EBF response to Basel Fundamental Review of the Trading Book: A revised market risk framework

Ref.:EBF_005704 Brussels, 31 January 2014 Launched in 1960, the European Banking Federation is the voice of the European banking sector from the European Union and European Free Trade Association countries. The EBF represents the interests of some 4,500 banks, large and small, wholesale and retail, local and cross-border financial institutions. Together, these banks account for over 80% of the total assets and deposits and some 80% of all bank loans in the EU alone. EBF response to Basel Fundamental Review of the Trading Book: A revised market risk framework Key Points The EBF acknowledges the tremendous efforts undertaken by the BCBS on the fundamental review of the trading book. The EBF especially welcomes the increased risk sensitivity, the greater recognition of the effect of diversification and hedging in the Standardised approach. Also, the EBF welcomes the abolishment of the double charge that was imposed by VaR and Stressed VaR, which had no theoretical underpinning. The EBF supports the proposed QIS, but stresses that sufficient time should be left for this exercise in order to understand the exact impact of the proposed framework that is a considerable change from the current framework. Furthermore, the QIS should be performed in stages. The EBF therefore welcomes the confirmation of the Trading Book Group to pursue a two-step process in which the QIS for actual bank portfolios will be the second step. Ideally the EBF would prefer a much more iterative approach to the framework definition and calibration. Even then, the EBF still would like to stress that for many banks it will be hard to do a full QIS on their actual portfolios as it will not be possible to have the necessary models ready within the required timeframe. As regards the calibration of the QIS, the EBF believes that any issues related to market risk capitalization levels was appropriately addressed in Basel 2.5 and sees no need for the FRTB to further raise trading book capital requirements. Given the additive method of calculation, requirements determined on this basis are sufficiently conservative. Moreover, the calibration should ensure that there is a capital incentive to move from the revised SA to the revised IMA. The EBF welcomes the revised proposal for a boundary between the banking book and the trading book which seeks to take into account the intent to trade and to bring more clarity over the assignment of instruments. However, the EBF finds that it should be possible to assign the same instruments to both books. In order to ensure a consistent interpretation and implementation across banks, additional guidance will be required. Furthermore, as with the revised boundary the re-assignment of instruments will be substantial, the EBF supports an approach based on notification and not on approval. This EBF a.i.s.b.l ETI Registration number: 4722660838-23 56, Avenue des Arts B-1000 Brussels +32 (0)2 508 37 11 Phone +32 (0)2 511 23 28 Fax www.ebf-fbe.eu

means that any assignment of instruments would first be implemented and notified to the supervisor subject to a materiality threshold, and then without objection within a certain period of time be deemed approved by the supervisor. While the EBF agrees with the concept of introducing liquidity horizons, some of the proposed liquidity horizons are exaggerated when compared to actual experience, particularly for FX and interest rates. Furthermore, the direct use of returns over different liquidity horizons in the historical method will break the link between the capital charge and risk management at the desk level. In order to preserve the logical correlations the EBF favours using a common horizon for the ES calculation, combined with additional stress type add-ons or scaling factors for some of the less liquid activities/instruments. Whilst the EBF supports the desk-level approach in the revised IMA, the EBF cannot support the model independent risk tool. EBF fails to see how this new tool could identify desks with complex, potentially illiquid instruments that carry higher model risk, and believes that this tool would be the same as introducing a non-risk sensitive floor to the IMA Capital charge. The result could be that desks with low-risk profile would not be validated for IMA or they would be obliged to mis-hedge their book to increase the internal model capital. The EBF believes that there are sufficient other measures to ensure proper capitalisation. Furthermore, the EBF sees no reason why the current CRM approach should not be maintained for securitisations. Due to the very high modelling standards the EBF finds it should still be possible to use internal models to calculate capital charges for certain correlation trading activities as the CRM model envisages. In general, the EBF finds that the proposal for a revised SA is overly complex and that it should be simplified. Especially the cash flow approach will be demanding for banks to establish and maintain. Hence, the EBF suggests that the BCBS considers a simpler framework more along the lines of a sensitivity based approach. Furthermore, the EBF is not in favour of using the SA as a floor or a surcharge. This does not provide the right incentives for continuous model improvement. Also, the EBF does not support the use of automatic surcharges. Surcharges should be based on individual circumstances at a bank and be set by the supervisor when circumstances so dictate. For default risk, the EBF supports moving to a charge that doesn t include migration risk, which will avoid double counting. However, the EBF proposes the use of a simpler method that is consistent with the banking book. Also the EBF advocates to use constant LGDs and a lower floor for sovereigns. Regarding the stressed calibration, the EBF recommends spanning the minimum observation horizon back to 2008, instead of 2005. The shocks observed in all of the risk factors during 2005-2008 are small compared to the levels observed during the crisis in 2008/2009. Also, a number of risk factors that are currently widely used (such as OIS, basis spreads and IPOs), did not yet exist in 2005. 2

