The altered paradigm
Financial crisis of 2008, fundamentally changed the landscape. Banks and other financial institutions were forced to revitalize their strategies. Key risks and challenges, hitherto unrealized came to the forefront – and required urgent resolution.
In light of the perils of material undercapitalization of trading book exposures, the Basel Committee on Banking Supervision (BCBS) introduced the Basel 2.5 reforms in 2009.
Recently the committee made revisions to the Basel 2.5 reforms, sections of which are being replaced with the standards of Basel 3. The new regulations are formulated to act as a deterrent to major risk hazards.
At its core, the Fundamental Review of Trading Book (FRTB) is a revised market risk framework streamlining the regulatory pipeline.
In fact, it is now part of statutory compliance - All banks must implement the revised market risk standards by January 2019 and implement reporting under the new standards by end 2019.
Why these revisions tighten approach
It’s essential for banks to carry sufficient amounts of capital in order to manage loss scenarios. These regulations help determine the minimum capital amount to be maintained at the bank.
The Basel committee’s demarcation is singularly clear: banks with high-value and high-risk assets need to possess greater capital than banks with more secure assets.
The above idea, is built around the notion of risk-weighted assets (RWAs).
The RWA approach evaluates assets in conjunction with the risks associated, highlighting exposure to possible losses, including credit risk management.
Losses usually arise from a number of risk factors:
- Market Risk
- Credit Risk
- Operating risk
As a result, total RWA computes individual RWAs and comes to a final risk analysis.
The principal focus area under consideration is market risk capital (or, market RWAs). This helps tabulate probable losses from positions contained in trading books that are subject to ‘mark-to-market’ accounting.
Under the new model, both internal modelling approach for market risk and the standardized modelling approach are addressed.
There is a shift from conventional trading book risk assessment along with the identification of solutions for other challenges such as credit risk management in banks.
Breaking down the FRTB — Components and implications
The revised model has the following major changes:
- Trading and banking books differences are rearticulated - positions identified as being held to maturity are chosen for regulatory purposes to be in the banking book, whereas positions tradable are earmarked for regulatory purposes to be in the trading book.
- Trading book positions come within the purview of mark to market; they, therefore, attract higher market risk capital charges.
- The trading book in its essence is bolstered with a list of instruments meant to be in the trading book unless supervisory approval is received for deviations.
- Finally, instrument movement limitations between the trading book and the banking book are clearly outlined.
Understanding the Model aspect of the framework
Revised standardized approach for market risk: The standardized approach has been reviewed and changed. This helps to shape a risk-sensitive framework, tackling impediments in the current standard approach.
The revitalized internal model approach for market risk is another strategic deviation, which strengthens the framework. Principal additions or extrapolations to the internal model comprise:
- Expected shortfall measure for better tail risk capture, replacing VaR and stressed VaR
- Capped capital reduction as a result of the hedging and portfolio diversification.
The framework continues to endorse the standard approach (SA) or internal model approach (IMA).
Bank supervisors have the option of approving or eradicating IMA deployment at the trading desk phase. IMA approval entails the following:
- P&L attribution: Testing for identification if P&L propelled by risk elements employed by desks’ risk management framework correctly addresses actual P&L material drivers.
- Back testing: Testing to ensure capture of risk factor for internal model.
SA requires mapping for all desks, and not just desks beyond the purview of IMA.
The SA process is built on risk challenges. The method then is not computationally unmanageable. Sensitivities must be defined for every instrument and aggregated at the trade-desk level.
The SA could probably bear higher charges compared to the IMA in the case of most trading desks; however, it is unnecessary for quantitative P&L attribution and back-testing to be maintained, thereby simplifying the system in both implementation and operation.
The road ahead – FRTB and the future of banking
FRTB will impact banks and financial institutions across functions. These changes will affect business models, process systems, and infrastructure. Banks will be expected to upgrade their systems and infrastructure in preparation for the changes, including improved financial risk management strategies.
Hardware requirements (driven by the rise in the number of simulations needed for the IMA) will also be an important area of consideration.
Business processes must be re-crafted in order to simplify capital charge calculations within the SA and the IMA. The revised desk approach for reporting and validation will signal alterations in procedure and processes.
Given this environment, banks must unravel a rapid launch plan or make their strategic FRTB programs more efficient. Banks will then have some time to engineer a well-defined integration flowchart and eventually an implementation roadmap.