BY RODA ULAS

Financial institutions play a “too big to fail” role in the global economy which can lead to catastrophic systemic risk. To mitigate the knock-on effects of unforeseen events, which may interfere with the financial stability and soundness of the economy, regulators and supervisory boards carry out analysis of existing regulatory requirements, to assess whether they are sufficient and fit for purpose.

In response to such analysis, The Basel Committee on Banking Supervision (BCBS), that sets standards for the prudential regulations of banks, are introducing a revised market risk capital framework known as Fundamental Review of the Trading Book (FRTB). The improvements are introduced as a result of the shortfalls in the current market risk framework. This article will explore how the BCBS are improving the market risk framework and what will be required of banks to implement these changes.

The revised framework, finalised on 14th January 2016, was subsequently analysed in a number of studies. One such study was the “The Regulatory consistency assessment programme” (RCAM), conducted by the Basel Committee, ensures regulatory consistency of frameworks. As a part of the programme, BSBC carried out an analysis of risk-weighted assets (RWA) in the trading book. The analysis unveiled a substantial variation of the publicly available RWA. The diagram below (diagram 1) illustrates that variation. It can be seen that the majority of the difference lies between the ranges of 15% and 45%, while the actual range stretches from 10% to 80%[1].

The analysis was carried out on 16 global banks with high trading activity. Due to a scarce amount of publicly available information, BCBS were unable to carry out a broad study on the reasoning behind the variation and therefore address this problem by implementing the FRTB.

Diagram 1[2]

Additionally, the committee carried out a trading book Quantitative Impact Study (QIS), which explored the changes in the framework post the implementation of the FRTB. The study revealed that the Standardised Approach (SA) capital requirements, which replace the Internal Model Approach (IMA), are 2 to 3 times greater in comparison to the IMA which encourage resilience against unforeseen events. By proposing the FRTB, there will be a 74% increase in market risk capital charges[3]. While the current calculation of capital requirements is based on value-at-risk (VAR) measure of 99% quantile, the new approach will use Expected Shortfall (ES) of 97.5% quantile which will enable it to capture tail risk[4].

Improvements

Following the analysis of three consultative papers and four QIS’s, the committee has introduced a framework known as the Fundamental Review of Trading Book, to supersede the Market Risk Capital Framework. The BCBS have improved the market risk framework by implementing the following changes:

  • Implementing a rigorous IMA consisting of consent at the trading desk as Internal models require higher regulatory analysis
  • A risk-sensitive SA to address the absences in the revised framework and serving as a floor and fall back to the IMA.
  • Converting to an Expected Shortfall (ES) from the Value at risk measurement, which measures risk under stress and considers loss beyond VaR level questioning expected losses.
  • Integrating liquidity horizons into the revised SA and IMA to mitigate sudden impairments of market liquidity.
  • Establishing an objective boundary between the trading and banking book to discourage arbitrage between books deviation – This will prevent an increase of capital charges as transferring illiquid assets from one book to another will be restricted

Having finalised the standards in January 2016, banks are required to report under the new standards by the end of 2019, however national supervisors are expected to have these implemented by the beginning of 2019.

What banks will be required to do

The changes appear straight forward at first glance, however replicating these changes will require an immense amount of exertion to successfully translate and apply them. Banks will be required to:

  • Produce an effective and efficient Target Operating Model
  • Allocate subject matter experts and resources to collect the necessary data
  • Modify measurements and calculations of Market risk
  • Invest in accommodating IT programmes and hardware and implement the correct tools
  • Enhance controls to ensure precision and consistency of reporting

Conclusion

To ensure that they are not adversely affected by the waves of potential risks and the volatile nature of the economy, banks should firstly understand the changes before applying them. Misunderstanding of the FRTB and implementing the modifications incorrectly could cost banks, time, money, reliability and reputation. Sourcing professional and experienced resources could ensure accurate translation and implementation of the revised framework and safeguard against the externals risks.

[1] http://www.bis.org/publ/bcbs240.pdf

[2] http://www.bis.org/publ/bcbs240.pdf

[3] http://www.bis.org/bcbs/publ/d346.pdf

[4] http://www.bis.org/publ/bcbs265.pdf