Specific comments A. General remarks on QIS, timeline and overall framework The EBF welcomes the second consultative paper on the Fundamental Review of the Trading Book (FRTB). The EBF finds that the BCBS has made substantial progress in various areas. However, the EBF still has some concerns over some of the proposed revisions, which will be dealt with in this response. The EBF supports the comprehensive Quantitative Impact Study (QIS) that the BCBS will undertake in order to assess the impact of the revised market risk framework. It is very difficult to assess the exact impact of all the suggested measures on the banks day-to-day market risk management and business organization. The QIS period will be very important to assess whether this framework is going to be adequately calibrated or not. Therefore, the EBF suggests that sufficient time is left for the QIS and that the QIS should be applied using a phased in approach. In this regard EBF welcomes the information from the Trading Book Group that they will pursue a two-phase approach in which the impact of the revised SA and IMA will be tested first (January-April 2014) on a hypothetical portfolio and then second (July-October 2014) on actual bank portfolios. However, the EBF would like to note that for many banks it will still be almost impossible to do a full QIS on their actual portfolios, as it will be very challenging to apply the new models within such a short timeframe, especially when taking into account the regulatory pressures within the financial markets area. Banks will therefore be required to make assumptions and use shortcuts. As a result, the quality of the outcomes may be less reliable, given that the timeline for the BCBS to finalise the new TB framework is set for summer 2015. There is no mention of the desired calibration level of the QIS. The EBF believes it would make good sense to maintain systemic regulatory capital at a level based on Basel 2.5 calculations, Issues related to market risk capital levels have been addressed in Basel 2.5 and should therefore not be the purpose of the FRTB. Given the additive method of calculation, requirements determined on this basis are sufficiently conservative. The calibration should, moreover, ensure that there is a capital incentive to move from the revised SA to the revised IMA. If this is not the case, the EBF cannot see many banks opting to use the revised IMA. The EBF particularly regrets that the proposed framework does not make use of the existing infrastructure that is available within the banks. This could limit the implementation costs and will surely make the implementation easier. The Stressed Expected Shortfall Exposure could easily be applied on the current P&L strings that are calculated for Stressed VaR. Banks routinely calculate sensitivities which can be used for the Standardised Approach. Subsequent 3

paragraphs will indicate where possibilities to make better use of available infrastructure and data should be explored. The revised models for the Internal Models Approach (IMA) and the Standardised Approach (SA) require a multitude of calculations and data maintenance compared with the current approaches. The new IMA approach, for example, requires three Expected Shortfall (ES) type calculations and one VaR type calculation on a daily basis. This would at least double the performance requirements of the current systems. B. Specific remarks B.1. Revised boundary for the trading book and the banking book The EBF welcomes the revised proposal for a boundary between the banking book and the trading book which seeks to take into account the intent to trade and to clarify the assignment of instruments. Furthermore the EBF welcomes the proposal to give banks the responsibility for justifying the prudential classification. However, the EBF would like to high-light the following concerns regarding the revised boundary: The revised boundary will require a high level of demonstration to the supervisor regarding assignment of instruments. EBF is especially concerned that a systematic documentation requirement for any classification that does not exactly meet the general presumption will impose a heavy documentation load on banks, even for activities that banks only intend to maintain in the banking book, i.e. i) instruments held as strategic investments (e.g. equities); ii) hedges of instruments belonging to the banking book and whose risks are managed together with the hedged instruments (e.g. options to hedge variable mortgages); and iii) instruments that cannot be valued on a daily basis or that do not belong to active markets (e.g. syndicated loans, primary issues). The EBF suggests that the BCBS allows for simplified documentation requirements for these situations and for banks to simply inform the supervisor of the list of concerned activities (along with a synthetic presentation of the activity). Furthermore, the BCBS should consider imposing a delay for the supervisory review and response. Furthermore, if the BCBS requires systematic prior approval from the supervisor, it might generate delays in implementation of the new framework for existing activities and for the launch of new activities or new products. The EBF suggests that the BCBS considers more communication options, and in particular allows for an ex-ante notification as long as an appropriate delay is respected (e.g. 1 month). Differentiation would be based on the complexity of the products and on the strategy, and be proposed by each individual bank. In general, the EBF doubts whether it would be feasible to clearly assign instruments to the trading book or the banking book on the basis of the proposed criteria (para 9). Furthermore, the criteria do not make it clear whether the same type of instrument can be held in both books. In EBF s view it should be possible to assign the same instruments to 4

