CRR3 Updates: IRB Model Changes & Risk Driver Identification

In December 2024, the European Banking Authority (EBA) introduced two critical updates to the Capital Requirements Regulation (CRR3). These updates address distinct yet interconnected facets of financial regulation:

1. Regulatory Technical Standards (RTS) on Risk Driver Identification and Position Directionality: This update specifies methodologies for determining the main risk driver of a position and whether transactions are long or short positions.
2. RTS on Material Model Changes in the Internal Ratings-Based (IRB) Approach: This update refines the assessment framework for material changes and extensions to IRB models, enhancing alignment with CRR3.

These updates address critical aspects of risk management. By enhancing methodologies and supervisory oversight, they aim to foster a more robust financial system and reduce potential vulnerabilities.

The two updates are interconnected through their alignment with CRR3 and their overarching goal of refining risk management practices. The RTS on Risk Driver Identification supports market risk calculations, while the IRB-focused RTS strengthens credit risk modeling and supervisory practices. Together, they address different yet complementary components of financial risk.

Source

[1]

The EBA publishes final standards on the specification of long and short positions under the derogations for market and counterparty risks | European Banking Authority

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[2]

The EBA consults on draft technical standards that specify material changes and extensions to the Internal Ratings Based approach | European Banking Authority

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RTS on Risk Driver Identification and Position Directionality

The Regulatory Technical Standards (RTS) on Risk Driver Identification and Position Directionality, issued under the Capital Requirements Regulation (CRR3), provide a comprehensive framework for assessing and categorizing financial positions to enhance market risk management. The RTS introduces new methodologies and refinements designed to standardize the classification and aggregation of financial positions across institutions.

1. Integration of FRTB-SA Sensitivities The RTS employs Fundamental Review of the Trading Book – Standardized Approach (FRTB-SA) sensitivities to identify the main risk driver of non-derivative and derivative positions. These sensitivities form the cornerstone of the methodology, offering a granular and standardized approach to calculating market risk. Institutions are required to evaluate various risk factors, such as interest rate shifts, equity price changes, or credit spread movements, and compute the corresponding delta sensitivities.

This approach ensures:

• Consistency in Market Risk Assessments: By standardizing the evaluation of sensitivities, institutions can align their practices with global regulatory frameworks, reducing discrepancies in risk evaluation.
• Risk-Weighted Comparisons: Sensitivities are risk-weighted using the FRTB-SA risk weights, ensuring that institutions consider the relative volatility and impact of different risk factors.

2. SA-CCR Add-ons for Derivative Positions The RTS integrates Standardized Approach for Counterparty Credit Risk (SA-CCR) add-ons for derivative positions. This method supplements the sensitivity-based framework by emphasizing a simplified yet robust calculation for derivatives. Institutions can utilize SA-CCR add-ons to determine risk drivers in derivatives such as swaps, forwards, and options.

Key benefits include:

• Simplicity for Complex Instruments: The SA-CCR add-ons provide an efficient mechanism to calculate risk exposures for a wide array of derivatives.
• Focus on Counterparty Credit Risk: By aligning with SA-CCR methodologies, the RTS ensures that counterparty risk is accurately represented in institutions’ capital calculations.

3. Simplified Methodology for Smaller Institutions Recognizing the operational challenges faced by smaller institutions, the RTS introduces a simplified methodology for calculating the main risk driver and determining position directionality. This methodology allows institutions to:

• Disregard FX Risk Drivers for Non-FX Trades: For positions not classified as pure FX trades but impacted by translation risks, such as foreign-denominated bonds, FX risks can be excluded under this methodology.
• Apply Streamlined Calculations: The simplified method extends to straightforward instruments like fixed-rate bonds, floating-rate notes, stocks, and plain vanilla derivatives, reducing computational burdens for smaller banks.

4. Unified Classification of Long and Short Positions The RTS establishes clear criteria for identifying whether a position is long or short in relation to its main risk driver:

• A long position increases in value when the main risk driver rises.
• A short position decreases in value under the same circumstances.

This clarity ensures uniformity in aggregating long and short positions, essential for accurate trading book calculations under CRR3.

