Evaluating the Costs and Benefits of FRTB

LIKE ANY SIGNIFICANT CHANGE IN REGULATORY RULES, FRTB INVOLVES TRADE-OFFS: CONSISTENCY VS FLEXIBILITY, STANDARDIZATION VS DIFFERENTIATION, COSTS VS BENEFITS

By: Sanjay Sharma, John Beckwith
Edited by Howard Walwyn

• FRTB comes with significant benefits for both regulators and firms, primarily by providing greater consistency and an effective fallback solution for Internal Model Approval
• FRTB also comes with many costs for firms, including capital, data, analytics and tech costs, desk reorganization, and reduced availability of hedging and portfolio diversification
• In the end, the regulators had to strike a balance between pressure to standardize and allowing differentiation and risk sensitivity
• The regulators were largely successful, but the rules will need to evolve throughout the implementation period if serious systemic risks are to be mitigated

Benefits of the FRTB

We argued here that the Fundamental Review of the Trading Book (FRTB) remains a critical initiative for the safety and soundness of global markets and banking systems, despite adoption headwinds from some of us in the industry.

In essence this is because the FRTB framework gives the industry an overarching view of how the risks arising from banks’ trading activities and portfolios should be assessed and quantified through a more credible and intuitive relationship with capital requirements.

To sum up briefly, the tools supporting this new intuitive connection between risk and capital are:

• A clear and impermeable boundary between banking and trading books
• The adoption of expected shortfall (ES), including differentiated liquidity horizons, to replace value-at-risk (VaR) as the core risk measure underlying the internal models approach (IMA)
• A revised sensitivity-based standardized approach (SA)

The main stated benefits of these tools are improved consistency across jurisdictions, the ability for SA to serve as a credible fallback and a floor for the IMA, and the capacity to address existing weaknesses in the internal models approach. Ideally all of these benefits exist within an overarching objective to not significantly increase the capital requirements of banks.

No increase in capital?

Although this is the stated goal of FRTB, initial estimates (certainly those prior to the Basel Committee for Banking Supervision revisions proposed in March 2018) suggested that the increase in capital charge for banks’ trading books from FRTB adoption might be considerably higher than the current capital regime. Admittedly the impact will vary by jurisdiction, based upon the various phase-in proposals, different approaches to minimum capital floors, and other key implementation details.

As would be expected, the sheer increase in the capital charge has attracted the attention of boards, executives, traders, and other senior managers. Furthermore, the wide gap between the standardized and internal models approaches will set the stage for competitive rebalancing across the industry. Banks that make the necessary investments (and obtain the necessary regulatory approvals) for using the IMA may need to allocate only half or less of the capital that banks using only the SA will need. Other factors being equal—and subject to what happens on the standardized capital floor—this gives an IMA bank twice the return on capital compared to an SA-only bank.

Desk level approval

The FRTB requires (or allows) banks to seek IMA at desk level (rather than business or institution level, per existing rules). This allows management to be selective, at desk level, when investing in risk and analytics frameworks and allocating capital. Furthermore, it means that capital markets management teams will have flexibility in organizing trading desk structures around the optimization of capital deployment. In short, the FRTB will have wide-ranging implications on how trading books will be organized, capitalized, managed, and regulated.

Data analytics and technology

Beyond the impact on capital charges, a significant cost of the FRTB—or benefit, depending on whose perspective you are adopting—is that it will drive senior and functional managements to review their existing data, risk analytics, and technology frameworks, and to assess their capabilities for supporting manifold increases in computational capacities across front office, risk, finance, and operations.

FRTB will reward availability and consistency of market data as well as integrated and robust analytics frameworks, and regulatory approval for IMA will require banks to demonstrate operational capability to run the analytic frameworks on a regular basis.

In addition to the impact on trading book management and capitalization, adopting FRTB standards will require a substantial overhaul of banks’ risk analytics frameworks and processes, including model selection, validation, and computation of parameters.

Hedging and portfolio diversification

The FRTB places two key constraints on banks’ ability to obtain hedging and diversification benefits across their trading portfolios.

First, unlike the current VaR-based framework, which embeds unlimited portfolio hedging benefits, FRTB constrains the value of capital improvements beyond a certain threshold. Specifically, the total capital charge for modellable risk factors based on Expected Shortfall (ES) is calculated as an equally-weighted average of:

1. an “unconstrained” bank-wide ES charge, with diversification benefit recognised across all risk classes; and
2. a set of “constrained” partial ES charges, one for each of the broad regulatory risk classes (interest rate risk, equity risk, foreign exchange (FX) risk, commodity risk and credit spread risk); these are then aggregated as a simple sum without any diversification benefit across risk classes.

