FRTB: The Fundamental Review of the Trading Book

The Fundamental Review of the Trading Book (“FRTB”) is one of the central pillars of postfinancial crisis reform, embodying a significant paradigm shift in the market risk calculation framework.

With the FRTB go-live expected in January 2022, the successful delivery of FRTB’s complex requirements will require an overhaul of existing business, data management and technological models to ensure compliance. This paper identifies some of the key risks facing banks during the FRTB implementation in the coming months and proposes actions that should be taken to mitigate such risks.

Recap: What is FRTB?

At the time of the 2007-9 financial crisis, the prevailing legislation governing capital rules issued by the Basel Committee on Banking Supervision (“BCBS”) was Basel II. The severe trading losses experienced during the financial crisis highlighted that the level of capital held for trading activities, under the Basel II framework, was largely insufficient.

In response, one of the activities initiated by the BCBS was FRTB. This was designed to thoroughly re-examine and reconstruct the capital provisions required to underpin a bank’s trading activities, ensuring that regulatory capital is sufficient in periods of significant market stress. The scope of the regulation cuts across Rates, Credit, FX, Equity and Commodity asset classes. One of the key objectives of the regulation is to promote consistency of implementation by national regulators. If achieved, this will mean that banks with similar trading activity and risk profiles will hold comparable levels of capital across jurisdictions. An enhanced set of risk and capital reporting obligations are intended to promote such transparency.

 

FRTB Tier 1 Capital Charge Calculation Approach

The diagram below illustrates the various levels of model eligibility test for the market risk capital charge components under FRTB and provides a comparison to the components under Basel 2.5:
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Essentially the Internal Model approval process has been made more granular and rigorous. First, a P&L attribution process provides an assessment of how well a desk’s risk management model captures risk factors that drive its P&L. Second, an enhanced daily backtesting framework is used to reconcile forecasted losses with actual losses. Where a trading desk fails these tests, the bank will be required to calculate capital requirements for that desk using the Standardised Approach.

1 FRTB requires that securitisation positions be excluded from the Internal Model-Based Approach (“IMA”) and included only in the Standardised Approach. Previously, under Basel 2.5, securitisation positions were included in the value-at-risk (“VaR”) and stressed-VaR calculations.

2 FRTB requires correlation trading portfolios (“CTPs”) to be capitalised under the Standardised Approach. Previously, under Basel 2.5, modelled default risk charges for CTPs were measured through a comprehensive risk measure.

3 Under Basel 2.5, certain jurisdictions apply standardised charges exclusively for products with specific risk thathave not received internal model approval. Further, certain jurisdictions require de minimis charges for positions not included in VaR.

Summary of FRTB Changes & Implications

Standardised Approach

Sensitivity- Based Method

Internal Model-Based Approach

IMA

Hard Delineation between Trading & Banking

Governance

Introduced Change

  • The existing Standardised Approach for minimum capital requirement will be replaced with a VaR like sensitivity-based calculation on internally-calculated trade sensitivities, a Default Risk Charge and a Residual Risk AddOn.
  •  Standardised Approach will become mandatory for benchmarking (all desks) & fall-back purposes (all desks failing IMA qualification).
  •  Utilises granular first and higher order risk factor sensitivities based on internal pricing models.
  •  Securitised products (such as RMBS) and Correlation Trading Portfolios are ineligible for the Internal Models Approach; their capital charges can be calculated using
  • Replacement of VaR and Stressed Value at Risk (“SVaR”) measurements of the P&L distribution with a new tail-risk metric called Expected Shortfall (“ES”).
  • The current blanket 10-day liquidity horizon is replaced by longer and varied risk factor based liquidity horizons designed to reflect the time period required to sell or hedge a given position during stressed markets.
  • Replacement of the Incremental Risk Charge (“IRC”) with a Default Risk Charge (“DRC”) model.
  • Punitive stressed capital add-on inclusion for non-modellable risk factors (“NMRF”).
  • The regulation seeks to provide incentives for banks to source high-quality data for use within internal models. It has proposed standards that will determine whether a risk factor can be used within an ES calculation, or whether it has to be assigned to a nonmodellable risk factor bucket and there
  • Under the existing regime, “trading intent” is the key factor in determining whether a position belongs to the trading book or not. It has been observed that this offers considerable individual decision making.
  • FRTB builds on “intent based” criteria by imposing strict limits on internal risk transfers between the banking and trading books, with the key purpose being to eliminate regulatory capital arbitrage.
  • Banking book positions can only be transferred into the trading book if the risk is offset through separate matched external hedges.
  • A “presumptive list” of instruments presumed to be included in the trading book. Any deviations in allocations will require explicit supervisory approval.
  • FRTB introduces a more rigorous model approval process that enables supervisors to remove internal modelling permission for individual trading desks at any time.
  • There is a strong emphasis on model-risk management, resulting in a multi-layered, onerous and ongoing approval process for the following: ES calculations for all liquidity horizons per asset class, maintenance of data supporting modellable/ non-modellable risk factors, P&L attribution and back testing VaR.