5. Operational Flexibility and Broader Application The RTS extends the scope of simplified methodologies to all institutions, regardless of size, for the instruments within its coverage. This provides operational flexibility while ensuring robust compliance with CRR3 standards.

RTS on Material Model Changes in the Internal Ratings-Based (IRB) Approach

The RTS on Material Model Changes in the Internal Ratings-Based (IRB) Approach provides detailed guidelines to assess the materiality of changes to credit risk models under CRR3. It reflects over a decade of supervisory insights and incorporates updates to ensure alignment with the evolving regulatory environment.

1. Alignment with CRR3 Amendments The RTS aligns with CRR3 by:

• Removing outdated references, such as the application of IRB for equity exposures.
• Introducing changes to reflect new CRR3 requirements, such as updated probability of default (PD) and loss given default (LGD) parameters, and enhanced supervisory expectations for credit risk model documentation.

2. Clarifications on Qualitative Thresholds The RTS refines qualitative criteria for assessing material changes:

• Definition of Default (DoD): Changes to DoD are considered material when they significantly impact the classification of defaulted exposures. Examples include modifications to criteria for determining whether an obligor is 90 days past due.
• Validation Frameworks: Adjustments to validation methodologies are categorized based on their impact. For example, more lenient thresholds leading to positive validation results are classified as material changes requiring approval, while conservative adjustments may only require notification.

3. Updated Quantitative Criteria Quantitative thresholds are adjusted to ensure consistency across institutions:

• Aggregation of Changes Across Models: Changes impacting multiple rating systems must be assessed in aggregate, preventing fragmentation of materiality evaluations.
• Extensions of Model Applications: A new threshold assesses the ratio of risk-weighted exposure amounts for additional exposures to the existing range of application, reflecting the risks associated with extending a model’s scope.

4. Categorization of Model Changes The RTS categorizes model changes into:

• Material Changes: Requiring prior supervisory approval, these include significant adjustments to methodologies or inputs affecting credit risk estimates.
• Non-Material Changes: These require notification and include less critical modifications, such as technical updates to align models with regulatory templates.

5. Enhanced Documentation Requirements Institutions must submit detailed documentation for model changes, including:

• Validation results.
• Impact assessments on model performance.
• Technical details of the changes implemented.

6. Simplified Approval for Non-Material Changes Non-material changes are streamlined under the updated RTS, reducing regulatory bottlenecks while maintaining supervisory oversight. This approach facilitates timely updates to models without compromising risk management rigor.

Capital Requirements Regulation (CRR3): Timeline of Implementation

The implementation of the updated Regulatory Technical Standards (RTS) under the Capital Requirements Regulation (CRR3) follows a structured timeline:

1. December 2024: The European Banking Authority (EBA) published the finalized RTS for both Risk Driver Identification and Internal Ratings-Based (IRB) model changes.
2. January 15, 2025: A public hearing will be held to discuss the Risk Driver Identification RTS, providing further clarifications and addressing stakeholder questions.
3. March 10, 2025: Deadline for consultation feedback on the RTS related to IRB material model changes.
4. 2025 Onward: Following European Commission endorsement, the RTS will undergo scrutiny by the European Parliament and the Council before being published in the Official Journal of the European Union.
5. Enforcement: The RTS will become binding 20 days after publication in the Official Journal, with institutions expected to comply from this effective date.

Institutions are encouraged to prepare proactively during this transitional period to ensure full compliance by the enforcement date.

Impact of the RTS on Risk Driver Identification

1. Enhanced Market Risk Analysis
   • The integration of FRTB-SA sensitivities ensures standardized evaluation of market risks, improving consistency in risk management.
   • For derivative positions, SA-CCR add-ons simplify risk assessments, offering institutions an efficient alternative while maintaining compliance.
2. Operational Flexibility for Smaller Institutions
   • Simplified methodologies significantly reduce the operational challenges faced by smaller or non-complex institutions.
   • By excluding non-critical drivers, such as FX for non-FX trades, the RTS minimizes computational burdens.
3. Uniform Risk Categorization
   • Standardized definitions of long and short positions ensure accurate and consistent aggregation across institutions, fostering transparency in risk reporting.
4. Global Regulatory Consistency
   • The RTS aligns EU standards with global frameworks, such as Basel III, positioning institutions to meet international compliance expectations.

