What is the revised framework for market risk and FRTB?

July 9th, 2018

On the occasion of their speech at the EFE conference on Basel IV, Pierre Lecour and Kevin L’Homme, consultants at Quanteam, tell us about the revised framework of market risk and the FRTB.

Pierre Lecour Quanteam

Pierre Lecour
Risk Engineer Consultant

Kevin L'Homme Quanteam

Kevin L’Homme
Finance Manager Consultant

What is the context of the new regulation initiated by the Basel Committee?

Pierre Lecour: The FRTB regulation appeared after the 2007-2008 crisis. The former regulations highlighted the shortfalls in equity capital saved for the risk coverage. FRTB also aims at reinforcing the monitoring of market risks.

Kévin L’Homme:  Financial models of banks and regulations, especially Basel regulations, were jeopardized and showed their limits during the 2007-2008 crisis.
As a result, some directives appeared around 2010-2012 and it was in this context that so-called FRTB initiative Basel 4 was born.

 

What are the institutions concerned by FRTB? When will this regulation be practical?

PL: Every banks and financial Institutions with market activities will be concerned by FRTB.

KL: At the beginning, a text had been published in January 2016 and had an application date of 1 January 2019. Since then, following discussions between the ECB and the FED, a new text was published in December 2017 and forecasted a progressive date of application between the 1st of January 2022 and the 1st of January 2027. There will be a transitional period of 5 years during which the former calculation method and the new one will persist. During these years, the new method will take more and more weight in comparison with the old one.
However, these dates can still be modified in so far since the text must be voted, especially at European level. According to rumors, the regulator should ask for a publication of the results from 2020. These results will not be used in the capital requirement calculation but banks will have to prove that there are able to produces these figures on a regular basis, from 2020 for the standard calculation method and from 2022 for the internal method.

Could you give us the main principles of FRTB?

PL: Broadly, the first thing to do will be to differentiate more clearly the banking book and the trading book in order to avoid regulatory arbitrage. It will be also necessary to better define the instruments taken into account in the credit risk calculation and to more precisely identify the correlation portfolios.

Simultaneously, the Expected Shortfall will replace the VaR. The Expected Shortfall allows to take into account the extreme cases of the tails of distribution, which might be smarter during the crisis periods.
The notion of liquidity horizons is also a key element in FRTB and will not give the same impact to all products in the risk calculation, depending on whether they are highly liquid or whether they are rare and illiquid, since in that case, it will be much more difficult to close their position on the market.

KL: I would add that the standard model will be enriched by being more based on the sensitivity calculations that are already being monitored in banks and stress tests, in order to materialize the convexity of some products.

It is also important to note that the calculation method will be much more granular than before since eligibility to the internal model will no longer be made at the bank level but at the trading desk level. Moreover, the standard model becomes a reference and will have to be calculated in any case: it will become a kind of back-up for trading desks when they will no longer be eligible to the internal model.

To conclude, one of the principles remains confused in the text: it is the observability of the data used for the calculations. From now on, these data will have to be “clean”, their source justified and above all verifiable directly on the market. This new context could therefor condition the amount of equity capital to be retained for banks. Data quality becomes one of the major issues of the FRTB regulation.

What are the prerequisites and the challenges regarding the implementation?

KL: First of all, we are waiting for the text to be signed and approved in order to be able to apply it. Indeed, there are still notions on which the regulator is still challenging the banking industry in order to adapt his text.

PL: Technically speaking, for banks, because required historical data volumes as well as the double calculation method, the implementation of FRTB will require a very important memory and storage capacity. Banks will have to revise their current IS architectures in order to support this new volume of metrics and data to collect.

Another prerequisite specific to banks is the choice of the calculation method and particularly the implementation of the internal model for eligible trading desks. Banks will have to audit risk factors, their modeling and have enough databases. They must be ready to support all requests that will arise from the implementation of FRTB.

KL: To conclude, banks will probably have to choose among their activities, those that will remain profitable following the constraints so by the regulations. Indeed, today’s highly profitable activities may become less so if they consume more capital. It will be necessary to anticipate the effect of this regulation on the profitability of the activities.

 

How will the calculation of market risks be reviewed?

PL: One of the first changes is the switch from VaR to Expected Shortfall, which we have already mentioned.

KL: On the credit risk side, the IRC (Incremental Risk Charge) will be replaced by the DRC (Default Risk Charge). The idea of this new indicator is to catch other risks than the default risk, such as, for example the counterparty risk.

PL: Moreover, the transition period will be a period of double production. Indeed, banks will have to carry out their calculations everyday with the standard method, in addition to their internal method. The risk calculations will be much heavier, which implies an increase in storage capacity but probably also the strengthening of teams in charge the risk calculations.

What are the benefits and the disadvantages of the new calculation method?

KL: The most significant benefits of the FRTB regulation for banks are the following:

  • A better representation of reality
    The new risks calculations should allow to no longer fall into the traps of previous regulations that showed their limits during crises.
  • Taking into account the liquidity horizons
    Before, the notion of liquidity was not much considered. It becomes so with the FRTB thanks to the introduction of asset class liquidity horizons. Credit instruments will be somewhat more penalizing because of their lower liquidity.
  • The convergence of the standard method and the internal method
    The notion of “floor” is introduced and will enable to set a limit in the transition from the standard method to the internal method. Banks will not be able to earn huge amount of capital from one method to another. In addition, FRTB forecasts a “buffer area” between the two methods in order to make it less abrupt the transition from an internal method to the standard method.

PL: To quote some of the most costly drawbacks:

  • Review of the architecture of the Internal Information System
    It is necessary to provide a computing power approximately 20 times higher than that required today.
  • Increased resource requirements during the transition period
    Both methods will have to be calculated in parallel during the transition period, which will greatly increase the resource requirements for several years. However, these needs will decrease as soon as the transition period will be over, and thus, consequently, the size of the teams as well.
  • A non-definitive text
    The FRTB text is reviewed every 6 months by regulators, according to QIS (Quantitative Impact Studies) which are given to them by the banks. The resulting changes can sometimes be quite substantial (for instance the eligibility conditions for the internal model have been revised, just like some calculation of the standard method). Banks are very dependent on these changes which constitute a zine of uncertainty: it is easy to understand that is it difficult for them to define a clear strategy today. For the moment, no closing date of the final text is really planned. The next deadline should be in 2019 but we are not sure that this date is validated.

KL: To conclude, we invite you to review together the calculation of the capital charges in the new standard approach during our EFE topical issues Conference of the Thursday 29th of November entitled “Basel IV or the finalization of Basel III” .

 

Pierre Lecour, Risk Engineer Consultant at Quanteam – FRTB Project

Kévin L’Homme, Finance Manager Consultant at Quanteam – FRTB Project