The FRTB: Do not underestimate the standardised approach

AxiomSL | SA-CCR
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September 1, 2016 – By: Nicola Hortin, Head of Regulatory Analysis Team EMEA, AxiomSL

There is currently a lot of discussion in the industry about the internal model-based approach to the FRTB; however, it is important that banks do not underestimate the challenges of implementing the FRTB standardised method, particularly as it will impact all institutions including those that adopt the internal approach. Among the significant changes that are being introduced by the FRTB is a stricter separation of the trading book and banking book. Regardless of whether they currently use standardised or internal models, banks will need to review their portfolios to determine if existing classifications of instruments and desks as trading book or banking book are still applicable or whether a revision of desk structure is required. While doing all of the above, it is important that banks do not lose sight of the wider context in which the FRTB requirements are being introduced. The FRTB is just one element in a package of new capital adequacy rules. The changes that are being made to the capital adequacy rules are so fundamental and so numerous that, although they are part of Basel III, some people are now referring to them as ‘Basel IV’.

With the Fundamental Review of the Trading Book (FRTB), the Bank for International Settlements (BIS) has completely rewritten the rules and calculations that determine how much capital banks must maintain in order to offset their exposures to market risk.1 There is currently a lot of discussion in the industry about the internal model-based approach to the FRTB; however, it is important that banks do not underestimate the challenges of implementing the FRTB standardised method, particularly as it will impact all institutions including those that adopt the internal approach. Among the significant changes that are being introduced by the FRTB is a stricter separation of the trading book and banking book. This measure is intended to reduce the possibility of arbitrage between the two books and to ensure a more consistent application across banks.

Regardless of whether they currently use standardised or internal models, banks will need to review their portfolios to determine if existing classifications of instruments and desks as trading book or banking book are still applicable or whether a revision of desk structure is required. Another key rule change is that model approval will be given at a desk level. Banks therefore will need to decide whether they will use standardised or internal models for each desk and, importantly, will need to explore whether each desk will remain profitable under the new regime, since these changes may result in increases to the capital requirements for the desk. With the BIS recommending implementation of the FRTB in 2019, banks need to start this impact analysis work soon. Those that go down the standardised route will find they need many data points that have not previously been required. For example, banks will need to calculate deltas and vegas for prescribed risk factors and then feed these into the standardised FRTB calculations. These data attributes historically have only been required for options, but now also will be needed for other product types.

Banks are likely to have most of the data required for the FRTB somewhere within their infrastructure; however, due to the complicated system structures that exist at many banks, sourcing these data will be particularly challenging. In many cases it will involve changing not only the systems that directly feed the regulatory capital calculation tool, but also other upstream systems, such as risk management systems. To expedite this data-sourcing process, many banks are likely to work with a third party which has already identified which additional data attributes are required.

The FRTB standardised approach also introduces new stress scenarios, which have not previously been part of the market risk process. Banks will need to run both downward and upward shock stress scenarios in order to calculate their curvature risk charges. They need to consider now how they are going to smoothly and efficiently integrate these additional steps into their regulatory calculation processes.

As already alluded to, even if they opt for internal models, banks will not be able to completely avoid the standardised approach. This is because the BIS’s final FRTB rules state that trading desks which use internal models will need to run the standardised calculations periodically and compare their internal model numbers with their standardised model numbers.2 The regulator is also considering introducing a floor for those that use an internal model, which will be based on the results of the standardised calculations.

While doing all of the above, it is important that banks do not lose sight of the wider context in which the FRTB requirements are being introduced. The FRTB is just one element in a package of new capital adequacy rules. Changes are also being made to the way in which banks calculate the capital needed to cover their exposures to counterparty credit risk,3 central counterparties (CCPs),4 operational risk5 and credit risk due to securitisations.6 Revisions to the credit valuation adjustment (CVA) calculations,7 which are being aligned with the new FRTB rules, also will be significant. The changes that are being made to the capital adequacy rules are so fundamental and so numerous that, although they are part of Basel III, some people are now referring to them as ‘Basel IV’.

There is a significant overlap between the data that will be needed to run all of these new Basel calculations, and many of the calculations are interdependent. For example, the same product data will be required for all of the calculations. It is therefore essential that banks plan strategically for the entire suite of new Basel capital rules rather than focusing on the FRTB in isolation. Banks that do not think about all of the new Basel capital rules collectively may end up using a separate regulatory calculation tool to manage each of the calculations. Given the overlapping and interconnected nature of the requirements, it is clear this would be extremely inefficient and unnecessarily complex. The most efficient way for banks to tackle the FRTB and other Basel capital rules is by using a single platform to run all of the different calculations. By doing so:

  • They will avoid the need to load the same data onto many different systems;
  • They will ensure consistency between the data used to run the different calculations; and
  • It will be easier for them to feed the outputs of individual calculations into other related calculations.

Banks also need to think about how they will manage the staggered implementation timetable for the various Basel capital rules, which will be phased in over a number of years. Many banks struggle to keep up with a quick succession of regulatory changes due to the inflexibility of their technology. These banks often find they need a complete software update to accommodate each regulatory change. Installing and testing such an update is a long and complicated process, which eats into the time banks have to prepare and increases the risk of missing a deadline.

To ensure they can keep pace with the implementation of the new Basel capital rules, banks should use a calculation platform that separates the regulatory functionality from the core platform functionality. This will mean that, when the final version of one of the new calculations is published, a bank will be able to add it to the platform quickly without having to update the entire infrastructure and impact other functionality and users in the process. As the name suggests, the FRTB will fundamentally change the way in which banks calculate their market risk capital charges; however, by planning carefully, focusing on issues such as data sourcing and considering the FRTB’s relationship with other Basel calculations, banks can ensure they are well prepared when the new requirements come into force.