Model risk, non-cleared swaps and Metro Bank

The week on Risk.net, May 27–June 2

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EUROPEAN banks pressed to boost model risk management

DEALERS fear bleak future for non-cleared swaps

METRO Bank aspires to IRB for credit risk

 

COMMENTARY: Internal disagreements

Big banks continue to protest the regulatory clampdown on the use of internal models, but it could result in a more level playing field. Proposals from the Basel Committee on Banking Supervision in March would limit the use of the internal ratings-based (IRB) approach to calculate credit risk-weighted assets where a lack of data means the probability of default and losses cannot be estimated accurately.

Upstart consumer player Metro Bank currently uses the standardised approach to calculate credit risk, but is keen to move towards the IRB. The move could bring significant capital benefits. For residential mortgages, IRB banks would typically use a risk weight of 8% to 20%, compared with 35% under the standardised approach. But gaining approval to use the IRB is difficult, conferring a competitive advantage on larger banks, Metro Bank's chief risk officer says.

Where internal models are still permitted, banks must prove to regulators they have the necessary infrastructure – no easy task. The Fundamental review of the trading book, finalised in January, contains a key test for obtaining model approval that major banks claim will be almost impossible to pass – causing some to question whether it is even worth the effort. Some regional banks rejoice at the idea that bigger, richer banks may no longer be able to gain an unfair advantage by using advanced models.

Banking supervisors have made their distrust of internal models apparent. The Basel Committee in March also unveiled proposals to scrap the own-models approach to credit valuation adjustment risk. Banks complain that forcing them to use less advanced approaches could encourage 'regulatory hedging', instead of hedging actual risks. European banks have responded by following their US counterparts in beefing up model risk management efforts – with a general acceptance of the guidelines that US regulators have developed.

In Asia, meanwhile, banks claim forcing use of the standardised approach for some credit risk exposures such as financial institutions and corporates could have a significant impact. While Asian banks do not tend to have high exposures to very large corporates, their exposure to financial institutions can be more meaningful.

 

QUOTE OF THE WEEK

"A client may feel they've got a matched position as they're intermediating two flows, so the derivatives cashflows wash through and they want to step out of the middle and collapse the trade. Then one of the banks says, 'Hold on, you need to write me a cheque for several million dollars" – The head of fixed income at a European bank in London on the impact of differences in the treatment of negative interest rates in credit support annexes.

 

STAT OF THE WEEK

Could the US banking system withstand real GDP dropping to –7.5%, unemployment spiking to 10%, stock prices losing 50% and home prices falling 25%? – Questions posed of large US banks by the US Federal Reserve Board's 2016 stress tests.

 

ALSO THIS WEEK

Hidden floor: dealers tackle negative rate CSA headaches
Banks pushing clients to remove costly interest rate floors in collateral agreements

Strength turns to weakness for old OTC market
Non-cleared notional falls $36 trillion as costs and complexity grow

SEC prepares Dodd-Frank buy-side stress tests
Asset manager stress tests aim to measure fund liquidity and contagion risks

New forex conduct code receives overwhelming support
Code covers ethics, governance, information sharing, execution, risk management, confirmation and settlement

Fed data dependency backfires
Past year has seen huge change in formation of rate expectations

Mortgage investors grapple with negative swap spreads
Collapse of US swap rate creates problems for valuation models

US banks fret over Fed's domestic internal TLAC concept
Lobbyists fear authorities have already reached a verdict on domestic internal TLAC

Regulators see 'long journey' to getting Orsas right
Insurers still treating own-risk assessment too much like a compliance exercise, Nordic supervisors say

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