Internal Model Method

What is the prudential treatment of cash flow spikes in the calculation of own funds requirements for counterparty credit risk under the Internal Model Method?

Cash flows related to future margin payments can create exposure spikes stemming from a mismatch in  the timing of margin- versus trade-related payments. As the capitalisation of cash flow spikes is affected by short-term increases in exposure, which can arise in the exposure profiles of portfolios subject to variation margining, the prudential treatment of the capitalisation of cash flow spikes needs to be built upon the CRR text. Based on Articles 284(4) and (6) of the CRR, it seems that the supervisory authorities assume that current regulatory texts imply the effectivisation of cash flow spikes. However, the CRR does not provide clear guidance on capitalising exposure spikes.  Effectivisation of cash flow spikes inside Effective Expected Positive Exposure (EEPE) ignores the usually small spike width and results in a high average effective exposure for one year. This results in an overly conservative exposure value and consequently causes a substantial increase in own funds requirements with no economic rationale. Hence, it results in exposure profiles at levels similar to that of uncollateralised trades, which highly overstates the actual risk.  Additionally, the business implications of potential effectivisation requirements are significant for EU banks as they provide end-users with derivatives to manage or hedge their business-related risks. Therefore, the common prudential treatment of cash flow spikes is crucial to maintain a level playing field for banks using the IMM under the CRR regime.