both the trading book and the banking book, for example interest rate swaps traded in the trading book that are used as hedges in the banking book. Also, it should be mentioned that just because a position is managed by a trading desk, it does not mean it cannot be in the banking book. Furthermore, the EBF finds that the list of general presumptions regarding what instruments should be assigned to the trading book is too far-reaching in some cases, for example for equity investments in funds and listed equities. In EBF s view some of these instruments could be placed in the banking book. The EBF finds that the definition of a trading desk, which is simply introduced for capital purposes, is too far-reaching. This is particularly true regarding the key attributes listed in para 23. EBF finds that the proposed rules for re-designation of instruments between the regulatory books are too restrictive. Especially, the proposal to translate an eventual capital reduction from switching between books into an extra pillar 1 capital charge is an excessive add-on, which EBF believes is not needed, as the switching is already subject to supervisory approval. For FX- and commodity positions in the banking book, the EBF doubts whether it is practical and feasible to construct notional trading books with daily theoretical P&L. This requirement should only apply to positions for which the bank wants to apply the IMA approach. Banks should be able to choose to apply the standardised approach for positions in the banking book. B.2. New treatment of credit risk in the Trading book The BCBS proposes that for both the revised IMA and the revised SA the total capital charge for credit risk will consist of an integrated credit spread risk capital charge, including migration risk, and an Incremental Default Risk (IDR) capital charge. Furthermore, BCBS proposes that whilst for non-securitisation exposures it will still be possible to use the Internal Models Approach, for securitisation positions - including correlation trading activities - it will only be possible to use the Revised SA going forward. The EBF has the following comments in this regard: B.2.1. Securitisations As securitisations will now be treated using exclusively the Revised SA, EBF finds that there is a need for clarifications regarding the Risk Weights applied to securitisations. Furthermore, it is not clear what will be the connection with the new Basel securitisations framework (Cf. Modified Supervisory Formula Approach of BCBS 236 1 ). Moreover, the proposed measures will lead to the end of the correlation trading activities, as hedges will no longer be recognized within this new framework. Due to the very high modelling standards in EBF s view the current Comprehensive Risk Measure (CRM) used 1 http://www.bis.org/publ/bcbs236.pdf 5

for certain correlation trading activities should be maintained. The BCBS points to complexity as the main criterion for not allowing the use of internal models for securitisations. In EBF s view this however is a misinterpretation of the concept of complexity. Many products that are identified as part of the securitisations category under the Basel accord are liquid products with deep markets and publically available prices and thus do not seem appropriate for mandated treatment under the standardised approach. Furthermore, if the worry is related to the comparability and variability of the banks individual CRM models, a more reasonable approach to follow would be to reduce the number of independent modelling choices a bank might be allowed to do when applying for approval of a CRM model (suitable model standardisations) which could e.g. be specification of the factors allowed in the model. B.2.2. Non-securitisations The EBF finds the exclusion of migration risk from the proposed IDR capital charge positive since it will avoid double counting and simplify the default risk measure. The EBF requests further guidance on what is meant with a 2-factor model, to ensure consistent interpretation across banks. The EBF does not agree to use equity data for calibration of correlations, as these do not necessarily give an indication of default correlations. Also, it should be noted that equity data cannot be used to calibrate sovereigns correlations. Also for non-securitisations, if one of the two ES models and IDR model is not validated, the revised SA should automatically be applied. The EBF thinks this provision is excessive and doesn t find there is a need to link the validation of the two models, as a separate standardised approach for default risk is available 2. In EBF s view inclusion of equities in the IDR charge will considerably increase the capital charge for equities. Movements of equity already reflect these elements. In cases where the capital horizon for equities is implicitly already set at one year, the IDR will overstate and double count this risk for equities. B.3. Factoring in liquidity The BCBS suggest two measures to address liquidity risk: a) introducing varying liquidity horizons in the market risk metric, and b) a model-independent assessment tool to identify desks 2 The CRR requires an internal model for migration and default risk whenever an internal model is used for specific risk (CRR Article 372). Presumably, the Basel Committee has been using the same reasoning to require a joint validation of credit spread risk and IDR (Annex 1 paragraph 186(r). In Basel 3 there is no distinct Standardised method for specific risk and IRC hence the joint requirement to have IM for specific risk and IRC. In the FRTB, there is a Standard charge for general & migration risks and one for IDR. Therefore, there is no need to link the validation of the two models. We could very well have an internal model for general & migration risk and use the standardised approach for IDR. 6

