Fundamental Review of the Trading Book

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The 2008 financial crisis revealed many weaknesses in the global risk management and regulatory environment. From a market risk perspective the regulators’ first attempt at remedying some of the perceived deficiencies was the “Basel 2.5” rules (formally the “Revisions to the Basel II market risk framework”), issued by the Basel Committee on Banking Supervision (BCBS) in 2009.

It has since been recognised that in a number of respects the Basel 2.5 changes did not go far enough and hence, as the name implies, a more “fundamental” review of the framework for market risk was needed. The BCBS issued its first consultative paper on the FRTB in May 2012 and a second followed in October 2013.

In this article we outline some of the key features of the FRTB and the challenges that banks will have in implementing the rules.

Standardised and Internal Model Approaches

Under the current regulatory regime banks may calculate their regulatory capital requirement for market risk under either the standardised or internal models-based approach. The standardised approach follows a prescribed set of regulatory calculations.

The models-based approach allows a bank to use its own models, providing they conform to prescribed regulatory standards. Supervisory approval is also required to adopt this approach.

The FRTB proposes changes to both the standardised and models-based regimes. The criteria for an internal model to qualify for the models-based approach have been strengthened, and it is likely that some banks will be forced to move to the standardised approach for at least part of their portfolios. For example, banks will need to compare the theoretical P&L predicted by their models with the actual P&L for each “trading desk” and strict statistical tests will determine whether the predicted and actual P&L is sufficiently close. Even where supervisory approval has been granted to use internal models, banks will still need to perform the standardised calculation alongside the models-based calculation.

The FRTB proposes strengthening the relationship between the models-based and standardised approaches. Banks will need to calculate the standardised charge for each trading desk as if it were a standalone regulatory portfolio. These charges will need to be publically disclosed in banks’ regulatory reports.

The FRTB also introduces a number of methodological changes to the standardised approach to make it more risk sensitive.

Trading book/banking book boundary

Under current rules banks are able to designate whether or not an asset is held with the “intention to trade”. This determines whether the asset is placed on the banking or trading book and hence whether the banking or trading book regulatory capital calculations should apply. Regulators have noted that this has given rise to opportunities for regulatory arbitrage and is difficult to police.

The FRTB proposes a number of changes to the trading/banking book boundary:

  • Definition of trading book – a set of explicit requirements defines instruments that are deemed to be held on the trading book (e.g. instruments managed on a trading desk).
  • Appropriate contents of trading book – the boundary definition is augmented with a list of instruments which are presumed to be within the trading book (e.g. instruments resulting from market making or underwriting activities)
  • Guidance on instruments that do not meet definition of being included on trading book – e.g. unlisted equities, real estate
  • Boundary permeability – the FRTB imposes strict conditions on banks being able to switch between the trading and banking books. In limited cases, where switching is permissible, if the bank would otherwise obtain a reduction in capital, the difference is imposed as an additional capital charge
  • Supervisor authority to re-designate – supervisors may require an asset to be moved from the trading book to banking book or vice versa if they deem it incorrectly designated. Banks must also prepare reports which enable the boundary to be easier to supervise
  • Valuation requirement – all instruments in the trading book must be fair valued daily

Treatment of credit

Credit products were held particularly accountable for losses in the financial crises and banks’ internal models were found to be lacking, particularly for securitisation type products. Under the FRTB, banks will no longer be able to use their own models for securitisation exposures and capital charges will be based on a revised standardised approach. Internal models will continue to be allowed for non-securitisation exposures but will be subject to a separate Incremental Default Charge.

Expected Shortfall

Under the current framework regulatory capital is based on Value at Risk (VaR). VaR has well documented deficiencies such as its inability to capture the tail risk of loss distributions. The FRTB envisages a move to the Expected Shortfall metric which is deemed to be more sensitive to the shape of the tail of the loss distribution. VaR measures the loss of a distribution to a given confidence level. For example, calculating VaR to a 99% confidence level would return the loss at the 99th percentile but would ignore losses beyond this level. The equivalent Expected Shortfall metric would calculate the expectation of losses in the 1% tail of the distribution – i.e. all values beyond the 99th percentile are taken into account.

Stressed calibration

Basel 2.5 introduced an additional capital charge based on “stressed VaR”, which was calculated alongside the usual VaR. The FRTB now proposes a move to a single (Expected Shortfall) measure calibrated to a period of significant financial stress.

Liquidity

The current market risk framework calculates VaR to a ten day horizon and therefore assumes that banks can exit or hedge their positions within this horizon. The financial crisis demonstrated that this was often not the case when holding illiquid assets and banks often sustained larger losses than a ten day VaR would predict.

The FRTB proposes addressing the liquidity issue through the introduction of variable liquidity horizons. The liquidity horizon will be defined as “the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions”. Risk factors will be assigned to five risk liquidity horizon categories ranging from 10 days (consistent with current 10 day VaR treatment) to one year (consistent with banking book treatment).

Implementation challenges

The implementation of the FRTB will provide banks with significant implementation challenges. Based on our communications with major banks, we expect the following to be amongst the most challenging areas:

  • Computational workload – the FRTB will dramatically increase the computational workload of producing capital calculations. According to our conversations with major banks, some banks believe that the computational workload will increase by as much as thirty times, although an increase of about ten times is the average view. In many cases this will mean banks having to make major changes to their IT infrastructure and modelling algorithms to accommodate the required processing within an acceptable timeframe
  • P&L attribution, backtesting and validation framework – the FRTB introduces more stringent tests for comparing actual P&L with the theoretical P&L predicted by internal models. The model validation framework has also been enhanced. Banks with a previous approval to use their internal models may find that some of their models do not meet the new framework standards, and therefore they may need to enhance their models or move to standardised for sections of their portfolio
  • Stressed period of risk – under the FRTB, Expected Shortfall is calibrated to a period of significant financial stress. Banks perceive problems in collecting sufficient data for this process, and even with the proposed “indirect method” where sufficient data is not available over the entire horizon, this is expected to be problematic to implement
  • Trading/banking book boundary – the FRTB introduces more stringent controls around the assets that can be held on the trading book, and an additional capital charge needs to be calculated if a bank transfers assets from one book to the other which would otherwise result in a capital benefit
  • Non-modellable risk factors – under the FRTB proposals, “modellable risk factors” are those factors for which a bank has sufficient products to give an appropriate historical time data series. Modellable risk factors are included in the Expected Shortfall calculation. Risk factors which do not meet this definition are deemed “non-modellable” and a separate capital charge will be calculated using a stress scenario approach.

This article was first published in edition 5 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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