Impact of the RTS on Material Model Changes in the IRB Approach

1. Improved Supervisory Controls
   • Enhanced oversight of material changes reduces compliance risks and ensures that credit risk models remain robust and aligned with CRR3.
   • The RTS leverages over a decade of supervisory experience to refine criteria for assessing materiality.
2. Clarity in Compliance Expectations
   • By removing outdated references and incorporating new quantitative thresholds, the RTS ensures clarity in regulatory expectations.
   • Institutions benefit from streamlined processes, focusing efforts on significant updates.
3. Transparency and Accountability
   • Enhanced documentation requirements provide supervisors with detailed insights into model changes, fostering accountability across institutions.
4. Efficiency in Model Adaptation
   • The distinction between material and non-material changes allows institutions to adapt models efficiently while maintaining compliance integrity.

CRR3: Steps for Compliance

Adhering to the new RTS under the Capital Requirements Regulation (CRR3) requires institutions to adopt proactive strategies to ensure seamless implementation and compliance. Here are the detailed steps for compliance:

Compliance with the RTS on Risk Driver Identification

1. Integration of Sensitivity-Based Frameworks
   • Institutions must adopt tools to calculate FRTB-SA sensitivities for non-derivative and derivative positions. These tools should enable the computation of delta sensitivities for various risk drivers, weighted using FRTB-SA risk weights to ensure consistency.
   • For derivative positions, implementing methodologies to compute SA-CCR add-ons is essential. Institutions should ensure their systems can handle the complexity of derivative risk assessment under SA-CCR frameworks.
2. Simplification for Smaller Institutions
   • Smaller banks should leverage the simplified methodology, focusing on straightforward instruments and excluding FX risk drivers for non-FX trades. This approach minimizes operational burdens while ensuring compliance with CRR3 requirements.
3. Training and Capacity Building
   • Institutions must train risk management teams on the new methodologies and tools to ensure accurate identification of risk drivers and classification of long/short positions.
4. Enhanced Reporting Systems
   • Robust reporting systems are necessary to consolidate risk assessment data and ensure compliance with CRR3's standardized approach. These systems should facilitate transparent reporting to supervisory authorities.

Compliance with the RTS on Material Model Changes in the IRB Approach

1. Proactive Engagement with Supervisors
   • Institutions should engage with supervisory authorities early in the process to discuss planned model changes. This helps streamline the approval process for material changes and align expectations.
2. Updating Validation Frameworks
   • Validation frameworks must be updated to align with revised qualitative criteria, such as the enhanced definition of default and validation methodologies. Institutions should document all changes comprehensively, including impact assessments and performance evaluations.
3. Meeting Documentation Requirements
   • Institutions must prepare detailed documentation for model changes, including:
     • Validation results.
     • Technical details of the changes.
     • Impact assessments on risk-weighted exposure amounts (RWEA).
   • This documentation is essential for supervisory reviews and ensures transparency in model updates.
4. Adapting to Quantitative Thresholds
   • Institutions must assess changes across multiple rating systems in aggregate to comply with updated quantitative thresholds. For extensions to model applications, institutions should calculate the ratio of RWEA for additional exposures to the existing range, reflecting the risk implications of these extensions.
5. Regular Review and Adjustment
   • As CRR3 evolves, institutions must establish mechanisms for regular review and adjustment of risk models to ensure ongoing compliance with regulatory updates.

Banking Regulation Future

The latest EBA updates signify a pivotal step in strengthening the EU’s regulatory framework under CRR3. By introducing detailed methodologies for risk assessment and refining the IRB framework, these RTS ensure a robust risk management ecosystem.

As regulatory expectations continue to evolve, institutions must prioritize operational readiness, leveraging digital tools and expertise to adapt swiftly. Looking ahead, further integration of technology-driven solutions may define the next phase of regulatory compliance in the EU banking landscape.