FRTB for structured products
The impact of an internal model under FRTB
What is the value of an internal model approach in the structured products business?
The complexity of measuring risks in a structured products portfolio
Structured products represent an important investment class in Switzerland. The total “live” volume of structured products is roughly CHF 200bn1, which represents 3% of all securities held in custody accounts in Switzerland, with the remainder consisting of direct investments mainly in bonds, shares, and funds . A large share of outstanding structured products in Switzerland are yield-enhancement products such as barrier reverse convertibles. Such products typically have path-dependent pay-offs, which cannot be priced using closed-form formulas. Given that the pricing of individual issuances already requires sophisticated approaches (often including Monte Carlo simulations), there are substantial challenges to the measurement of portfolio-level risks with high accuracy.
Capital charges and the Fundamental Review of the Trading Book
Structured products and of Businesses involving non-vanilla instruments like the structured products business typically attract significantly higher regulatory capital requirements than vanilla flow businesses. Even when hedged closely, the non-linearity of the payoffs leads to residual risks that attract punitive regulatory capital charges under the Basel standardised approach for market risk, which are expected even to increase substantially under the revised standardised approach of the Fundamental Review of the Trading Book (FRTB).
The new market risk framework FRTB does not only represent an overhaul of the standardised approach, it also introduces new standards to be met under the Internal Model Approach (IMA). Our analyses show that for structured products portfolios the IMA can reduce capital charges by up to 70%2 compared to the revised standardised approach. An IMA, however, is accompanied by a range of model acceptance criteria, which serve as prerequisites for obtaining and retaining IMA model approval.
Key challenges for Internal Model Approaches
One of the key model acceptance criteria is regular P&L attribution testing, which focuses on closely aligning the risk pricing with front office pricing. This testing creates significant challenges for obtaining model approval of structured products businesses, yet failure to comply with the testing will result in the application of the punitive FRTB standardised approach. A full revaluation approach in the IMA ES modelling would minimize the risk of failing the P&L attribution testing. In the context of the structured products business, however, such an approach would require a nested simulation, which is commonly considered to be computationally unachievable.
In this article we set out an innovative expected shortfall modelling approach. It enables full revaluation of a structured products portfolio within a Monte Carlo framework (nested Monte Carlo), but is, however, still computationally achievable. While this approach has been implemented for a structured products business, it is suitable for integration into a wider full portfolio modelling framework.
It is time to assess the capital impact of an Internal Model Approach on your structured products portfolio.
George Garston - Assistant Manager, Risk and Regulation Advisory
George is an Assistant Manager within Deloitte's Financial & Regulatory Risk advisory practice in Zurich. His experiences within Deloitte include valuations of a wide range of financial derivatives, Solvency II implementations, model validations and research-based activities focussing on financial mathematics.
Mattia Bacchetta-Cattori - Senior Consultant, Risk Advisory
Mattia is a Senior Consultant within Deloitte's Financial & Regulatory Risk advisory practice in Zurich. He worked on projects in the banking and insurance industry, developing stress tests, quantitative risk and pricing models.