that trade particularly illiquid complex products. The EBF will comment on the modelindependent assessment tool in chapter B4. B.3.1. Liquidity horizons The EBF in general agrees to the principle of taking into account different liquidity horizons, but is not sure that the proposed method is the most suitable approach. Some of the chosen liquidity horizons are penalizing with reference to certain risk factors and somewhere appear inconsistent among each other. This is particularly true for FX and interest rates. Hence, the EBF proposes to change the liquidity horizon for FX- and interest rates to 10 days for well-established and liquid markets, as supported by observed market data during the past and other crises. EBF trusts that the BCBS will be best positioned to specify objective and measurable criteria to define what constitutes established and liquid markets. Furthermore, the EBF has some concerns regarding the introduction of the liquidity horizon in the calculation of the stressed ES in Para 181d: The direct use of returns over different liquidity horizons in the historical method 3 will break the link between the capital charge and the way risks are managed at desk level. It may also break hedge relations within a desk (e.g. a corporate bond for which the spread is partially hedged with a sovereign) Moreover it may lead to non-sensible co-movements of risk factors as they span different time horizons. Large downward moves of equities could be accompanied with downward moves in volatilities. In order to preserve the logical correlations the EBF would favour using a common horizon for the ES calculation and additional stress type add-ons or scale factors for some of the less liquid activities/instruments. The EBF would favour a 10 day period as these would preserve meaningful correlations, also for the more liquid products. For Monte Carlo models, little is said in the document and the EBF seeks some clarification. However, there is an important risk that the connection between the desks risk management and capital charge under the FRTB could be broken. The EBF would like to stress the importance of the use test: the implementation of the revised market risk framework must retain a link between the desk management of risk and the capital charges. There is an operational difficulty on the series of returns required: it is not possible to derive distributions, particularly in the tail, with short series of overlapping long-term returns. Indeed, a 1 year series of overlapping N-days returns really capture only 260/N data points. Besides, if the 1 year calibration period exhibits a marked trend, the N days returns will mainly capture the average trend over that period. 3 Footnote 36, page 86 in the CP. 7

The Basel text is silent with respect to the calibration of the correlations between risk factors of differing liquidity horizon. The EBF would like the BCBS to clarify the way it envisages correlating risk factors. B.4. Revised models-based approach The EBF in general supports the proposed desk-level approach and also welcomes the fact that banks will be able to decide themselves which desks are to be designated in scope. However, given that a totally new set of rules are to be introduced, the EBF finds that banks currently using the IMA should be allowed the option to use the revised SA in the future instead. Furthermore, in the EBF s view the revised models-based approach will be operationally challenging, especially due to the computation of multiple Expected Shortfalls; e.g. at the level of the entire trading book, asset class level and trading desk level. In combination with the proposed long term liquidity horizons, there is a strong disconnection between risk metric and the revised internal models. Below the EBF comments on specific elements of the revised IMA. B.4.1. General criteria The EBF welcomes the BCBS to express the stressed ES as the partial RF set stressed ES multiplied by the ratio of current full RF set ES divided by current partial RF set ES (para 181.d). The application of the indirect approach using a reduced set of risk factors, however, is not sufficiently precise. In order to achieve a level playing field and to increase comparability it would be preferable if the regulator could indicate which reductions are acceptable for broad classes. For example: may a multi curve framework (such as swaps with a different reset frequency that have their own curve) be represented by a single curve? Or, as another example, may a rating based curve be used for bonds, instead of individual issuer curves? For the stressed period this is not only a question of the amount of effort required but also a question of availability. The EBF finds that the proposal for a monthly recalibration of the stressed period is too operationally demanding. The EBF does not see any benefits from frequent recalibration and believes that the current practice of a yearly recalibration is suitable. Concerning the measure based on stressed observations banks must according to the proposal identify the 12 month period of stress over an observation horizon that must at a minimum span back to 2005. Even with a reduced set of risk factors any additional calculation of a 12-month stress period represent a significant additional burden on resources which could be set to good use on other tasks. Having this in mind and also having in mind that the years 2008 and 2009 are internationally acknowledged as the 8

