Model Risk Management under FRTB regime

Usually in previous regulatory guidelines standardized approach was not meant to be a model. There was not linkage between standardized approach and internal model based approach.

The regulators were able to compare the capitals under standardized approach between two banks because rules were same for all the banks but for risk managers there was no logical or intuitive relationship between the capitals calculated between standardized and internal model based approach for a given portfolio.

Making Standardized approach risk sensitive is the a path breaking change made by regulators.

In FRTB standardized approach’s risk sensitivities come from the derivative pricing models. These pricing models have uncertain outcomes. Capital has to be calculated at the desk level. So each desk’s model has to go through the normal model risk management process framework where it will be checked for conceptual soundness, outcomes analysis and ongoing monitoring.

Currently (Basel 3 and before) when capital was allocated for specific risk charges, risk managers generally went for lookup tables and apply some formulas. This is no more valid in FRTB. FRTB has introduced the concept of non modellable risk factors. Any risk factor which has less than 24 data points will attract Non Modellable Risk Charge (NMRC).

FRTB also acknowledges that under various situations (specially exotic option pricing) the prescribed delta, gamma and vega approach do not work well. Modelers and subsequently validators need to be cognizant about this issue and ensure that model development framework addresses those issues for those situations.

Under FRTB portfolio level capital has to be developed under three correlation scenarios. At the desk level the scenario with maximum capital value is to be chosen. The calculation approach used to derive capital will come under the purview of model risk.

Default risk charges uses various inputs which are not always straight forward and deterministic. The choices made by the first line of defense would require validation by the second line of defense.

In internal model based approach, Expected Shortfall is calculated.The model is stress calibrated that is: calibrated in stressed scenarios. When this calculation is performed not all the risk factors are used for calibration. The first line of defense has to decide which factors they are using and which they are not using. They then have to justify their choice. The second line of defense will have to review and critique on their choices.

Same approach has to be used for add-ons due to non-modellable risk factors. Based on the exceptions the multipliers have to be decided. Similarly for PnL attribution the lines of defense need to decide the approach and that approach will be reviewed by second line of defense.

Huge opportunities in Ongoing Monitoring

By insisting capital allocation at desk level regulators want banks to keep detailed tab on each and every trading activity. Even if a desk qualifies for Internal Model Based approach, it is mandatory to calculate capital with standardized approach.

This will result in massive amount of data being generated which would be required to be monitored. Banks will require sophisticated model monitoring frameworks which would keep an eye on outliers, do pattern analysis of each data sequence generated, so that timely warning signals would be raised.

To handle this amount of data banks will require sophisticated technological framework which would use advanced statistical tools to perform pattern analysis of the risk data generated.

The triggers would not only be pattern dependent but also a combination of risk measures. Lets understand it with an example. Suppose a time sequence of (gamma OR vega) is showing some out-liers. The monitoring system should raise a trigger but it may not be critical. But suppose this pattern is observed in (gamma AND vega) sequence then it may really a case where risk managers should be cautioned. This will give rise the research on a new field of financial risk management.

Banks may choose to develop such frameworks in-house or may choose to employ vendor models.

From the vendor perspectives there will be huge competition among vendors where each vendor will claim that his model monitoring framework is better because better and advanced techniques used with it. Hence there would lie further issues of disclosure of methodologies and techniques by the vendors. No vendor would like to disclose his methodology of model monitoring framework fearing to be copied by the competitor.

Concluding thoughts

From market risk management framework it appears that regulators have made a giant leap to understand and manage risk but because of the data intensiveness of the suggested approach and new run from ongoing monitoring will start.


There is also a publication: Model Risk Management under the FRTB Regime



I will update this page as I learn and understand FRTB more.


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