24 March 2021

ISAD: Creating a Better Test for Capital

When it comes to implementing new standardized methodologies, this testing can be achieved through an industry benchmarking initiative that allows a firm to compare its approach with others.

From the earliest days of the pandemic, it became clear that effective coronavirus testing would be critical in monitoring the spread of the disease and giving healthcare professionals the vital information needed to make well-informed decisions. The importance of basing decisions on the results of tests extends to many other areas – even to bank capital models. When it comes to implementing new standardized methodologies, this testing can be achieved through an industry benchmarking initiative that allows a firm to compare its approach with others.

Following a one-year delay in the implementation of Basel III due to the impact of the pandemic, many jurisdictions are expected to propose legislation in the coming months that will transpose the global standards into national law. These will cover the Fundamental Review of the Trading Book (FRTB) market risk rules and the revised credit valuation adjustment (CVA) risk capital rules.

Among the various changes, the new framework will place greater importance on standardized approaches, and all banks – even those using internal models – will be expected to calculate capital requirements on this basis. In order to serve as a credible alternative to internal models, the new standardized approaches are more risk-sensitive than in the past. But with that risk sensitivity comes complexity, making it challenging for all banks to achieve a consistent interpretation and implementation of the rules.

That’s where benchmarking comes in – a project ISDA launched in 2018. By benchmarking their implementation against an industry standard, banks can ascertain whether they have interpretated the rules in line with others and make any necessary adjustments. Benchmarking also gives supervisors greater confidence that the capital framework is being effectively implemented.

Comprising two distinct processes over a period of months – a unit test and a hypothetical portfolio exercise – banks use prescribed input sensitivities and hypothetical trades to benchmark their capital calculations against an industry standard. They can then identify and rectify any variations in a timely and cost-effective way.

Since the benchmarking initiative launched, 55 banks have participated in the exercise, together with nine technology vendors that have licensed the unit tests for use with their products. This means smaller banks that choose an off-the-shelf solution rather than implementing the standardized approach in-house also have access to this solution. So far, the focus has been mainly on benchmarking the FRTB standardized approach, but there is also increasing focus on the standardized approach to counterparty credit risk and the revised CVA risk capital rules.

ISDA has always advocated for globally consistent capital rules, and this applies as much to the rollout as to the drafting process. By enabling banks to compare their approach to an accepted standard, ISDA’s benchmarking initiative will ensure accuracy in implementation, which in turn will help the industry to save both time and money.

To find out more about ISDA benchmarking, click here.

ISDA

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