most stressful periods during the crisis, we would recommend that the minimum observation horizon is required to span back to 2008 instead of 2005. Given the considerable burden banks will encounter due to the requirement of calculating multiple VaR/ES models we would propose that banks calculate a one day VaR and a one day ES daily. The ES calculation for the stressed period and different liquidity horizons could be calculated weekly as this has more a role in calculating capital then in daily management. The weekly figures could be scaled up if the average daily VaR/ES for that period is higher than the daily VaR for the position date. The formula for the calculation would become (under the assumption the weekly figures are based on the Thursday positions): Stressed ES Thursday Position = Thursday ES Full Risk Factor ThursdayES Thursday Reduced Risk Factor MAX ( ES Weekly Average Full Risk Factor ES Thursday Full Risk Factor ; 1) Furthermore, the use test is evidently becoming even less important and is now to play merely a marginal role. The EBF is strongly in favour of retaining the use test requirement. This presupposes, however, that it is possible to use the prescribed models in full or in part. As things stand, the EBF does not assume this will be the case. It is therefore unlikely that the use test requirement will be met. Also, regarding further restrictions on models: o Parametric approaches: The EBF assumes that the new requirements will not oblige banks to apply a simulation approach. The use of variance-covariance approaches should therefore continue to be permitted; o Full valuation: It should be made clear that supervisors will not be able to require totally full valuations for all instruments, including complex ones. It should remain possible to use approximation approaches such as the delta-gamma approximation. B.4.2. Determining the eligibility of trading activities To find out whether a trading desk would be allowed to use the revised IMA each trading desk must satisfy P&L attribution, backtesting requirements and a model-independent risk assessment tool on an on-going basis. General comments In EBF s view this method seems to be very restrictive as in many cases banks would have to fall back to the revised SA, and diversification benefits would be considerably reduced (use of stress periods, liquidity horizons, and specific regulatory factors). 9

The proposed desk level model validation is a pass or fail regime whereby a desk approved for revised IMA might suddenly be invalidated and the desk capital charge calculated with the revised SA. The EBF would appreciate if the regulation takes a more progressive approach, in which desks which stop meeting the criteria will not suddenly fall into the Standardised Approach. Also, the proposal does not make clear the pace with which a desk, that has formerly failed the criteria but now meets it again, will be able to return to the revised IMA. In EBF s view the regulation should set a clear path for how to return to an internal model. Finally the EBF foresees a situation where approval / rejection of models on a desk-by-desk basis could place further strain on the supervisors resources, and consequently the supervisors ability to deal with, in a timely manner, banks potentially significantly increased number of applications for IMA approvals. This should be taken into consideration going forward. The model-independent risk assessment tool Especially, the EBF fails to see how the proposed model-independent risk assessment tool would achieve the objective of identifying desks with complex, potentially illiquid instruments that carry higher model risk. Low risk density is not necessarily an indication of modelling problems. Furthermore, EBF fails to see the reason to link the denominator (exposure measure) of this new ratio with the exposure defined in the new BCBS Leverage Ratio framework. In practical terms, the model-independent risk assessment tool would be tantamount to setting a non-risk sensitive floor to the IMA Capital charge. Also it would threaten many desks, particularly those with low risk profile, from not being validated moving them to the (punitive) revised Standardised Approach or be obliged to mis-hedge their book to increase the internal model capital. Therefore, the EBF firmly rejects the introduction of this new model-independent risk assessment tool. P&L attribution and backtesting requirement Regarding the proposed P&L attribution process the EBF welcomes the BCBS recognition of the fact that P&L variance is not necessarily a sign of modelling problems. With this in mind, supervisors should interpret quantitative requirements for the degree of fit cautiously and in consultation with the banks (i.e. no automatic withdrawal of model approval for a desk if variance thresholds are exceeded). EBF however, has some concerns about the operational burden linked to the computation of the risk theoretical P&L for model approval purposes. In EBF s view the proposed pragmatic approach for the back testing requirement would not be able to backtest the ES parameter. The link between counting outliers to two quantiles (VaR estimates) and the quality of the ES estimate is rather weak. Therefore it would not make much sense to automatically reject a model solely on the basis of backtesting results. Supervisors would need to have some discretionary leeway when evaluating the findings of backtesting. In addition, 10

