Newsletter – May 2025
The EBA has released the draft regulatory standard to provide further clarification on how financial institutions should assess the size of their business under the derogations for market and counterparty credit risk focusing on determining trade direction and primary risk drivers.
Under the Capital Requirements Regulation (CRR), institutions can apply simplified methods to calculate own funds requirements for market and counterparty credit risk, as long as their on- and off-balance-sheet business remains within specific thresholds. The European Banking Authority (EBA) has released a final draft Regulatory Technical Standards (RTS) outlining the approach for identifying the main risk driver and assessing the transaction direction ie. if they qualify as long or short position. The newly proposed standards are part of the EBA’s roadmap of the Banking Package for implementing the final Basel III reforms in the EU.
According to Capital Requirements Regulation (CRR) financial institutions are required to determine the scale of both on- and off-balance-sheet business for the evaluation of conditions applicable to:
a) the exemption for small trading book business, as outlined in Article 94 of the CRR,
b) the simplified methods for determining the expected value of derivative transactions, as specified in Article 273a of the CRR, and
c) the simplified standardized approach for market risk, as defined in Article 325a of the CRR
For doing that it is necessary to determine the main risk driver of a position on and off their balance sheet and whether the position is long or short. In the amendments to the CRR introduced by Regulation (EU) 2024/1623 (CRR3) it is clearly stated that a long position means positive sensitivity of an asset with respect to its main risk driver. That is, if the market value of a position increases when the value of its main risk driver increases, then it is long otherwise it is a short position.
To give an example, consider a fixed rate bond, zero or fixed coupon in either reporting or foreign currency. Its dependence on two risk drivers, interest rate (IR) and credit spread (CS) has the same direction: the bought bond is short in IR and CS so it is short with respect to both at the same time (and the sold bond is long with respect to IR and CS, so it is long with respect to both at the same time, respectively). However, in case of zero or fixed coupon in foreign currency, the FX risk driver has the opposite direction (bought bond is long in FX).
Accordingly, the main challenge is to determine what the main risk driver is for which the draft provides a detailed methodology proposal for each instrument type, distinguishing derivative and non-derivative instruments. The primary approach for identifying the key risk drivers of both derivative and non-derivative positions relies on sensitivities by applying either the FRTB SA risk-weighted sensitivities, or the SA-CCR risk category add-ons.
However, the mentioned calculations may be difficult for small banks and financial institutions, therefore – in accordance with the derogation for the calculation of the capital requirements for Counterparty Credit and Market Risk calculation of the Regulation (EU) No 575/2013 - a simplified methodology also has been proposed and presented for consultation by the EBA. The final draft already includes proposals that take into account the results of the consultation.
General method
Regarding the general methodology the new RTS proposal refers to the SA-CCR’s supplementing regulatory standard set out in Commission Delegated Regulation (EU) 2021/93. Under the new RTS proposal, the general method – as requirement - applies only to instruments not covered by the simplified method.
Simplified method
Institutions Eligible for the Simplified Methodology
In the new RTS proposal the authorization to apply the simplified methodology was granted for all institutions, covering the instruments within its scope.
Instrument scope
The proposed instrument list is as follows: FX spot (cash) positions, commodity spot positions, funds and ETF, repos, forward rate agreements (FRAs), caps and floors, swaptions, forward, futures and options on bonds, CDS indices, FX options, equity swaps and commodity swaps. The RTS describes in detail how to identify the main risk driver and the direction of the trade (long or short) for each instrument types, separately. In addition, it has also been proposed that the FX risk driver may be disregarded for not pure FX trades.
Under the simplified method FX risk driver may be excluded under for certain non-FX instruments, such as bonds, stocks, and derivative transactions with non-currency underlying assets. The proposed exemption applies to fixed rate bonds, stocks, certain floating rate notes, ETFs, Equity and Commodity Forwards, FRAs, IRSs, caps/floors, swaptions, index and single name CDSs, and certain vanilla options.
Given these amendments, the difficult task of determining the main risk driver is not needed in many cases, as seen in the case of example of a fixed rate bond above as the position is long (short) with respect to both its risk driver at the same time. For cases when the task cannot be avoided (e.g., fixed-rates inflation linked bonds or floating-rate notes) the simplified method provides tables for the main risk driver depending on maturity, credit quality and sector. Subsequently, a criteria is given to determine if the position is long or short.
As an example, in the case of the fixed-rates inflation linked bonds or floating-rate notes notes the 3 main risk driver can be IR, CS, and inflation and the RTS sets the direction of the positions on the basis of the following:
a. where the main risk driver is the risk-free rate, the position is long if the bond is sold and short if the bond is bought;
b. where the main risk driver is the issuer credit spread rate, the position is long if the bond is sold and short if the bond is bought;
c. where the main risk driver is the inflation risk factor, the position is long if the bond is bought and short if the bond is sold.
Next steps
After the completed consultation, the RTS supplemented with the consultation’s results will be presented to the Commission for endorsement, then reviewed by the European Parliament and the Council following by its publication in the Official Journal of the European Union. However, until the RTS is upgraded to the Regulation, Article 4 of Commission Delegated Regulation (EU) 2021/931 of 1 March 2021 gives the criteria to calculate the main risk driver; it is based on comparing the so-called add-ons computed for the risk drivers in the CRR. The latter calculation depends on the used methodology.
How can we help?
KPMG Hungary can help by interpreting regulatory requirements and best industry practices through tailored workshops and market benchmarking. With our professional team we offer calculation of capital requirements for counterparty credit risk or credit valuation adjustment for possibly multiple methods that are allowed by regulation to financial sector participants.
The newsletter was created by: Edina Szirmai and Zoltán Kádár
