30).
The document addresses the exemption from regulatory capital related to the "residual risk add-on" (RRAO) under the new standardized approach (SA) of the FRTB. The RRAO applies to instruments whose risk is not covered by the two other pillars of FRTB-SA, namely the Sensitivities-based Method (SbM) and the Default Risk Charge (DRC). CRR3 introduces a provision allowing exemption from the RRAO for hedging instruments that themselves carry residual risks, provided the hedged position remains capitalized. The EBA was mandated to define RTS specifying eligibility criteria for this exemption. These RTS distinguish cases where the RRAO relates to a risk factor not accounted for in the SbM (non-SbM) — such as CMS spread options — and other cases. For instruments linked to non-SbM factors or certain exotic underlyings (dividends, future realized volatility, variance), the RTS require that sensitivity to the non-SbM risk be reduced by the hedge, with detailed internal policies and an independent review. For other cases, where sensitivity cannot be precisely measured (e.g., barrier options, natural risks), exemption is granted only if the hedge fully offsets the residual risk. These measures aim to ensure a prudent and harmonized application of the exemption, preventing abuses and guaranteeing the robustness of the prudential framework. The exemption will only apply after CRR3 enters into force, postponed by one year by a delegated act of the Commission (p. 3-4).
The EBA developed several RTS to transpose the FRTB reform into European law within the CRR3 package, which transforms reporting requirements into capital requirements. The RRAO constitutes one of the three pillars of the FRTB standardized approach, imposing capital for residual risks not covered by the SbM and the DRC. CRR3 introduces a provision allowing exemption from the RRAO for hedging instruments carrying residual risks, under conditions. The EBA was mandated to define technical eligibility criteria for this exemption to avoid divergent application among institutions and ensure consistent and prudent implementation. The document aims to establish clear criteria, adapted to different types of instruments (non-SbM factors, exotic underlyings, other cases), with internal policy and independent review requirements. The goal is to ensure a level playing field, convergence of practices, and comparability of capital requirements within the EU (p. 5-8, 19-20).
1. Regulatory framework and definition of the RRAO:
- The RRAO is a pillar of the FRTB standardized approach, covering risks not accounted for by the SbM and the DRC.
- CRR3 introduces an exemption from the RRAO for hedging instruments carrying residual risks, provided the hedged position remains capitalized (p. 3, 5).
2. Instrument typology and risk factors:
- Distinction between instruments exposed to non-SbM risk factors (not shocked in the SbM), instruments with specific exotic underlyings (dividends, future realized volatility, variance), and other instruments (e.g., barrier options, natural risks).
- CMS spread options are the main example of non-SbM instruments (p. 5-8, 18).
3. Eligibility conditions for exemption:
- For non-SbM and certain exotic instruments, the institution must demonstrate that sensitivity to the risk factor is reduced by the hedge.
- The hedge must not generate other residual risks that are not capitalized.
- Residual exposure must be dynamically managed within internal limits consistent with Article 103(2)(b)(ii) of the CRR.
- Detailed internal policy is mandatory, specifying strategy, limits, duration, trading desks involved, criteria distinguishing hedged instruments and hedges, and counterparty selection.
- Independent review is mandatory to validate compliance with conditions (p. 6-16).
4. Cases of instruments other than non-SbM or specific exotics:
- Exemption granted only if the hedge fully offsets the residual risk.
- Prudent approach justified by the impossibility to measure sensitivity ex-ante and ex-post.
- Also applies to instruments with exotic underlyings not covered by sensitivity (e.g., natural risks, longevity) (p. 7-8, 16-17).
5. Documentation and control requirements:
- Need for a formalized internal policy and complete documentation, including counterparty identification, transaction justification, and limit management.
- Continuous monitoring of hedges, including PnL tracking and position evolution.
- Independent review to ensure compliance and prevent abuses (p. 13-17).
6. Cost-benefit analysis and regulatory options:
- Three options considered to distinguish instruments: (1a) distinction between non-SbM and others, (1b) common conditions, (1c) distinction between non-SbM, certain exotics, and others.
- Option 1c chosen for greater precision and proportionality.
- For sensitivity reduction, chosen option (2a): any demonstrated reduction suffices, without minimum threshold.
- Inclusion of criteria on counterparty consideration in internal policy (option 3a).
- Independent review mandatory (option 4a).
- Strict requirement of full offset for other instruments (option 5a).
- These choices aim to ensure a prudent, harmonized, and proportionate application (p. 19-23).
7. Public consultation feedback:
- Four responses received, with debates on the scope of eligible instruments, the need or not for a minimum sensitivity reduction threshold, and counterparty consideration.
- The EBA adjusted texts to remove the notion of "significant" in sensitivity reduction, allowing exemption upon demonstrated reduction.
- Removal of overly restrictive requirements on counterparty justification, while maintaining a demanding internal policy.
- Confirmation that complex instruments such as Bermudan options are not eligible for exemption under Article 2 but may fall under other provisions.
- Maintaining a prudent and simplified approach to avoid excessive complexity (p. 24-29).
Established facts:
- The RRAO is a key element of the FRTB-SA framework, covering residual risks not captured by the SbM and the DRC.
- CRR3 introduces an exemption from the RRAO for hedging instruments carrying residual risks, under strict conditions.
- The EBA defined precise criteria to distinguish eligible instruments according to the nature of risks (non-SbM, specific exotics, others).
- Reduction of sensitivity to the non-SbM risk factor is the main condition for exemption in this case.
- For other instruments, only full compensation of residual risk allows exemption.
- A detailed internal policy and independent review are mandatory.
Assumptions:
- Non-SbM and certain exotic instruments allow reliable sensitivity measurement.
- Other instruments, notably those with complex payoffs or non-standard exotic underlyings, do not allow reliable measurement.
- Material cases of exemption use mainly concern CMS spread options.
Interpretations:
- The distinction between instrument types allows adapting requirements and avoiding an overly punitive or lax approach.
- The exemption aims to reflect the economic reality of hedges while preserving the prudential framework’s robustness.
- The independent review is an essential safeguard against abuses.
Uncertainties:
- The precise impact of the exemption on capital requirements will depend on effective adoption by institutions and implementation of internal policies.
- Evolution of financial instruments and hedging practices may require future adjustments.
- The delayed application linked to the postponement of the FRTB implementation (CRR3) creates a transitional period without exemption (p. 3-8, 19-29).
The EBA concludes that the proposed RTS establish a clear, prudent, and proportionate framework for the exemption from the RRAO on hedging instruments carrying residual risks. This framework distinguishes instruments according to the nature of their residual risk, with adapted requirements to ensure that only instruments effectively acting as hedges benefit from the exemption. The RTS impose detailed internal policies and an independent review to guarantee compliance and robustness of the arrangement. The EBA recommends adopting these RTS, which will apply from the entry into force of CRR3, after the postponement period. These measures aim to harmonize practices, strengthen comparability of capital requirements, and support the stability of the European banking sector. No specific action plan is detailed, except for the scheduled regulatory entry into force (p. 17, 19-29).
Synthesis note written from the full document by DataSAI Academy. This note comes from the scientific library of the DataSAI Academy, open to all.