FRTB being another regulation – another set of actions, deadlines, yaddayaddayadda…
The Basel Committee released Fundamental Review of the Trading Book (FRTB) in January 2016 to address the shortcomings of existing market risk capital frameworks (Basel 2.5) and to design a minimum capital standard for market risk. Since then, the clock has begun ticking and banks are battling to implement FRTB. With officially regulatory reporting set to begin from December 31st 2019, industry participants are betting on delay of reporting date to 2021 (or later), in line with our current expectations of the go-live date for the market risk requirements in the CRR2 in Europe – which in turn will begin a 3 year phase-in and monitoring period.
FRTB is clearly an extremely demanding regulation, which requires intensive effort and planning to be effectively implemented in any organization. It overhauls the standardized approach to market risk, replaces value-at-risk (VAR) with expected shortfall (ES) as the standard risk measure, redefines the boundary between banking and trading books, and impacts many other areas that require significant transformation of technology and operational infrastructures. But, it still lacks clarity on a number of key aspects such as eligibility testing, non-modellability and the boundary between the trading and banking books. With these grey areas in the requirements and also the uncertainty remaining around national regulations, there is s an opportunity for the industry to influence the final legislation (e.g. highly debatable non-modellable risk factors (‘NMRFs’). And, to gain competitive advantage by devoting sufficient time not just to comply with the regulation but also to assess the strategic impact of this new capital framework.
The structure of a bank’s trading operations will be a key driver in determining the final market risk capital requirement through its impact on eligibility testing (desk level performance) and on the subsequent aggregation of the Internal Models Approach (IMA), and standardized approach (SA) capital requirements (loss of diversification between IMA and SA methods). And, with capital output floor (preliminary set at 75%) defining the final market risk capital requirement. Overall FRTB will result in significantly higher capital requirements and may continue to shrink profit margins, particularly for banks with substantial market risk exposure and activity in complex financial products. As such, it is imperative that industry participants think ahead on how best to adjust trading strategy and product portfolio, and more closely align front office activity and capital planning.
Some recommendation, please?
FRTB will impact a number of bank activities such as Front Office valuations and trade decision support, product control, limit setting, financial reporting, treasury management and capital planning. It will also create not an easy choice between applying and maintaining internal modeling approval or relying exclusively on standard modeling. The complexity involved in any IMA implementation means industry participants will need to have some idea in advance of whether they can pass the required tests. Some participants are better positioned to predict this than others. Those with strong risk infrastructure in place have been using it to forecast which desks would pass P&L attribution and gauge the capital impact of using IMA versus the SA. For others, time is short. They need to begin envisioning their infrastructure and models under FRTB, determine which desks would pass model approval, and quantify what the capital and business impact of not passing the test would be. While regulatory delays may grant them some leeway, many banks need to move quickly in order to make informed decisions on the ultimate impact of FRTB on their business and operations.
We are increasingly being asked by our clients what actions should be taken in light of the uncertainty that still remains. We are recommending our clients to prioritize efforts on those aspects of the requirements that are good practice and represent “no regrets” choices, such as:
On a small scale: go for prototype
- Take a small sample of desks (2 or 3), and work through the FRTB front to back process. (You may include one desk subject to linear risk, one desk subject to non-linear risk, and one securitization desk)
- Include both standardized (SA) and internal model approaches (IMA) for the calculated capital requirements for sample desks
- Test all aspects of the FRTB workflow including P&L Attribution standards and MI requirements, propose remediation actions
- Develop list of key findings and RWA estimation based on new rules
On larger scale: establish a sound foundation
- Establish standardized modeling capabilities
- Develop integrated current and target state operational models with other related BCBS initiatives (e.g. SA-CCR, Leverage Ratio, IFRS9) to avoid duplication of effort and to identify potential synergies and holistic approach to reporting
- Complete process, organization, model and technology impact assessments – including a thorough review of risk methodologies to comprehend the modifications that are required to implement FRTB in the current infrastructure
- Enhance data management for market risk (data dictionaries, data gap assessments), data cleansing and alignment (FO and Risk) including product/risk factor taxonomies
- Enhance model governance and understanding modeling differences across FO, Risk and Finance
- Establish robust program management to drive the delivery of calculation model enhancements, model governance structure, organizational change and IT delivery