Significant RWA Savings for Banks Using the Fair Value Option under the Prudential Boundary Approach

New CRR III Standardized Approach for Operational Risks

This short specialist article presents findings from consulting practice on determining the financial component in the new OpRisk standardized approach in accordance with CRR 3. It shows that banks using the fair value option have potential to optimize their RWA figures.

Regulatory Framework

The capital requirements for operational risk are determined in accordance with the CRR Articles 311-315. The requirements are specified in the Draft RTS and ITS from the consultation paper EBA/CP/2024/05. The final RTS and ITS are expected to be published in the second quarter of 2025. In accordance with CRR Article 314(6), the financial component is defined as the sum of a trading book component (TC) and a banking book component (BC), i.e.

FC = TC + BC

The TC and BC figures are calculated as a 3-year average of absolute values based on FINREP items. The distinction between the trading book and banking book components is either based on the accounting standard used for FINREP reporting or the regulatory distinction of the trading book in accordance with Part 3, Title I, Chapter 3 of CRR 3. The use of the accounting-based approach, the so-called accounting approach (AA), is defined as the standard to be applied in this context, see RTS Article 9(1). Under certain conditions, institutions may deviate from this and use the prudential boundary approach (PBA) based on the derogation in RTS Article 9(2). The main prerequisite for using the PBA is the existence of an unwarranted increase (UI), i.e. an unjustified increase in the FC.

The Fair Value Option as a Cause of Unwarranted Increases

The fair value option (FVO) is widely used by banks and is particularly applied when the financial instrument under consideration does not qualify for hedge accounting. It is easy to show that in the typical use case of the FVO, where the associated economic hedging transactions are derivatives, there is generally an unwarranted increase. The PBA is therefore open to all institutions that use the FVO with this hedging model.

Case Study

The following case study is based on an implementation of the PBA at a European banking group that was accompanied by us but is fictitious. The parent company is a trading book institution with a material trading book. The fair value option is used by several institutions in the group, whereby the underlying transactions are economically hedged by derivatives. The Group has decided to apply the PBA for Group reporting. The starting point is the finding that in the accounting approach the valuation results of the fair value option and the associated hedging derivatives are reported in different components of the FC. Therefore, an unwarranted increase results. […]

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