Implications

Technology

Traditionally, large banks have relied on using the Internal Models Approach. The necessity for all banks to perform standardised calculations will translate into a very large IT effort/cost and require low latency architecture, as many repeatable calculations will need to be run at desk level. Revised Standardised Approach calculations may need to be incorporated in existing Risk Management System engines or a new calculator may need to be added. In both scenarios, there will also be a need for tighter integration between Front Office, Market Risk Management & Finance. The FRTB revisions will affect capital calculations engines and internal risk management framework - all of which will need to be amended, and possibly supported by enhanced workflow/controls. In both scenarios, there will also be a need for tighter integration between Front Office, Market Risk Management & Finance – a fully integrated middle office with a heavy focus on data quality & consistency.

Data

In addition to Front Office sensitivities, the Standardised Approach requires good quality static data to be associated with each risk factor. For example, industry sector, region, market capitalisation and credit rating are all required attributes. Depending on the bank’s current capabilities, some of these inputs may not yet exist in production.

Capital “Cliff Effects”

The following will all contribute to elevated capital requirements: 97.5% ES tail (relative to 99% VaR), wider (desk) use of the standardised model, erosion of portfolio diversification benefits and capital add-ons for nonmodellable risk factors and default risk. The viability of certain capital intensive businesses may need to be evaluated.

Costs

Reduced flexibility and imposition of multifaceted solution is likely to lead to higher capital requirements and operational costs. For example, matching external hedges to internal risk transfers can be costly.

Business Strategy

Banks need to consider if they need to restructure their desks to reduce complexity related to models and the capital calculation.

Operations

Failure to meet the IMA eligibility criteria will result in the application of the Standard Approach.

Infrastructure

Substantial infrastructure changes are required to meet FRTB reporting requirements. The need to keep Front Office, Risk and Finance data consistent for Back testing/PLA tests means banks will need to look at their front-toback infrastructure and processes, with many forced to build out centralised Middle Office functions. Investment in a Market Risk Middle Office/Data Quality function will ensure data quality issues are resolved in a timely manner otherwise the capital risks being adversely impacted in a significant way.

Reporting

Broadened supervisory scope will require more communication between banks and supervisors. Banks must prepare, evaluate and make available to supervisors reports on their: boundary determination and compliance, inventory ageing, daily limits, intraday limits (for banks with active intraday trading) and assessments of market liquidity.

Costs & Timeframes

Banks must implement their FRTB capabilities internally by 1 January 2020, allowing for a 2 year parallel run. Total costs for medium to large organisations are expected to be in the range of $75m – $100m over a 3 year period

Summary of FRTB Changes & Implications

Standardised Approach

Sensitivity- Based Method

  • The existing Standardised Approach for minimum capital requirement will be replaced with a VaR like sensitivity-based calculation on internally-calculated trade sensitivities, a Default Risk Charge and a Residual Risk AddOn.
  •  Standardised Approach will become mandatory for benchmarking (all desks) & fall-back purposes (all desks failing IMA qualification).
  •  Utilises granular first and higher order risk factor sensitivities based on internal pricing models.
  •  Securitised products (such as RMBS) and Correlation Trading Portfolios are ineligible for the Internal Models Approach; their capital charges can be calculated using

Internal Model-Based Approach

IMA

  • Replacement of VaR and Stressed Value at Risk (“SVaR”) measurements of the P&L distribution with a new tail-risk metric called Expected Shortfall (“ES”).
  • The current blanket 10-day liquidity horizon is replaced by longer and varied risk factor based liquidity horizons designed to reflect the time period required to sell or hedge a given position during stressed markets.
  • Replacement of the Incremental Risk Charge (“IRC”) with a Default Risk Charge (“DRC”) model.
  • Punitive stressed capital add-on inclusion for non-modellable risk factors (“NMRF”).
  • The regulation seeks to provide incentives for banks to source high-quality data for use within internal models. It has proposed standards that will determine whether a risk factor can be used within an ES calculation, or whether it has to be assigned to a nonmodellable risk factor bucket and there

Hard Delineation between Trading & Banking

Governance

  • Under the existing regime, “trading intent” is the key factor in determining whether a position belongs to the trading book or not. It has been observed that this offers considerable individual decision making.
  • FRTB builds on “intent based” criteria by imposing strict limits on internal risk transfers between the banking and trading books, with the key purpose being to eliminate regulatory capital arbitrage.
  • Banking book positions can only be transferred into the trading book if the risk is offset through separate matched external hedges.
  • A “presumptive list” of instruments presumed to be included in the trading book. Any deviations in allocations will require explicit supervisory approval.

