by Brendan Sheehan, Senior Pre-sales Consultant
Various capital market regulatory requirements introduced post the 2007-2008 financial crisis have attempted to address key concerns around the management of counterparty credit risk, liquidity risk and market risk, as well as efforts to reduce operational risks of various forms. However, the very process of introducing new regulatory requirements introduces what may be called “regulatory risk.”
Regulatory risk can manifest in several forms:
• Uncertainty around the precise specification of the final regulatory requirement:
In the context of the post 2007-2008 financial crisis regulatory reforms, this can be viewed at two levels:
1. The final regulatory requirement as described by Basel
2. The final regulatory requirement as drafted by each local regulatory jurisdiction
• Uncertainty around the date of introduction of the new regulatory requirement
• Embedded optionality in the regulatory requirement itself
• Temporality considerations (i.e., how the calculation as specified by the requirement can change over time due to changes in portfolio structure or market data)
• Remaining “grey areas,” even after the final specification has been drafted
• Side-effects on downstream regulatory requirements that depend on the output of the new regulatory requirement as input. These side effects can be of a qualitative or quantitative nature.
• Adapting to future changes in regulatory requirements. For example (as an extreme case), a legal ruling that causes netting not to be recognized in a jurisdiction or (as a less extreme case) the introduction of new instruments due to IBOR reform.
In the context of capital market regulatory requirements, regulatory risk then translates into other types of risk, such as:
• IT Risk: Are existing systems descriptive enough, flexible enough and scalable enough to adapt to the new regulatory requirement? Is there a need to adapt the existing calculation chain to make it more dynamic?
• Capital Requirement Risk: If the regulation has an impact on capital requirements, then it is necessary to be able to measure and manage the impact of any change.
Variations of the final SA-CCR regulatory requirement
Different flavors of the SA-CCR emerge due to several factors:
• The Basel specification evolves over time
• Each local regulatory jurisdiction takes a snapshot of the Basel text as it is specified at a given point in time
• Each local regulatory jurisdiction may go beyond the Basel text and provide more guidance in a given part of the specification
Many jurisdictions, particularly in APAC and the Middle East, are already enforcing the SA-CCR. The local version of the SA-CCR text has adhered closely to the Basel text as specified when the local version of the SA-CCR was drafted. Grey areas are de facto often addressed informally outside of the legislative framework.
Both the EU/U.K. and U.S. versions of the SA-CCR will come into force in June 2021 and January 2022 respectively, with U.S. entities having the option to calculate capital requirements using the SA-CCR before the mandatory adoption date.
The Basel, EU/U.K. and U.S. versions of the SA-CCR differ in several important areas:
• Handling of multiple margin agreements
• Negative Rates
• Index Decomposition
The EU/U.K. version of the SA-CCR goes further in the following areas:
• Hedging set definitions
• Risk Factor Mapping
• Measures of credit quality
• A simplified version of the SA-CCR
The U.S. version of the SA-CCR provides bespoke guidance on:
• Settled-to-Market Trades
• Measures of credit quality
• Day-count convention
What are the consequences of such variety across regulatory jurisdictions? One could venture to argue that variety can be helpful, as it can provide clarity on grey areas of the SA-CCR specification for other jurisdictions. On the other hand, if a bank has entities in two or more institutions, then these institutions need to ensure that their IT systems can manage the idiosyncrasies of the SA-CCR for each jurisdiction.
Embedded optionality in the SA-CCR
There are several parts of the SA-CCR text where there is a choice in how to calculate trade level parameters. This typically applies to structured products where each trade can be treated individually or as a whole and cap/floors where treatment can be at trade level or caplet/floorlet level. The difference in approach can be significant. As an example, suppose we have a 10-year floor with a payment frequency six months, a strike of 1.2 and a nominal of 10 million. If viewed at trade level, the EAD (Exposure at Default) as calculated under the SA-CCR is ~2.904 million and ~2.898 million if calculated as the sum of the EADs of each caplet. In practice if netted the final EAD will also be dependent on the trades in the netting set.
The ability to perform what-if analysis is particularly important before go-live as generally speaking regulators will not allow the freedom to cherry-pick among the various choices available.
The SA-CCR aims to avoid the cliff effects associated with the bucket structure embedded in the add-on table of the Current Exposure Method it is designed to replace. Nevertheless, under the EU/U.K. version of the SA-CCR, it is possible to use the trade-level risk weighted delta as per the FRTB-standardized approach to identify the appropriate risk factors to map to where the primary risk factor is not obvious. As the risk-weighted delta is sensitive to changes in market data over time, being able to perform what-if analysis due to the cliff effect of a change in risk factor mapping can be very useful to both Risk and Reporting teams.
Side-effects on downstream regulatory requirements
The SA-CCR acts as the source of input for numerous downstream regulatory requirements such as RWA, the CVA Capital Charge, the Large Exposures Measure and the Leverage Ratio. In the context of RWA under the IRB approach there is an argument to adapt the effective maturity formula to calculate different effective maturities for both trades maturing in less than one year and trades maturing more than one year.
Grey areas and adapting to future changes in regulatory requirements
Another type of embedded optionality under the U.S. rules relates to settled-to-market (STM) trades. It is possible to elect for STM trades as being considered as collateralized-to-market (CTM) trades. This will result in a greater netting benefit, but STM trades will have the higher MPOR of CTM trades. Another consideration is the impact on the PFE multiplier. Because of the portfolio-dependent nature of such considerations what-if analysis is required in order to assess the appropriate choice. Solution adaptability is key. The choice of solution architecture will define the list of available parameters on which what-if analysis can be performed, as well as the ease with which they can be applied.
Jurisdictional variations, temporal variability and embedded optionality within the SA-CCR framework mean that a flexible, real-time calculation chain is necessary in order to perform the kinds of analysis required to adapt successfully to the SA-CCR.