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FRTB = ‘Finessing’ the Review of the Trading Book

Has NMRF killed off IMA? And what can we do to resuscitate it

RiskMinds – London

Eduardo Epperlein
Risk Methodology Group

The analysis and conclusions set forth are those of the author. Nomura is not responsible for any statement or conclusion herein, and opinions or theories presented herein do not
necessarily reflect the position of the institution.

November 14, 2023 © Nomura

Contents

 A high-level comparison between Basel 2.5 and FRTB

 A critical assessment of the NMRF framework

 NMRF capital charge in the context of RNiV and backtesting

 Potential solutions to the NMRF issue

 A Technical Note on the consequences of infrequent market data on VaR

 Summary and conclusions

1
The Fundamental Review of the Trading Book (FRTB) introduced many
improvements to the Basel 2.5 framework

 FRTB has a more comprehensive and risk-sensitive set of capital charges, with less pro-cyclical features.
 A new desk-level P&L Attribution Test (PLAT) and Backtesting was introduced.

However, the Non-Modellable Risk Factor (NMRF) framework requires ‘finessing’

Feature Scope Basel 2.5 FRTB

Core capital charges

Default Risk Debt  

Charge Equity NA 
Current market VaR NA (hence, less pro cyclical)
Market Risk
Stressed market Stress VaR Stress Expected Shortfall (ES)
Via Liquidity 10 – 120 days
Liquidity Risk Charge 10 days (for all risk types)
Horizons (depending on risk type)
Performance Monitoring and Missing Risks
PLAT Desk level NA 
Entity level  
Backtesting
Desk level NA 
Missing or non- All risks in the Risk-Not-in-VaR (RNiV)* NMRF*
modellable risk VaR engine (usually subjective) (formulaic)

* NMRF charges can typically exceed of 100% of the VaR, whereas RNiV is normally no more than ~ 20% x VaR. 2
Recent ISDA survey indicates a material reduction in Internal Model
Approach (IMA) adoption under FRTB, likely attributed to NMRF issues
Let us try to enumerate some of the concerns with the existing NMRF framework

A. How would we manage the NMRF capital charge?

 The only practical way to do is by improving the Risk Factor Eligibility Test (RFET), which can be done either through more frequent
trading or buying 3rd party observability data.
 However, we should note that neither of these actions impact the actual level of market risk

B. Was NMRF designed to capitalize for liquidity risk?

 There is obvious a causal relationship between market liquidity and the RFET. However, FRTB already introduces a liquidity penalty
via Liquidity Horizons (LH) defined in the capital calculation. For example, equity implied volatility risk has a LH of 60 business days.

C. Perhaps NMRF is there to replace the old RNiV, either from non-existent or infrequently updated time series.
 However, we should note that FRTB already introduces a powerful way to test for missing risk via the PLAT, and VaR backtesting at
both desk and entity level.

Let us hence explore NMRF in the context of RNiV

3
If NMRF was truly meant to represent missing risk then NMRF/ES (or
RNiV/VaR) = 13% would already lead to a capital multiplier
 If we assume a normal distribution of P&L we can easily estimate a capital shortfall multiplier as follows.*

Φ−1 (0.01) 𝑅𝑁𝑖𝑉

𝑆ℎ𝑜𝑟𝑡𝑓𝑎𝑙𝑙 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑓 = ≡ 1+
𝐸𝑥𝑐𝑒𝑝𝑡𝑖𝑜𝑛𝑠 𝑉𝑎𝑅
Φ−1 ( )
250
 In FRTB, the capital multiplier is 𝑘 = 1.5𝑓 (floored at k = 1.5 in the GREEN zone and capped at k = 2 in the RED zone).
 With 10 exceptions in the RED zone, the probability of incorrectly accepting a deficient VaR model through backtesting (i.e. a Type 2
error) is 3%. By the time we have 13 exceptions the Type 2 error become so small (0.3%) that it triggers an automatic desk kick out.**

Hence, a sensible framework suggests that the NMRF capital charge should also be capped at 33%ES

* Φ−1 is the inverse cumulative distribution. https://www.bis.org/bcbs/publ/d457.pdf

** Based on typically observed NMRF/ES levels of about 100% the probability of incorrectly accepting the VaR model (Type 2 Error) is truly remote at 10-10
4
Once we accept that the current NMRF is incommensurate with the true
market risk, what options do we have at our disposal?*
A. Complete elimination of RFET and NMRF
 This has the advantage of avoiding the complex nature of the RFET implementation and running cost (including buying 3 rd party data).
Please note that desk-level PLAT and Backtesting is already designed to identify missing risks.

