Is Indirect Approach for Stress Expected Shortfall of FRTB Internal Model Method Well Defined?

Abstract

FRTB proposes Indirect Approach (IA) to address data challenges during period of stress for calculating stress Expected Shortfall (ES) under Internal Model Method (IMM). Unlike other topics like Non-Modellable Risk Factors (NMRF) and Profit and Loss Attribution Test (PLAT), Indirect Approach gets little attention and discussion in literatures, ISDA Forums and Basel Quantitative Impact Study (QIS) due to its contingency on data readiness and complexity of operating. This paper investigates if Indirect Approach is well defined and robust to give certain and stable results and identifies some weaknesses by testing the impact of portfolio structures, underlying parameters (correlations, volatilities and means) as well as scaling factor floor on the performance of the approach through several simplified representative examples, and proposes several alternative approaches and calls for further investigation and testing to improve the approach and avoid diminishing the incentive for institutions to implement and use the Internal Model Method.