Default Risk Charge: Standardised and Internal Models Approaches

Sanjay Sharma and John Beckwith

“When you lose control of risk at a financial institution, you do a variety of unfortunate credit extensions or purchases – and all of a sudden, you’ve blown up your business” – Stephen A. Schwarzman

The Default Rule Change (DRC), applied in both its standardised and internal models form, is designed to ensure that the risk of jump-to-default (JTD), not simply the risk of credit migration, is applied to trading activities. The BCBS explicitly calls for DRC calibration to be aligned with “credit risk treatment in the banking book to reduce the potential discrepancy in capital requirements for similar exposures across the banking and trading books”.¹¹ BCBS, d352, p. 3.

In this chapter, we will review the mechanical implementation of the DRC under the SA, then turn to the less-prescriptive DRC approach required under the IMA, and conclude with a glossary of credit terms as reference to trading and risk professionals more accustomed to market risk activities. We start by exploring the foundations of credit risk as implemented within the banking book, to help us understand how those foundations apply to the concept of default within FRTB’s market risk framework.

FOUNDATIONS OF