RESEARCH

New Market Risk Framework – 20 years in the making

7/4/2018 - Monocle Research Department

In May 2012, the Basel Committee on Banking Supervision (BCBS) issued the first paper in a series of consultative documents aimed at revising the current Market Risk Framework. The purpose of the proposed amendments is to improve the requirements and calculation of regulatory risk capital for the trading book. These proposals are collectively referred to as The Fundamental Review of the Trading Book (FRTB). The ensuing industry feedback, along with a hypothetical portfolio exercise and an interim impact study, culminated in the finalised standards being published in January 2016, under the title Minimum Capital Requirements for Market Risk. The new standards replace the existing framework, which represents 20 years of Market Risk regulations. The BCBS deadline for new regulations was originally set for January 2019, but a decision has subsequently been made to move out the implementation date to January 2022, along with the first reporting disclosures expected in the same month.  

A review of the regulations was necessary as the framework was deemed weak and inadequate, following lessons learned during the 2008 Financial Crisis. One area that required revision was the boundary between the banking and trading book. The old regulation lent itself to being exploited by institutions to create arbitrage opportunities by transferring assets between the banking or trading book to game capital requirement rules. Furthermore, there was no logical or natural relationship between the capital calculated using the Standardised Method and Internal Model Approach, leading to large discrepancies between these two approaches. These discrepancies contributed to the need for a universal method of calculating a bank’s capital charge.  

The following table summarises the main FRTB changes and objectives:

Trading vs Banking book boundary	Limits regulatory arbitrage Clear designation of instruments Clearer guidance on internal risk factors
New Standardised Approach (replaces Standardised Measurement Method)	Sensitivities based approach Default risk charge Residual risk add-on Closer calibration with IMA structure
Internal Model Approach (IMA)	Expected shortfall with liquidity horizons Default risk charge and stressed expected shortfall Constraints on hedging and diversification Desk-level model approval/eligibility test

The BCBS has redefined the classification of instruments between the banking and trading books. The new definitions are more prescriptive, less ambiguous and, thus, less open to interpretation. The new regulations aim to promote a common, objective understanding among regulators as to what types of instruments belong exclusively in either of the two books. Previously the distinction was mainly based on a subjective definition of “intent” – an intention to trade vs an intention to hold until maturity. The definitions now include explicit position descriptions and characteristics between the trading and the banking book. Trading characteristics include instruments held for short-term resale and profit from short-term price movements, locking in arbitrage or hedging risks arising from any of these activities. Instruments seen as held for these purposes include those resulting from underwriting commitments, part of a correlation portfolio, or giving rise to net short credit or equity positions in the banking book. Instruments to be included in the banking book include unlisted equities, real estate, retail credit and equity funds.  

Previously, the calculation of capital requirements for market risk was addressed through two approaches: the Standardised Measurement Method (SMM) and the Internal Model Approach (IMA). Under the new standard, the changes to the SMM are so fundamental and comprehensive that they constitute a new approach, called the Standardised Approach (SA). The SA will be relevant to all banks regardless of whether they choose exclusively to adopt the IMA. The SA will serve as a floor and fall back to the IMA. As such, the SA is designed to share a common risk data infrastructure with the IMA and to be sufficiently risk sensitive without compromising its implementation by banks with more conservative trading operations.  

Standardised Approach

The most notable change from the SMM is that the main SA charge is based on risk sensitivities within all the broad asset (or risk) classes, and includes two additional components, namely the Default Risk Charge (DRC) and the Residual Risk Add-on (RRA).  

 

Internal Model Approach

The most notable change in the revised IMA is that it now calls for market risk to be calculated and reported via a single Expected Shortfall (ES) metric at a 97.5% confidence interval, replacing the well-known Value at Risk (VaR) and Stressed VaR metrics at 99% confidence. The aggregated ES values for modellable risk factors, together with a Stressed Capital Add-on (non-modellable or stressed ES), forms the basis of the capital charge for market risk. There is also a Default Risk Charge component like in the SA, and an SA Calculated Charge (CC) for unapproved desks.  

 

Of further importance is the incorporation of varying liquidity horizons into the revised SA and IMA to mitigate the risk of an abrupt and severe impairment of market liquidity across asset markets. This will replace the static 10-day horizon assumed for all traded instruments under VaR in the current framework.   The BCBS has indicated that these changes will result in a significant increase in market risk capital requirements. It is, therefore, imperative that banks adopt prudent consideration and planning to ensure that adequate structures and resources are in place.   With a first reporting date of January 2022, it is important that banks take the necessary steps to prepare for this change:  

• Banks must understand the effects of FRTB on both the reclassification of the banking and trading books.

• Institutions must understand the impact on Risk Weighted Assets (RWA) to reflect the updated liquidity horizons, risk weights and other changes.

• Banks need to start the collection and management of quality market data in sufficient volumes, especially those who wish to use internal models.
• The collection and management of quality market data, in turn, calls for enhanced data architecture, as well as the realignment of processes and functions within the bank.

• The anticipated increase in capital requirements coupled with the increase in costs of implementing and maintaining FRTB compliance will force banks to reassess their business strategy, as well as look at the future sensitivity of all currently affected profit centres.

These effects need to be communicated to senior management and the front office to raise awareness and understanding of the fundamental changes that FRTB will bring about.  

In conclusion, the effects of FRTB are profound, reaching across all organisational and technical levels of a bank. Throughout the bank, there are additional and more rigorous regulatory requirements on data, business models, processes, technological infrastructure, reporting, governance and management. Banks must not be caught dragging their feet. The timelines are tighter than they appear. Regulators will need a head-start to evaluate and approve desks for IMA, meaning desks will need to be ready well ahead of their regulator’s set deadline. Even before all of this, they will need to internally evaluate if IMA is even a cause worth pursuing and to what extent. Then there is the matter of sourcing the relevant data and enhancing data systems central to many of their existing operations. For smaller banks not used to the level of complex data and modelling required, it is going to be a fundamental adjustment not only in the upgrading of systems, but also in training and preparing personnel to operate under the Standardised Approach.