Implementation Impact of the Fundamental Review of Trading Book, Key Challenges and Proposed Solutions

Overview?

FRTB addresses material weaknesses of the current Market Risk framework exposed by the financial crisis. Some of the key features of the regulation are a clearer distinction between the Trading and Banking Book boundary, Regulatory capital charge using Internal Model Approach (IMA) and Standardized Approach (SA) including rigorous approval process to achieve IMA eligibility. Market Risk regulatory capital has the potential of going up by close to 40% approximately as per quantitative studies. Many banks might end up spending more than 80% of their effort on 20% of the IMA desks.?

Operational Impact, key challenges and its impact?

1. Non Modellable Risk Factors (NMRFs) : NMRFs could drive the total capital charge by around 29% or more. Reduced set of risk factors used for IMA capital charge must ? explain atleast 75% of the full set in a stressed period and must be modellable. Due to?seasonality or old historical window more than a decade old, it is possible that the firm cannot pass the “observability” test of having continuously available real prices. Hence, the solution to this is that as firms are allowed to use committed quotes or third party vendor data or arm lengths price transactions between two or more counterparties, it is advisable that more banks use the IMA approach and share them. Overall it will improve the chances of more desks being eligible for IMA calculations.?

2. Map transactions to Risk Factors : The information flow in banks is really different from the bucketing prescribed by the bank. In order to pass the Risk Factor Eligibility test and carry out the individual Risk factor analysis. Some banks are using banks creating their own languages to handle the risk factor bucketing while there are vendor solutions which help to handle it. It is possible to use the existing Valuation Control data flow infrastructure. Involvement of the front office is required to a huge extent as they understand where the liquidity lies. Hence, it is essential that risk systems work in close coordination with the front office to ensure proper risk factor mappings and observable quotes are utilized. Hence, sharing of infrastructure for pricing and MTM like the same market data and condensing trading systems may help.?

3. Capital Optimisation and Strategic Solutions : In order for any desk to be eligible for IMA, three quantitative tests namely Top of the house minimum 10% of bank/s RWA to be explained by positions within IMA eligible desks, P&L Backtesting and P&L Attribution. Because there is a huge capital/infrastructure investment for passing all these tests for a small or medium sized bank it would be preferable to go for an approach like SA wherein the standardized rules are prescribed for more calculations. A number of factors to be accounted for, for example, if implementing IMA, any bank still needs to calculate capital using SA approach as a floor, bank’s overall trading strategy and vision must be considered including specifics of how risk is hedged.?

4. Inter-connectivity of Models : It is not only important that each of the models are built correctly but also how they interact with each other. For example, how exceptions on the backtesting models using VaR but used for capital charge based on Expected shortfall. Interplay of various models is crucial for FRTB to work well.?

5. Frequency of Regulatory Reporting and Disclosures : Increase in the granularity and frequency of qualitative and quantitative reporting , robust governance is required to satisfy the internal and external requirements. Infrastructure must be in place to source granular IMA and SA data elements. Also, prepare desk level disclosure to regulators instead of bank level disclosures. Automations including business intelligence tools like Tableau or Cognos, or AI & ML can help risk analysts and risk managers with automated reports with minimal or no manual intervention.?

6. Desk Structure : There is desk level Backtesting for model approvals. All desks trading the same product must use the same inputs and models across geographies. The way the desk is structured can impact the capital. Each trader must be on desk only and cannot be part of both banking book and trading book. Many banks would do anything to stay off the SA approach. This approach could kill business or close trading desks. Hence, banks look to optimize the desk structures for survival of some business. In addition to this, maintaining a strict boundary between trading and banking book with transfer restrictions is operationally challenging. Model governance and validation processes need to be integrated to achieve this.?

7. Cross dependencies between IBOR transition and FRTB : With the LIBOR trade population reduction and RFR linked trades not having enough liquidity, issues might arise in terms of Interest Risk or GIRR data and liquidity may result in material increase in market risk capital requirements. Also close coordination between stakeholders is a key to ensure that smooth transition to RFRs is communicated to personnel working in FRTB projects. For example, IT resources need to ensure that reliable test environments for both projects are available. RFR data quality and backfiling must be considered as top priority using third party vendors or in-house models.?

Conclusion?

Front office, market risk analysts and managers, Technology, market data teams , front office , quants and methodology ,must work in close coordination and full cooperation to ensure the successful implementation of FRTB. Each of these areas must be carefully assessed to ensure the impact of each of these platforms is adequately captured and included in the planning activities and high level architecture of the bank.