FRTB Standardised Approach (IV): Residual Risk Add On (RRAO)

In previous articles we have seen introduction in prequel, the bigger picture, followed by delta, vega and curvature charge and default risk charge. In this last leg of the series, let us finish it off with last part of the equation i.e. RRAO. Before we jump to RRAO, let us do a quick recap.

Delta, Vega and Curvature across risk classes.

Sensitivity Based Charge computed above is added to DRC (which by the way is also computed separately for securitised CTO, securitised non-CTP and non-securitised) to cover for risk of default by counterparty.

Finally, Residual Risk Add On: This component's name gives away some material information of what it entails. It covers for any other risk beyond main risks (delta, vega, curvature) or DRCs. It provides for conservative, simple treatment for complex products. One may wonder how complex can it be to not have been covered under so many risks already prescribed under previous two components (SBA and DRC). Well, believe it or not investment bank deal in longevity risks too that are traded in insurance-type derivatives; in financial markets we also have derivatives on weather, natural disasters etc.

The RRAO implementation however is simple in math but complicated in determination whether a product qualifies for RRAO or not. BCBS has attempted to bring clarity around instruments that should qualify for RRAO charge by detailing many aspects. Summary of the same has been listed below.

Once the qualification criteria is fulfilled, all you have to do is a simple math.

RRAO (capital charge) = Gross Notional * RiskWeight

In above formula Risk Weight is 1% for products having exotic underlying while it is 0.1% for other residual risks.

Under Standardised Approach, the final capital charge would be summarised as sum capital charge under three components.

In future, I will summarise FRTB IMA approach in detail (it will take some parts) within a new series I shall start this week. I will also attempt to describe implications, challenges, impediments and timelines that banks are facing for FRTB implementation in future. If you're interested in reading about them, you can connect with me or follow me.

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