FRTB Standardised Approach (III): Default Risk Charge (DRC) Calculation Steps and Examples

In my previous article for this series, I wrote about how FRTB recommends to calculate delta, vega and curvature charge on instruments are risk classes where applicable.

There are two more components that need to be added to delta, vega and curvature charges before we arrive at. i.e. Default Risk Charge and Residual Risk Add On. Here in this article we will focus on DRC.

DRC: Default Risk Charge

So far we've learnt that delta and vega covers for linear risk, curvature covers for large shocks/non-linear risk. But what about risk of default by the counter-party. If you've bought corporate bonds issued by Government of Zimbabwe (poor choice of investment by the way), you should very well cover for the risk of default by Govt. of Zimbabwe + keep aside capital to cover for the losses that may incur due to said default.

The Default Risk Charge is intended to capture the Jump-to-Default (JTD) risk of an instrument i.e. the loss that would be suffered by the holder, if the issuer of the bond or equity were to default. It is computed for each instrument separately and is a function of the face amount (or notional), market value of the instrument and the Loss Given Default (LGD). This is different from the change in market value due to credit quality which is captured by the Sensitivities Delta charge for Credit Spread Risk factors.

FRTB explains in detail how banks should arrive at this charge. I have briefly summarised them in below for non securitised instruments.

Step 1: Calculate GROSS JTD exposure by exposure, for each trade on the instrument (which could likely be bonds or equity). The bank could be 'long' the exposure implying that it'd incur losses if bond/equity issuer defaults. The bank could be 'short' the exposure implying it stands to profit from default of obligor.

LGD is 100% for equity instruments and non senior debt instruments. It is 75% for senior debt instruments while 50% for covered bonds.

Step 2: Scaling: the gross JTDs are wighted in accordance to their maturity if they have maturity less than a year. For maturities, greater than one year, it is not scaled at all.

Step 3: Net the JTDs: Obvious step to offset long vs short position on same obligor. There is no netting benefit in this step if the obligor/issuer is different.

Step 4: Weight the DRCs: Default risk weights are assigned to net JTD by credit quality categories (i.e rating bands), irrespective of the type of counterparty, as in the following table

Step 5: Allocate the weighted DRCs to 3 different buckets as applicable i.e. Government, Corporate, Sovereigns

Step 6: Hedge Benefit recognition: The hedging relationship between long and short position within each bucket is incorporated using a hedge benefit ratio; but no hedging is recognised between the buckets.

Step 7: Calculate DRC Charge: Sum of bucket level charges computed.

Let us review all these steps in a simple example as shown in below over simplified slide for EQ position in a stock by an investment bank. Considering a plain vanilla stock with no other instruments in the portfolio steps of bucketing, hedging are not relevant.

Example 1:

Let us consider another example, where we have Credit Default Swap. Imagine an Investment Bank selling a protection on a corporate bond with BBB credit rating.

Example 2:

If we had both positions in the same portfolio desk, how would we get the combined DRC? Well, step 5, 6 and 7 discussed above come into action.

• As part of step 5, they (i.e. example 1 and 2) both belong to 'corporate bucket'.
• As part of step 6, we have to see any hedging benefit that we might have observed. however, both positions were JTD (long) - so essentially there is not hedging benefit (implying hedging ration =1).
• Step 7 mandates sum of final DRCs which is given by below formula for each bucket. So our DRC for above oversimplified examples taken together will be $ 1.8 mil + $ 1.5 mil (both fell in corporate bucket with hedging ratio as 1 and there wasn't any JTD (short) in our examples.

In next article, I shall talk about RRAO i.e. Residual Risk Add On, which will be final leg in the FRTB Standardised Approach series.

#frtb?#sba?#StandardisedApproach?#basel?#investmentbanking?#riskmanagement?#marketrisk?#bcbs?#bankingsector?#regulatorychange?#delta?#vega?#curvature?#capitalcharge #drc #default #defaultriskcharge #rrao