Regulation | The Fundamental Review of the Trading Book

LAGOS (Capital Markets in Africa) – The very aptly named Fundamental Review of the Trading Book (FRTB) is set to go live in 2019 according to the final standards (1) published by Basel Committee on Banking Supervision (BCBS) in January this year. The paper calls for the rules to be incorporated into national legislations by January 2019 with banks expected to use FRTB for calculating reported regulatory capital by January 2020.

Whilst its main objective is to reform the market risk capital framework, which has remained relatively consistent (2), the impact of the standards reaches much further beyond just market risk modelling.

Background and rationale
After three rounds of consultations, four quantitative impact studies and around five years of discussions, the final FRTB standards are finally here to completely revamp the market risk capital requirements with the intent to remediate shortcomings in the current market risk framework post-crisis and to promote a more stable, transparent and consistent market risk capital framework across various jurisdictions.

The following are among the deficiencies within the current framework, which act as the overarching objectives guiding the main areas of reform:

• Inadequate capture of tail and liquidity risks.
• Possibility for the existence of regulatory arbitrage between banking and trading book.
• Disjoint nature of standardised vs. internal models as well as the disparities across various jurisdictions.

Summary of the main reforms
There are three main areas of reform proposed by the standards:
Trading book/banking book boundary
The final framework imposes stringent rules for internal risk transfers between trading and banking books, which are likely to have a material impact, given the contradiction between the new proposals and current hedge accounting practices of allowing partial designation. In addition, the new framework introduces a presumptive list of assets that should be placed in the trading book unless a justifiable reason exists not to do so. This is intended to limit an institution’s ability to move illiquid assets from its trading book where they must be marked to market to its banking book to avoid higher capital charges. One of the main criticisms about the current trading book/banking book boundary is that the definition may lead to insufficient capital being held against the risk that banks run.

The revised internal models approach (IMA)
The revisions of the IMA replaces the current 99% 10-day value-at-risk (VaR) and stressed VaR approach with a 97.5% stressed expected shortfall (ES) in order to improve the capture of tail risk. Market liquidity is accounted for through varying liquidity horizons (ranging from 10 – 120 days) based on risk classes which define the liquidity holding period from a capital calculation point of view. In addition, the breakdown of correlations under stressed conditions is recognized through restraints on diversification benefits.

The inclusion of strict formal market data observability and quality standards requiring risk-factor level analysis to demonstrate that risk factors meet “real” price criteria to support the eligibility of risk factors within the ES measure or be subject to an alternative non-modellable risk factor (NMRF) add-on charge which adds further complexity.

All model approvals will be granted on a desk level, nominated by the bank itself, which will likely put additional strain on the relevant national supervisor. Banks will have to prove the mettle of their internal models through back testing and P&L attribution assessments using daily model results on a desk by desk basis instead of portfolio level. Failure to meet the validation criteria that is implemented will result in the desk having to report under the standardised approach for a minimum of 12 months.

In addition, the current incremental risk charge (IRC) will be replaced with a Default Risk Charge (DRC) as the modelled measure for default risk, which will have the mandatory inclusion of equities.

The revised standardised approach (SA)
The new standardised regime is more risk sensitive through the inclusion of first- and higher-order risk factor sensitivities in the delta, vega, and curvature charges, in order to serve as a more credible fallback for the internal models approach, the standardised “bucket” risk weights within each risk class under the standardised approach have been calibrated to stressed market conditions using an ES methodology.

Another component of the revised standardised approach is the standardised Default Risk Charge (“standardised DRC”). The standardised DRC as a whole is calibrated to the credit risk treatment in the banking book to reduce potential discrepancies. And where other risks occur beyond the main risk factors mentioned, this is catered for under a simple Residual Risk add-on charge.

In addition, upon further calibration, the revised standardised approach will potentially act as a floor to the internal models approach-based Pillar 1 capital charges, adding to the computational volume that a bank infrastructure would be required to handle. The inclusion of residual and basis risks in the new SA, as well as the lack of recognition of risk-reducing higher-order sensitivities, will likely result in higher capital charges.

Given the sheer enormity, complexity and cross functional nature of the data demands, both from an IMA and SA perspective, the FRTB certainly calls for better alignment between Front Office (FO), Finance, Risk and Technology functions.

However, while the revisions are well-intended to address shortcomings in the current market risk regulatory framework, some of them may result in unwarranted or unintentional side effects, such as increased market risk capital volatility and increased systemic risk (3). This is particularly true for most Emerging Markets economies, and as a result, there has been much lobbying within the industry for BCBS to modify the new SA further in order to simplify it (“Simplified Standardised Approach”) for smaller institutions who typically maintain relatively smaller trading books (4).

Challenges and implications
As a result of the stricter and more prescriptive demands of the FRTB, banks are presented with a number of methodologies, data granularity and computation challenges regardless of whether they deliver the internal model approach or the sensitivity based approach. And while BCBS reassures that the intention of the reforms are not necessarily to increase capital requirements, the committee estimates that the rules are likely to lead to an approximate median capital increase of 22% and a weighted average capital increase of 40% compared with the current framework (5) when considering the potential 3 to 4 times increase under the SA compared with the new IMA.

Beyond the data & infrastructure strain, methodology implementation challenges and subsequent capital impact, the FRTB will have significant effects on the economics of trading activities, with banks responding by altering desk strategies and redeploying capital as required. This would need to be supplemented with significant organizational, governance and operational change as well as the coordination of efforts that would be required to deliver this major reform.

Since no regulation can act in isolation, BCBS anticipates further refinement and recalibration of the market risk measures due to the impact of related evolving frameworks including the principles for effective risk data aggregation and risk reporting (BCBS 239), credit valuation adjustments (CVA) standards that will govern CVA risk management separately from FRTB regulation, capital requirements for credit risk, treatment of sovereign exposures and interest rate risk in the banking book. BCBS has also indicated that it would provide separate additional guidance pertaining to market risk disclosures.

While the details of some areas of the FRTB remain in flux and there are still a number of unaddressed issues and widespread discussions within the industry, including, but not limited to, NMRFs, P&L attribution as well as the impact on liquidity specifically in Emerging Markets (6), a very clear takeaway is that the time for piecemeal action has ended, and the need for a comprehensive and transformative change has arrived. Banks now have the chance to seize the opportunities that the FRTB offers in terms of strategic investments in good data, better infrastructure and the best possible expertise.

1 Minimum capital requirements for market risk, January 2016, BCBS (https://www.bis.org/bcbs/publ/d352.htm)
2 Revisions to the Basel II market risk framework, December 2010, BCBS (http://www.bis.org/publ/bcbs193.pdf)
3 Fundamental Review of the Trading Book, ISDA/ GFMA/ IIF – March 2016
4 ISDA/AFME response to the DG FISMA consultation document – June 2016
5 Explanatory note on the revised minimum capital requirements for market risk (https://www.bis.org/bcbs/publ/d352_note.pdf)
6 FRTB Industry Working Group – April 2016 Trading Book Group meeting notes

This article features in the November edition of INTO AFRICA Magazine, insights on Real Estate and Property Investment prospects and challenges in Africa.

Contributor’s Profile:
Ahimsa Gounden is Barclays Africa’s senior Market Risk capital analyst. Her primary foci are regulatory and economic market risk capital demands of the Corporate and Investment Bank. Ahimsa previously worked on the implementation of market risk systems, policies and frameworks for the multiple Barclays Africa entities across the continent. Ahimsa holds an Honors degree in Advanced Math of Finance from the University of Witwatersrand.