Second, the legacy Incremental Risk Charge models for calculating RWAs are replaced with a new default risk charge (DRC) model, which aims to capture default risk exclusively, without taking into account any rating migration or market risks. The new DRC approach places significant limitations on the types of risk factors and correlations that can be used within the model.

Business and desk impact

By virtue of the new construct of charging capital at individual trading desk level, the FRTB is bound to have a significant impact on the structure, scope and scale of trading activities. In short, banks will need to optimize their regulatory trading desk structures with limited scope for obtaining diversification benefits across desks.

As an example, some trading desks dealing in instruments that have low trading volumes will face a higher capital charge under FRTB, even if the market for those instruments is generally deemed by market participants to have good liquidity. Furthermore, non-linear and structured securities will face a higher capital charge, particularly if they involve a high degree of convexity (curvature).

More serious impact will be faced by any IMA desks that fail the P&L attribution test because their input parameters are not traded with sufficient frequency, or because there is undue noise around model-generated sensitivities. These outcomes will significantly impact the pricing of new transactions, especially trades with longer maturities or holding periods. At the same time, management expectations of the returns from positions with longer holding periods will need adjustment if a trading book moves from IMA to SA, or vice versa.

The trading activities that face the most significant impact are those which include securities with conservative liquidity horizons, residual risk add-on, and non- risk factors (NMRF). Some trading activities, such as FX options, could mitigate a high SA charge by seeking IMA, with a reasonable expectation that their NMRF and residual risk charges will be small.

However, there are no guarantees that this will be the case, so all trading banks should conduct bottom-up impact analysis—down to security level as well as desk level—to assess the options they have for both strategic and tactical decisions on their optimal organizational structure and desk-scaling. FRTB could result in an adverse spiral effect, where trading volumes for instruments and sectors that are currently illiquid may be even further affected if banks exit those markets due to higher FRTB capital charges, thus further pressuring trading volumes and liquidity, and so on, until the market for those instruments disappears completely. Instruments affected by this phenomenon could include off-the-run sovereign bonds and highly-rated corporate bonds, which may not always enjoy high trading volume in particular regulatory jurisdictions. This feature of the rules could also exacerbate systemic risk by leading to increased concentrations of holdings among large banks if smaller banks cease trading in these securities.

A careful balancing act

Like other fundamental changes to regulation, FRTB is viewed by some stakeholders and participants as onerous, misplaced, or inconsistent. Many have already expressed this sentiment. In defence of the FRTB, however, it can be stated that universal regulations cannot fit all constituents as a matter of design. Therefore, a significant new ruleset like the FRTB is inevitably a balancing act that aims to accurately capture both current and foreseeable risks. Prescriptive factors and methodologies are designed to encourage and promote standardization and prevent banks from using internal methodologies, which are inevitably challenging for regulators when making comparisons across banks’ risk profiles. Meanwhile, a higher degree of standardization is desirable for counterparty risk management and the assessment of systemic risk. This holds even if the one-size-fits-all approach can distort reported risk measures to some extent. The lesser of two evils is greater standardization, which allows banks and local regulators to agree on interpretations, application and implementation.

The risk is that if large and medium-sized banks adopt the SA for most of their trading books and activities—which seems like a very realistic outcome at the time of writing—there is a strong likelihood that systemic risks will remain unmodeled and thereby latent. In the evolving search for a universal risk parameter, several contenders have emerged and been found wanting—including VaR and stress-testing frameworks. In addition to the inadequacies of universal risk parameters, the threat from standardization is that gaps are magnified from a systemic risk perspective.

Comparability vs. differentiation

The hard choice, then, for regulatory standard-setters has been to find a balance between consistency and standardization of risk quantification frameworks:

The overarching trade-off is comparability of risk parameters across institutions versus allowing for flexibility and differentiation, which prevents magnification of systemic risk.¹

Any appraisal of the costs and benefits of the FRTB as a regulatory framework should thus span three questions:

• Are the capital requirements optimal and consistent across the underlying risks?
• Are the required processes and computations feasible and desirable from the perspective of technology and personnel resources?
• Will it lead to better and suitable risk measures and transparency, and help to mitigate both institution-specific and systemic stresses and crises?

As it stands, the FRTB represents a good foundation for capturing trading and market risk according to the first two criteria, but it will need continued evolution and refinement over the implementation period if it is fully to address the transparency and risk management questions raised in the third bullet.