B. Adjust RFET
 Currently RFET can kick out an excessive number of risk factors, even for seemingly liquid risk factors (per ISDA survey).
 Relaxing the observability thresholds could potentially improve the coverage of ‘modellable risk factors’, and, hence, reduce NMRF

C. Increase the diversification benefit in the NMRF formula

 The existing NMRF formula (below) splits the contribution across (I) credit, (J) equity and (K) ‘other’ risk classes. Both credit and
equity get full diversification benefit, whereas the remaining get a  = 0.6.
 One simple improvement to make the formula more reasonable is to apply a smaller value of , subject to supervisory approval.
 In addition, any revised formula should be subject to a 33%ES cap, as mentioned in the previous slide.

* There may be other strategies to create a more sensible and risk-sensitive NMRF framework. 5
 Technical Note: Infrequent market data updates (or observations) can
lead to ‘fat-tailed’ distributions and, hence, higher VaR*
 Let us first consider a market factor that is updated daily with a normal distribution of returns of unit volatility θ=1. Then assume that this
same market factor is only updated (or observed) every n business days, such that its effective volatility becomes 𝜃𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 = 𝑛.
 For n = 5, the distribution of returns can look like the figure below. We can also plot both the theoretical pdf (f) and cdf (F) of market
returns, where, in between observations 𝜃𝑢𝑛𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 = 0. Note that the resultant ‘fat-tail’ generates a higher 99% VaR for n = 5.

1 1 𝑥2 𝑛−1 1 𝑥2
𝑓 𝑥 = exp − 2𝜃2 + exp − 2𝜃2
𝑛 𝜃𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 2𝜋 𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑛 𝜃𝑢𝑛𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑 2𝜋 𝑢𝑛𝑜𝑏𝑠𝑒𝑟𝑣𝑒𝑑

(4/5)

‘fat tail’
Sample returns over 100 days

(1/5)

(4/5) VaR (n=5) VaR

6
* Paper submitted to Risk.net: ‘Infrequent MtM neither reduces VaR nor backtesting exceptions’, Eduardo Epperlein and Jean Herskovits
Technical Note: continuation
 We can actually solve the previous equations analytically to obtain a simple formula for VaR as a function of n
𝑉𝑎𝑅 1𝑑𝑎𝑦 = 𝑛Φ−1 1 − 𝑛(1 − 0.99)
 And likewise for 10 day VaR (assuming 𝑛 ≥ 10).
𝑉𝑎𝑅 10𝑑𝑎𝑦 = 𝑛Φ−1 1 − 𝑛(1 − 0.99)/10
 Below we plot both 1 & 10 day VaR normalized to Φ−1 (0.99) and 10Φ−1 (0.99), respectively.
 It is commonly assumed that infrequent market updates can lead to lower VaR. However, our model shows that a 10 day market update
leads to a 74% increase in 1 day VaR, approaching parity for n = 35 days. Similarly, for 10 day VaR we see an increase that persists
even beyond 35 days. However, we should also note that both 1 day VaR and 10 day VaR eventually reach zero when n is 50 and 500
days, respectively, as the tail becomes depleted.
 Hence, if one were to make a case for a minimum update frequency that is sufficiently conservative it should be once every 35 days for 1
day VaR (or greater than 7 updates per year).

7
 Summary and conclusions

NMRF remains one of the key obstacles towards IMA adoption.

 We started by highlighting the enhancements introduced by FRTB and where NMRF fitted into it.

 We expressed some concerns with NMRF and argued that it might best be interpreted as a type of RNiV

 By using the RNiV analogy and well-established backtesting techniques we argued that the NMRF capital charge
should be capped at 33%ES

 We explored some approaches to make the NMRF framework more commensurate with true missing risk

 We showed that infrequently observed market data can actually lead to ‘fat-tails’ and, hence, generate higher 1 day
VaR and capital charges