Why the FRTB Remains Critical

IF THE FRTB IS NOT IMPLEMENTED, GLOBAL MARKETS AND BANKING SYSTEMS WILL BE PRONE TO SYSTEMIC SHOCKS

As the world approaches the 10^th anniversary of Lehman’s collapse and the ensuing global financial crisis, memories within the industry are fading along with lessons learnt. It is in this context that the Basel Committee on Banking Supervision (BCBS), and its member supervisors, press forward. Their mission is to negotiate, finalize and implement the long-awaited framework designed to prevent a future systemic, global financial crisis when the next stress event occurs. Developed over a decade and rooted in substantial study and dialogue, the Fundamental Review of the Trading Book nonetheless faces adoption headwinds from some of us in the industry.

There are two principal arguments for resisting the finalization and adoption of FRTB. The first claims that regulators and industry have already done enough to mitigate systemic risk and that FRTB will simply add cost and complexity to an already over-regulated financial industry. The second claims that backward-looking regulation, as FRTB is assumed to be, will not prevent the inherently unknowable drivers of the next crisis. In fact, some purport that positive feedback from comprehensive regulation, combined with hindsight bias, could lead to larger financial bubbles and excesses in the future.

This paper aims to address both concerns and to provide a justification for the necessity of the FRTB framework. We argue that regulations implemented since the 2008 global financial crisis, while laudable, do not address the main deficiencies in regulation that led to it. Our view is that if FRTB is not implemented, global markets and banking systems will be prone to systemic shocks that will likely stem from identified but unaddressed weaknesses in current market risk frameworks. We also make the case that FRTB is a robust, self-correcting, market-based framework for creating stable and enduring trading environments that will persist in the faster, more connected global financial ecosystems of the future.

Criticisms of FRTB

Arguments from FRTB skeptics have been made along the following lines:

• Implementation costs are too high;
• FRTB is too complex to implement;
• Excesses in the U.S. housing market that led to the financial crisis have been resolved;
• FRTB is obsolete and unnecessary because legislative and regulatory developments since the financial crisis have de-risked and simplified bank trading books (often cited as evidence are Basel 2.5, stress testing, leverage ratios, resolution planning and G-SIB capital buffers).

In our view, these arguments miss the fundamental point. FRTB is not designed to be simply a new capital calculation engine. Rather, FRTB is designed to transform the measurement and management of trading activities into robust processes that are sensitive to the observability and proprietary of risk factor sensitivities as those change over time. In short, FRTB, for the first time, incorporates securities-level liquidity into the framework for managing trading risk and its impact to the trading book will be as consequential as Basel II was to the banking capital framework.

Why other regulatory developments and standards are not nearly enough

G-SIB buffers, leverage ratios and Basel 2.5 rules principally address bank regulatory capital, however heading into the 2008 financial crisis, bank capital did not appear to be a weakness. In fact, as late as 2007, bank capital was widely touted as source of a strength.

Table I compares US bank leverage, liquidity risk and size from just after the lending crisis in 2001 to the beginning of the market crisis in 2007. Note that leverage at both large and small banks declined during this period even while gross assets in the system nearly doubled. Capital at the banks was not the issue.

Table I: Size, leverage and liquidity risk of U.S. Financial Institutions¹

	2001Q4				2007Q4
	Assets ($bn)	Leverage	Liquid assets	Short-term funding	Assets ($bn)	Leverage	Liquid assets	Short-term funding
Commercial banks	6,552	11.0	6.6%	26.5%	11,182	9.8	4.6%	33.2%
of which: large institutions	2,291	12.2	6.7%	32.9%	5,422	11.8	4.6%	37.5%
Savings Inst.	1,317	11.6	3.0%	18.2%	1,852	9.1	2.3%	22.6%
Credit Unions	456				699
Brokers	2,376	28	2.4%	57.3%	4,686	45	0.4%	63.4%
GSEs	1,417	42.3	0.2%		1,677	23.7	0.7%
Hedge funds (AUM)	539				1,868
Total	12,657				21,964

What was the principal contributing factor to the 2008 GFC? It was increasingly illiquid securities held outside of the banking system funded with short-term borrowings which were backed directly and indirectly by banks. Compare the increase in leverage ratios and short-term funding at brokers and hedge funds to that of banks. As we now know, securities held in the shadow banking system were backed by banks using a variety of off-balance sheet mechanisms and started to become illiquid in late 2006. Nonetheless, these assets continued to be marked to market, model, or myth throughout 2007 and 2008. Many banks temporarily avoided write-downs on illiquid assets by moving instruments from trading books to banking books. Financial participants became wary of the solvency of their counterparties which ultimately included major regulated banks.

Increased regulatory capital ratios or limitations/reformations of specific structures will not avoid the next crisis. Innovative traders will create new structures to arbitrage existing rules and market liquidity will inevitably be driven by banks with access to central bank liquidity. Rather, the appropriate lesson is that bank capital deployed against trading book securities must dynamically conform to changes in the observed trading liquidity of these securities.

