The Internal Models Approach

Sanjay Sharma and John Beckwith

“Simplicity does not precede complexity, but follows it” – Alan Perlis

FRTB’s IMA addresses the weaknesses of Basel 2.5 framework across two main aspects: it is designed to capture tail and liquidity risks; and it prescribes a substantially more rigorous and periodic model-approval process at RTD level with more consistent identification and capitalisation of material risk factors. Expected shortfall is used as the principal determinant of capital to reflect tail risk. Differentiated liquidity horizons are prescribed for categorised risk factors based on worst-case estimates for liquidating or hedging them without adversely influencing market prices. FRTB also incorporates potential breakdowns in risk factor correlations across periods of market stress by prescribing two different methodologies and averaging the resulting capital charge across them. IMA also has a new default risk charge methodology, which has restrictions on the type of underlying models allowed. In addition, for the first time BCBS has prescribed the requirements for the availability and frequency of historical market data as inputs for internal models. Hedging and diversification benefits are recognised only

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