Overview of the Simplified Standardized Approach (SSA) for Market Risk
Background
Globally, there is a lot of work that is happening on implementation of Fundamental Review of the Trading Book (FRTB) regulations across jurisdictions. Our earlier series of articles on FRTB explained the:
a. Standardized Approach (SA) — Link to read my article on SA
b. Internal Models Approach (IMA) — Link to read my article on IMA
Both the above approaches are very elaborate, requiring banks to have sophisticated data management architecture and advanced technology system to support the strenuous calculations and reporting requirements under the FRTB approach. Globally, however, there is an increasing push towards SA because of its comparative ease of implementation compared to IMA. Banks are trying to figure out benefits of choosing between either of the two approaches. Scales seem to be tipping in favor of adopting SA for now.
Regulators understand the fact that not every single bank operating in their respective jurisdictions may have the resources or means required to build a system capable of handling the rigor demanded by SA (let alone IMA, which is far more complicated to implement and maintain vis-à-vis SA).
In this article, we discuss the foundations of the Simplified Standardized Approach (SSA).
Simplified Standardized Approach (SSA)
The Simplified Standardized Approach (SSA) is a simpler alternative over the Standardized Approach (SA). SSA enables an organization to use a set of simpler pre-defined rules and parameters for measurement of market risk and regulatory capital requirements. One may view the SSA as a scaled down version of the SA.
The benefit of using SSA is it enables banks to calculate risk capital without having to delve into advanced modelling techniques. As a result, banks can save a lot on time and efforts committed for model building, maintenance and validation under the SSA.
Which banks are eligible to use SSA?
- They are not using IMA for any desk.
- They are not categorized as a global SIFI.
- They do not hold correlation trading positions.
- They do not engage in complex trading.
Certain regulators may ask banks to demonstrate that using the SSA for their capital calculations does not provide them with an incentive to generate regulatory arbitrage vis-à-vis SA.
Risk Classes under the SSA:
Under the SSA, following are the risk classes considered:
o IR risk: risk from holding/trading positions in fixed income instruments i.e. bonds and other interest rate sensitive products.
o FX risk: risk from holding/trading positions in FX and gold.
o EQ risk: risk from holding/trading positions in equities.
o CMTY risk: risk from holding/trading positions in commodities (excluding gold).
The capital requirements under the SSA is a combination of trading positions bank holds in the above four risk classes. Specific scaling factors are defined for each of the classes. Scaling factors ensure a conservative calibration to regulatory capital requirement.
Capital Requirement under SSA = (IR Risk * Scaling Factor IR)+ (FX Risk * Scaling Factor FX) + (EQ Risk * Scaling Factor EQ)+ (CMTY Risk * Scaling Factor CMTY)
Key differences between SSA and SA:
Below are a few key points giving the difference between the two approaches:
o A reduced set of risk classes for capital calculations. This enables banks to consider only those risk factors that are most applicable to their trading portfolios
o Documentation and model validation requirements are lighter under SSA as compared to SA
o Calculations are comparatively straightforward under SSA. This can reduce the data management requirement and the complexity of calculations.
The above is not an exhaustive list, but it gives the reader the idea of basic differences between these two approaches.
One point to note is that the SSA being a comparatively easier approach may fail to capture the risk profile for certain assets or positions. This may result in the bank failing to capture the characteristics specific to certain risk classes and assets. This may result in the bank under-estimating certain portion of risk that they carry on their books. Therefore, the SSA may not reflect the accurate exposure which would otherwise be calculated under the more comprehensive SA approach.
Conclusion
Regulators around the world have the authority to decide which approach they permit banks in their jurisdiction to use, i.e., whether they allow IMA, SA or SSA. For banks in India, the Reserve Bank of India (RBI) has asked banks to follow the SSA from April 1, 2024. RBI also may over time consider transitioning banks to SA if banks in its jurisdiction are able to demonstrate their system and resources capability with respect to managing large data requirements, technology systems supporting fairly complex calculations as demanded by SA. I personally think it’s a good idea by the RBI to start with the SSA. This will give time for banks (even the smallest ones) to get used to the new guidelines. Once systems are in-place, both the RBI and banks will be comfortable if the regulator decides to transition to SA.
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