Global supervisors and central bankers should be given credit for putting in place the myriad of new rules since 2009 which have made the global banking system safer and more secure. Nonetheless, very few of the provisions taken to date address the fundamental challenge of managing liquidity across all asset types and securities. Basel 2.5 does not provide a capital distinction for varying liquidity horizons or unobserved risk factors. Reallocation of instruments between banking and trading remains allowable with relative ease. FRTB is the only framework which creates a comprehensive, variable framework for attributing additional capital to risk factors and instruments as underlying liquidity in trading assets deteriorates.

Comparing Costs of Implementing FRTB with Fallout from a Systemic Event

Several studies have estimated the costs of the 2008 GFC expressed in terms of GDP and employment. A recent Bank of England staff working paper summarizes the results of 5 of these studies which estimate the range of impact to 2010 US GDP between -1% and -8%. Clearly, the cumulative global impact over time would have been orders of magnitude higher. However, by simply applying the lowest estimate (-1%) to the most recent 2nd quarter estimate of US GDP ($20.4 Trillion), the costs for even a small avoidance or delay of the next systemic crisis dwarf any FRTB implementation costs that would be incurred by the banking industry.

FRTB vs. Stress Testing

Stress testing is an important tool for prudential supervision which was not available before the crisis. At the same time, stress testing is cumbersome, costly, and limited by the imagination of authorities who will likely not envision every black swan until it occurs.

The FRTB framework goes to the heart of addressing vulnerabilities built into trading platforms and market systems which remain extant today. At its core, FRTB addresses:

• Diminishing and variable marketability of trading instruments through new frameworks around liquidity horizons, risk factor observability and non-modellable risk factors;
• Migration of less liquid trading instruments to more banking book loss estimation through the new default risk charge and, for the standardized approach, the residual risk add‑on;
• Current “all-or-nothing” approach to supervisory intervention by instituting a more granular, desk-centric regulatory framework built upon sensitivities at the local level;
• Arbitrage possibilities between banking and trading books by creating a less permeable, more well-prescribed boundary;
• Misalignment across front-office models and risk models by creating a new framework for P&L attribution and back testing

Even if FRTB has minimal impact to overall capital requirements today, as is the stated goal of BCBS, the new framework will nonetheless create an environment to capture and capitalize future emerging threats within specific risk factors and securities in real time. The main strength of the FRTB framework that has not received deserved attention is that trading constraints become driven by market forces rather than regulatory measures put into effect after a crisis is underway and its aftermath.

Why FRTB Can Be Implemented By Banks of All Sizes

In chapter 11 of our book, The FRTB: Concepts, Implications and Implementation (RISKBooks, 2018), we outline a 13-step plan in 3 stages for FRTB implementation which can be followed by banks across all geographies and sizes. While the implementation timeframe, resources and cost of implementation will vary across banks, we believe that the most important aspects of FRTB’s three levels of implementation can be adopted at reasonable cost by any bank. Furthermore, we believe most banks will find that the groundwork required for FRTB implementation, particularly around data integration and model alignment will become mandatory over coming years as sales and trading platforms become faster, more automated and more systemically connected.

Conclusion and Preface to Our Book

The banking industry is undergoing a transformation that started in the 2000s. From the heady days when belief in the global universal bank model drove unabated acquisitions and financial innovation, we have moved to the need and requirement for risk transparency and manageability. The global banking pecking order, measured in terms of size, growth and profitability, has undergone unprecedented shifts as banks have had to grapple with increased regulation, tepid global economic growth, low interest rates, shifting political winds, and perceived competition from new entrants. The tide is now turning for banks and institutions that took a hard look at the circumstances surrounding the 2008 Global Financial Crisis and invested in transforming their frameworks. For others that have been slow to transform, visible signs of progress appear to be much further away.

It is critical to recognize that if banks are to serve their primary function as financial intermediaries and propagators of economic growth, they need resilience as well as flexibility. Do we want our financial institutions to be like rocks – stable but inflexible, or like bridges – flexible but built to a very high degree of reliability and threatened only by the rarest, implausible events? Rock-like structures can be made resistant to floods and high winds when designed and built, but come at a cost of rigidity, brittleness, and ultimately, the need for costly replacement. Bridges, on the other hand, are more flexible but also more challenging to maintain. A bank’s destiny lies in its flexibility to adapt to shifting winds, and face earthquakes in between. The metaphorical notion of changing an engine while the plane is flying is the most challenging task an organization can undertake. Yet, this is exactly what banks have been grappling with over the last decade. Most have come good, some have passed with flying colors, and the rest will likely follow. The good news is that a significant proportion of banks around the world now control their destiny and will continue to do so for the foreseeable future.

Our mission in writing FRTB: Concepts, Implications and Implementation is to assist banks in furthering this goal. In this book we describe foundational aspects of market risk measurement and management and build upon them to provide an in-depth review of FRTB, its logic, practicality and impact. We take a practitioner’s view of its prescription, guidelines and their implications, and address what needs to be done for effective implementation.