The ECB & Trade Flows: The Road to Hell is Paved With Good Intentions

Friday, April 22, 2022 | By Hernan Zuniga, CCR Product Manager, and Alejandra Premat, Lead Mathematician, Algorithmics

The ECB & Trade Flows: The Road to Hell is Paved With Good Intentions

Those of us who have followed the regulatory approach to internal models over the years have witnessed a remarkable evolution from its infancy, when it was very principles-based, to the current state, where it has become much more rules-driven; an evolution that has moved the focus from “modeling” into “compliance.”

Although there are many factors that have driven this paradigm shift, making regulatory numbers meaningful for external parties is at the forefront. For achieving this, modeling consistency is fundamental, and also helps regulators in their almost impossible task of keeping abreast of what banks are doing.

With that goal in mind, in the ever-complex area of counterparty credit risk exposure modeling, both BIS and local regulators have in recent years published reports and run programs with consistency as the main focus.

One such program has been the ECB’s “Targeted review of internal models” (TRIM).  TRIM provides guidance and interpretation of regulation for credit risk, market risk and counterparty credit risk where it delves into 10 specific areas, with the declared objective of reducing modeling variability across European Union banks. 

In one such area, thanks to an overzealous interpretation and prescription of what constitutes capitalizing elements of risk, they appear to have departed from the international consensus marked by BIS guidance, as well as clarification and implementation by regulators in other jurisdictions, and in so doing have introduced a very significant inconsistency with other jurisdictions that puts European banks at a clear disadvantage should they pursue/maintain their internal model approach.

That area is the modeling of margin period of risk (MPoR). Whereas the BCBS had previously given guidance to capitalize exposure due to a delay in the return of collateral after a trade payment (collateral spikes), the ECB prescribes the capitalization of a more general and greater risk caused by asymmetric delivery of both trade and collateral flows during the MPoR (collateral and forward settlement spikes).

Given the regulatory mandate to eliminate unsecured relationships between professional counterparties, margin period of risk modeling becomes particularly relevant and the interpretation from the ECB not only places EU banks at a disadvantage with respect to their peers, but also favors banks that don’t use internal models or even favor unsecured exposures over secured ones, as in neither of these cases are trade flows considered as capitalizing elements.

In our new whitepaper, SS&C Algorithmics discusses how the European Central Bank, in an attempt to reduce internal model inconsistency for counterparty credit risk, may have introduced a substantial inconsistency with other jurisdictions by requiring the capitalization of forward settlement risk. Download your copy to learn more about how this inconsistency came about and the ramifications of including this risk in the calculation of capital requirements.

EMEA, Regulation, Risk Management

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