Model

In this article, we discuss the challenges of implementing the internal model approach under FRTB and Solvency II. In particular, we focus on the P&L Attribution test, which financial institutions have to continuously perform and pass to maintain their eligibility for internal model use. The article outlines the similarities and differences between the two regulatory regimes that require the P&L Attribution test; FRTB for banks and Solvency II for insurance companies.

The set of Basel III rules finalized the development of the regulatory capital framework’s post-crisis reforms, accompanied by an industry's lobby battle. However, there is an element of the newly developed FRTB regime, which carries on keeping the industry leaders awake during the nights: the new approach to treating the non-modellable risk factors (NMRFs). This topic is gaining prominence both due to the knotty nature of these risks and because 29% of total market risk capital charges under FRTB could be attributable to NMRFs. However, we argue that despite the differences in the treatment of hard-to-model risks, the existing framework could still be put to use while addressing the new FRTB requirements.

We present some technical concepts regarding different valuation structures both from a financial point of view and a mathematical perspective.

In this note, we explain Libor Market Model for interest rate. Furthermore, we go through the calibration of LMM conforming to Solvency II.