Gaming tests, loss provisions and synthetic Libor

The week on Risk.net, September 28–October 4, 2019

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The week on Risk.net, September 28–October 4, 2019

How banks game stress tests: the ‘shocking’ truth

Leaked memo exposes effort to swap out risky assets despite Fed’s push to end “window dressing”

IFRS 9 flings loan-loss provisions haphazardly higher

Under the standard, cash piles for bad loans were expected to ramble. Just not quite so much

Synthetic Libor mooted as ‘tough legacy’ fix

Recalibration of doomed rate or catch-all legislation under debate as lifeline for lingering contracts

 

COMMENTARY: Capital punishment

Two sets of recent proposals from Europe’s banking regulator on market risk capital rules – designed to replace a series of patches following the financial crisis a decade ago – this week drew consternation and frustration from banks.

Both relate to implementation of standards from the Fundamental Review of the Trading Book that decide the capital banks need to hold against risk-taking positions in portfolios.

Following several consultations, the latest version of FRTB – devised by the Basel Committee on Banking Supervision – has lowered the overall capital impact of the framework, as evidenced in the latest BCBS data.

But dealers are still concerned that some of the new measures are too tricky to implement, particularly the tests that determine the allocation of capital.

The first set of proposals would force institutions to include derivatives valuation adjustments in profit-and-loss estimates. Bankers are worried this would require them to make unnecessary recalculations at more granular levels than they do currently. And that would, they say, increase the likelihood that banks fail so-called backtesting, which gauges the soundness of internal models.

Some risk managers believe the derivatives valuation adjustments should be excluded from the tests completely, while others have provided solutions that the European Banking Authority fears will lead banks to take divergent approaches or result in regulatory arbitrage.

In a second move by the EBA, dealers also say plans to capitalise complex non-modellable risks in derivatives are punitive. The EBA has put forward three alternatives for capitalising curves used to price options and swaptions.

Banks are critical of all three approaches and claim they would lead, in varying extents, to either reliance on models that are not practical to build or reversion to a stressed capital surcharge that would inflate the amount of capital a bank needs to put against trades.

One risk specialist argues the regulator should ditch the idea altogether, saying: “We feel that no text and no provision at all would be better and leave banks to negotiate with their supervisor.”

Rejecting that idea, the EBA points out that it would result in the application of unequal treatments across the European Union.

Meanwhile, dealers have been exposed for gaming stress tests meant to gauge the amount of capital they must hold against future market shocks.

The balance sheet “window dressing” in question involved a large US bank proposing an asset swap trade with a European dealer, whereby it would offload equities for bonds to manipulate its trading book in the run-up to the US Federal Reserve’s annual stress test.

In a memo seen by Risk.net, there is talk of “mutual benefit” – implying the US bank could help out its European counterpart similarly during the next stress test conducted by the EBA.

The EBA might then be forgiven for lacking complete sympathy with the plight of banks who complain that they cannot comply with its edicts on capital.

STAT OF THE WEEK

A sample of 38 banks had 2.1% on average of their total assets in securitisations in the second quarter of this year, but at Wells Fargo, this figure was 15%, equivalent to $287.5 billion of securitisation exposure. Financial watchdogs are closely monitoring these products with concerns that securitisations could inflict big losses, particularly when linked to loans with low credit quality and poor recovery rates.

QUOTE OF THE WEEK

“All we’ve done is coded everything a human trader would ever do” – how Stephen Cavoli, head of execution services at market-marker and execution services provider Virtu Financial, describes the firm’s machine learning-powered agency execution algorithms.

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