a time limit should be introduced for eliminating shortcomings. Also, back testing on clean, actual P&L should take into account the allocation of capital to non-modellable risk factors. B.4.3. Qualitative Standards - Stressed Calibration The BCBS recognizes the significant computational burden (page 18) to search for the stressed period, but only in terms of the number of risk factors. However, the EBF would like to point out that it is often the number of valuations (which is independent of the number for risk factors), and thus the number of scenarios in the simulation, that is time consuming. As the proposal now is written, it can be interpreted as requiring full simulation even after simplifications. This makes the calculations extremely calculation intensive. Therefore, the EBF proposes that other approximation methods should be allowed, e.g. using an analytical model, as long as it also explains 75 % of the variation in the full ES model. These approximate models should also be allowed to be used to find candidates for the stressed period, as long as these candidate periods are then verified by full simulation. The EBF finds it important to allow other methods to finding the stressed period, not just to reduce the risk factor set. B.5. Revised standardised approach The EBF finds that the proposal for a revised SA has become overly complex. Especially the proposed cash flow approach will be very demanding for banks to establish and maintain. EBF instead suggests that the BCBS considers a simpler solution based on sensitivity based approach. Cash flow approach The EBF is concerned with the proposed cash flow approach. The EBF understands the aim of this approach is to be independent from any internal model as far as possible, but with this approach it will be very difficult to cover all the products of a trading bank, and also the operational requirements linked to a cash flow approach would be excessively heavy for banks. A few examples can illustrate this: First, it is puzzling that the variable part of cash flows is purely ignored; either it is the floating rate part in the GIRR or the default leg of a CDS in the CSR. An example is the case of interest rate swaps (para 76) where the method asks for the mapping of each fixed cash flow (coupon or spread) of a swap on the vertex of the GIRR. The fact that the variable part of coupons is not taken into account leads to a wrong risk measure. With such an approach the perfect hedging of a fixed rate bond long position with a swap paying this fixed rate against a variable rate would eliminate the interest risk on coupons but would keep unchanged the interest rate risk on the principal. In the EBF s view this could be corrected replacing each variable coupon (not fixed) by a positive flow equal to the notional (the one on the coupon period for amortized products) at the beginning of the coupon period and a negative one at the end of the coupon period (this for a variable coupon to be received: the opposite for a variable 11

coupon to be paid). This variable cancellation technique is completely accurate only for the variable rates which are applied to their definition period. With this technique the above obligation and its hedge would generate an interest rate risk at the end of the period of the next incoming coupon (instead of the maturity date of the obligation): the corresponding zero-coupon amount is equal to the bond notional plus the fixed amount of the variable coupon. Second, FX risk is not mentioned for several instrument categories were it may occur, e.g. equity options. The mentioned examples highlight the difficulty of being exhaustive with the cash flow approach. Even the correction which has been suggested for interest floating rates does not work properly for CMS rates, set in arrears etc. Therefore, the EBF finds that it would be better to capitalize on the basis of a sensitivity metrics approach which is more risk sensitive, in line with risk management and already available. Regulators should be confident with the greeks calculated by financial institutions (and actually the delta of options is already intended to be part of standard framework) and that replacing the cash flows in the standard formulas for market risks (interest risk, credit spread risk, etc. NOT default risk of course) by corresponding sensitivities should give a complete and relevant measure for derivatives. The EBF understands that the regulator has some concerns as to whether sensitivities capture convexity sufficiently. However, as tenor based sensitivities translate more or less to individual cash flows one could factor in the convexity element as a function of the tenor. Another issue with the proposed revised SA is the management of offsetting positions. They seem to be highly penalized. Considering the GIRR it seems that 2 cash flows on the same currency and on the same date but with opposite signs will generate a risk of 10% of the cash flows amount when there should be no risk. This will generate unjustified capital charges on facilitation / and market making type activities that involve a lot of de facto back to back trades. It should be possible to net cash flows/sensitivities within vertices per product type (e.g. swaps). For the sensitivity approach this would also decrease the operational and implementation burden as these figures are available on an aggregated basis. This is largely true as well for the Credit Risk calculations. It also important to point out the inconsistency regarding the proposed approach to take into account hedging and diversification effects which could incite banks, in many cases, to take directional positions. GIRR Furthermore, as regards the calculation of capital requirements for General Interest Rate Risk (GIRR) the EBF does not believe it makes good sense to introduce an option for various algorithms under the standardised approach. The standardised approach should be clearly defined 12

