Basel III Reduced Risk Factors for Stressed Expected Shortfall
Summary
In the Basel market risk framework, the reduced set of risk factors is used to calibrate stressed expected shortfall when a sufficiently long history is unavailable for the full model. Banks select factors relevant to their portfolio and with adequate historical observations; the set requires supervisory approval and must meet modellability data quality requirements. It must explain at least 75% of the variation in the fully specified expected shortfall model over the stated measurement period.
The explanation distinguishes this calibration set from the full set used in the current period. Current exposures linked to factors absent from the reduced set need to be mapped to suitable factors in that set for stressed-period calculations. In exceptionally broad market disruptions, supervisors may consider treating some factors that fail the modellability test as modellable. This is described as a rare supervisory response, not a routine way for banks to include non-modellable factors. The discussion is based on cited Basel provisions and is not a complete implementation guide.
Key ideas
- The reduced set supports stressed expected shortfall calibration using a longer history.
- Its risk factors must meet modellability data standards and receive supervisory approval.
- The set must explain at least 75% of full-model expected shortfall variation.
- Current factors outside the reduced set are mapped to suitable factors within it for stressed calculations.
- Supervisors may exceptionally intervene when systemic conditions make many factors non-modellable.
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# what is reduced set of risk factors in the context of basel III? # what is reduced set of risk factors in the context of basel III? I'm going through the MAR - Calculation of RWA for market risk sections on tps://www.bis.org basel framework page, but not quite understand the reduced set of risk factors. Is it subset of modellable rfs, or non-modellable rf's or is it unrelated and chosen upfront and contains both modellable and non modellable rfs? ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/78097 https://www.bis.org/basel_framework/chapter/MAR/31.htm > 31.24 There may, on very rare occasions, be a valid reason why a significant number of modellable risk factors across different banks may become non-modellable due to a widespread reduction in trading activities (for instance, during periods of significant cross-border financial market stress affecting several banks or when financial markets are subjected to a major regime shift). One possible supervisory response in this instance could be to consider as modellable a risk factor that no longer passes the RFET. However, such a response should not facilitate a decrease in capital requirements. Supervisory authorities should only pursue such a response under the most extraordinary, systemic circumstances. > 31.26 (6) In cases where banks do not sufficiently justify the use of current market data for products whose characteristics have changed since the stress period, the bank must omit the risk factor for the stressed period and meet the requirement of MAR33.5(2)(b) that the reduced set of risk factors explain 75% of the fully specified ES model. Moreover, if name-specific risk factors are used to calculate the ES in the actual period and these names were not available in the stressed period, there is a presumption that the idiosyncratic part of these risk factors are not in the reduced set of risk factors. Exposures for risk factors that are included in the current set but not in the reduced set need to be mapped to the most suitable risk factor of the reduced set for the purposes of calculating ES measures in the stressed period. https://www.bis.org/basel_framework/chapter/MAR/33.htm > 33.5 (2) This calibration is to be based on an indirect approach using a reduced set of risk factors. Banks must specify a reduced set of risk factors that are relevant for their portfolio and for which there is a sufficiently long history of observations. > (a) This reduced set of risk factors is subject to supervisory approval and must meet the data quality requirements for a modellable risk factor as outlined in MAR31.12 to MAR31.24. > (b) The identified reduced set of risk factors must be able to explain a minimum of 75% of the variation of the full ES model (ie the ES of the reduced set of risk factors should be at least equal to 75% of the fully specified ES model on average measured over the preceding 12-week period). https://www.bis.org/basel_framework/chapter/DIS/50.htm > Table MRB (e) A description of the stress testing applied to the main significant portfolios that are modelled. For example, banks may describe the reduced set of risk factors used to calibrate the period of stress and the full set of risk factors, the share of the variations in the full ES that is explained by the reduced set of risk factors, and the observation horizon used to identify the most stressful 12 months. So 33.5 (2) (a) says pretty clearly that the reduced set can only contain modelable risk factors. Per 31.24, if it's not possible construct aa reduced that that contains only modelable risk factors and explains 75%, then the regulator has the power to just proclaim some non-modelable risk factors to be modelable, if they want to.
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