Regulatory exemptions during extreme market stresses: EBA publishes final RTS on extraordinary circumstances for continuing the use of internal models

The Covid-19 pandemic triggered unprecedented market volatility, causing widespread failures in banks' internal risk models. These backtesting failures threatened to increase capital requirements and restrict the use of advanced models. To avoid a potentially dangerous feedback loop from the lower liquidity, regulators responded by granting temporary exemptions for certain pandemic-related model exceptions. To act faster to future crises and reduce unreasonable increases to banks’ capital requirements, more recent regulation directly comments on when and how similar exemptions may be imposed.

Although FRTB regulation briefly comments on such situations of market stress, where exemptions may be imposed for backtesting and profit and loss attribution (PLA), it provides very little explanation of how banks can prove to the regulators that such a scenario has occurred. On 28^th June, the EBA published its final draft technical standards on extraordinary circumstances for continuing the use of internal models for market risk. These standards discuss the EBA’s take on these exemptions and provide some guidelines on which indicators can be used to identify periods of extreme market stresses.

Background and the BCBS

In the Basel III standards, the Basel Committee on Banking Supervision (BCBS) briefly comment on rare occasions of cross-border financial market stress or regime shifts (hereby called extreme stresses) where, due to exceptional circumstances, banks may fail backtesting and the PLA test. In addition to backtesting overages, banks often see an increasing mismatch between Front Office and Risk P&L during periods of extreme stresses, causing trading desks to fail PLA.

The BCBS comment that one potential supervisory response could be to allow the failing desks to continue using the internal models approach (IMA), however only if the banks models are updated to adequately handle the extreme stresses. The BCBS make it clear that the regulators will only consider the most extraordinary and systemic circumstances. The regulation does not, however, give any indication of what analysis banks can provide as evidence for the extreme stresses which are causing the backtesting or PLA failures.

The EBA’s standards

The EBA’s conditions for extraordinary circumstances, based on the BCBS regulation, provide some more guidance. Similar to the BCBS, the EBA’s main conditions are that a significant cross-border financial market stress has been observed or a major regime shift has taken place. They also agree that such scenarios would lead to poor outcomes of backtesting or PLA that do not relate to deficiencies in the internal model itself.

To assess whether the above conditions have been met, the EBA will consider the following criteria:

1. Analysis of volatility indices (such as the VIX and the VSTOXX), and indicators of realised volatilities, which are deemed to be appropriate to capture the extreme stresses,
2. Review of the above volatility analysis to check whether they are comparable to, or more extreme than, those observed during COVID-19 or the global financial crisis,
3. Assessment of the speed at which the extreme stresses took place,
4. Analysis of correlations and correlation indicators, which adequately capture the extreme stresses, and whether a significant and sudden change of them occurred,
5. Analysis of how statistical characteristics during the period of extreme stresses differ to those during the reference period used for the calibration of the VaR model.

The granularity of the criteria

The EBA make it clear that the standards do not provide an exhaustive list of suitable indicators to automatically trigger the recognition of the extreme stresses.  This is because they believe that cases of extreme stresses are very unique and would not be able to be universally captured using a small set of prescribed indicators.

They mention that defining a very specific set of indicators would potentially lead to banks developing automated or quasi-automated triggering mechanisms for the extreme stresses. When applied to many market scenarios, this may lead to a large number of unnecessary triggers due the specificity of the prescribed indicators. As such, the EBA advise that the analysis should take a more general approach, taking into consideration the uniqueness of each extreme stress scenario.

Responses to questions

The publication also summarises responses to the original Consultation Paper EBA/CP/2023/19. The responses discuss several different indicators or factors, on top of the suggested volatility indices, that could be used to identify the extreme stresses:

• The responses highlight the importance of correlation indicators. This is because stress periods are characterised by dislocations in the market, which can show increased correlations and heightened systemic risk.
• They also mention the use of liquidity indicators. This could include jumps of the risk-free rates (RFRs) or index swap (OIS) indicators. These liquidity indicators could be used to identify regime shifts by benchmarking against situations of significant cross-border market stress (for example, a liquidity crisis).
• Unusual deviations in the markets may also be strong indicators of the extreme stresses. For example, there could be a rapid widening of spreads between emerging and developed markets triggered by regional debt crisis. Unusual deviations between cash and derivatives markets or large difference between futures/forward and spot prices could also indicate extreme stresses.
• They suggest that restrictions on trading or delivery of financial instruments/commodities may be indicative of extreme stresses. For example, the restrictions faced by the Russian ruble due to the Russia-Ukraine war.
• Finally, the responses highlighted that an unusual amount of backtesting overages, for example more than 2 in a month, could also be a useful indicator.

Zanders recommends

It’s important that banks are prepared for potential extreme stress scenarios in the future. To achieve this, we recommend the following:

• Develop a holistic set of indicators and metrics that capture signs of potential extreme stresses,
• Use early warning signals to preempt potential upcoming periods of stress,
• Benchmark the indicators and metrics against what was observed during the great financial crisis and Covid-19,
• Create suitable reporting frameworks to ensure the knowledge gathered from the above points is shared with relevant teams, supporting early remediation of issues.

Conclusion

During extreme stresses such as Covid-19 and the global financial crisis, banks’ internal models can fail, not because of modelling issues but due to systemic market issues.  Under FRTB, the BCBS show that they recognise this and, in these rare situations, may provide exemptions. The EBA’s recently published technical standards provide better guidance on which indicators can be used to identify these periods of extreme stresses. Although they do not lay out a prescriptive and definitive set of indicators, the technical standards provide a starting point for banks to develop suitable monitoring frameworks.

For more information on this topic, contact Dilbagh Kalsi (Partner) or Hardial Kalsi (Manager).