with as few alternative options as possible. This is the only way to ensure comparability, transparency and the greatest possible simplicity. Options The EBF welcomes the dedicated approach for options and the retention of the logic of the scenario matrix approach (with modifications). The extended aggregation approach is, however, far too complex. The EBF emphasizes the need to clarify that bonds with embedded prepayment options, to protect final borrowers, should not be treated as structured products. The implicitly incorporated options are not usually exercised exclusively on basis of market developments and thus materially differ from more standardized option products. Grouping these together with derivative options and structured products that incorporate derivative options under the RSA would disadvantage and undermine the prevalence of such bonds to the detriment of the end consumers whose loans are funded by these. Furthermore, regarding options non-delta risk in the standardised approach, where for each option, the profit/loss in a scenario matrix is calculated it is the EBF s understanding that the scenario matrices for options on the same underlying are added together and the risk exposure for that underlying is set equal to the largest loss in the resulting scenario matrix for that underlying. The total capital is then calculated from the individual exposures. This means there is significant netting of options on the same underlying but no netting across underlyings. With specific reference to interest rate products where standard expiries and underlying tenors both range from 1 month to 30 years, and where there is clearly a high correlation between proximate parts of the yield curve, The EBF believes it would be better to make expiry/tenor buckets and net within those buckets. Treatment of FX risk in the banking book The EBF asks for clarification regarding how notional values should be derived for traditional banking book items such as retail loans and deposits, which are often not booked at Fair Value and where the proposed cash flow method are not obvious how to apply. Capital requirement for FX risk The proposal for the revised standardised method for FX risk introduces the term bucketing. As the term is not relevant for direct FX risk the EBF assumes that the BCBS intends to cover not only direct FX risk but also combination effects of simultaneous interest rate and FX movements. As FX risk covers also the banking book this would require to cover non-mark-to- market effects in the banking book from interest rate movements. The EBF assumes this is not the intention of the BCBS. Instead, the EBF proposes that banking book items that are not at Fair Value would not 13

be required to be bucketed based on the maturity of neither the notional nor the cash flows. The net present values of those items would rather go into the first bucket. Moreover, the proposal would introduce FX risks in subsidiaries that are pure banking book units (without trading desks) without items that are only denominated in their home currency and even if these items are not accounted for at Fair Value. The EBF finds this both counterintuitive and unnecessary. B.6. Relationship between the internal models-based and standardised approaches The EBF continues to reject the idea of floors and surcharges. In addition, if this requirement is kept, the EBF fears that this would introduce safety margins within the market risk structure aiming to reducing volatility in the calculation of capital charges caused by moving between the standardized and models based approach. However, Basel 3 has already introduced the general concept of capital buffers, which add safety margins on top of the minimum requirements. The EBF is of the opinion that the calculation of the capital charge for specific risk types, such as the market risk, should be as true as possible. Therefore, conservative buffers within the market risk structure should be avoided. Moreover, if parallel calculations using the standardised approach continue to be required, these should not have to be made daily, but only on the reporting days. B.7. Disclosure requirements If SA calculations have to be made public, there is a danger that investors, for example, will tend to ignore model-based figures even if these are a better reflection of the bank s risk situation. It will be extremely difficult to make the SA fully risk sensitive, including all risk factors in the trading books (especially the more exotic risks and basis risks). Furthermore, the broad categories proposed will not lead to a full risk sensitivity. Hence, comparing figures could lead to incorrect conclusions about the internal calculation and/or could lead to continuous criticising of the standard model. This could require quite some effort to explain why standard figures deviate from the internal model, even though they are not designed to generate the same results. The EBF therefore does not support disclosure of SA calculations. 14