Governance

  • FRTB introduces a more rigorous model approval process that enables supervisors to remove internal modelling permission for individual trading desks at any time.
  • There is a strong emphasis on model-risk management, resulting in a multi-layered, onerous and ongoing approval process for the following: ES calculations for all liquidity horizons per asset class, maintenance of data supporting modellable/ non-modellable risk factors, P&L attribution and back testing VaR.

Implications

Technology

Traditionally, large banks have relied on using the Internal Models Approach. The necessity for all banks to perform standardised calculations will translate into a very large IT effort/cost and require low latency architecture, as many repeatable calculations will need to be run at desk level. Revised Standardised Approach calculations may need to be incorporated in existing Risk Management System engines or a new calculator may need to be added. In both scenarios, there will also be a need for tighter integration between Front Office, Market Risk Management & Finance. The FRTB revisions will affect capital calculations engines and internal risk management framework - all of which will need to be amended, and possibly supported by enhanced workflow/controls. In both scenarios, there will also be a need for tighter integration between Front Office, Market Risk Management & Finance – a fully integrated middle office with a heavy focus on data quality & consistency.

Data

In addition to Front Office sensitivities, the Standardised Approach requires good quality static data to be associated with each risk factor. For example, industry sector, region, market capitalisation and credit rating are all required attributes. Depending on the bank’s current capabilities, some of these inputs may not yet exist in production.

Capital “Cliff Effects”

The following will all contribute to elevated capital requirements: 97.5% ES tail (relative to 99% VaR), wider (desk) use of the standardised model, erosion of portfolio diversification benefits and capital add-ons for nonmodellable risk factors and default risk. The viability of certain capital intensive businesses may need to be evaluated.

Costs

Reduced flexibility and imposition of multifaceted solution is likely to lead to higher capital requirements and operational costs. For example, matching external hedges to internal risk transfers can be costly.

Business Strategy

Banks need to consider if they need to restructure their desks to reduce complexity related to models and the capital calculation.

Operations

Failure to meet the IMA eligibility criteria will result in the application of the Standard Approach.

Infrastructure

Substantial infrastructure changes are required to meet FRTB reporting requirements. The need to keep Front Office, Risk and Finance data consistent for Back testing/PLA tests means banks will need to look at their front-toback infrastructure and processes, with many forced to build out centralised Middle Office functions. Investment in a Market Risk Middle Office/Data Quality function will ensure data quality issues are resolved in a timely manner otherwise the capital risks being adversely impacted in a significant way.

Reporting

Broadened supervisory scope will require more communication between banks and supervisors. Banks must prepare, evaluate and make available to supervisors reports on their: boundary determination and compliance, inventory ageing, daily limits, intraday limits (for banks with active intraday trading) and assessments of market liquidity.

Costs & Timeframes

Banks must implement their FRTB capabilities internally by 1 January 2020, allowing for a 2 year parallel run. Total costs for medium to large organisations are expected to be in the range of $75m – $100m over a 3 year period

Current FRTB Timeline

On 22 March 2018, the BCBS released the latest consultation paper on FRTB. One of the headline changes was the further delay to the initial timeline, with the implementation date and reporting date being pushed out to January 2022.
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As such, banks must implement their FRTB capabilities internally by 1 January 2020 allowing for a 2-year parallel run, with reporting of risk and associated capital operational by 31 December 2021. evertheless, firms should target go-live for production parallel runs 12 months in advance ensuring sufficient data to perform the required qualifying tests to obtain accreditation to use an IMA. As 2020 approaches, it is anticipated that bottlenecks will emerge in the process as firms clamour for last minute approval. Ensuring operational readiness in good time will maximise the likelihood of proactive discussions with the regulators and ultimately support model approval.

It is expected that capital will not be impacted by FRTB until 2025, as the first 3 years are likely to be reporting only. From 2025 the increased capital will be discounted for the first 3 years, so the full impacts of FRTB capital charges are not expected to be absorbed until around 2028.

At present the industry has struggled to demonstrate if risk factors are modellable or not, defined by having more than 24 observations a year with no more than a 30-day gap between observations. This has led to fear that previous Quantitative Impact Studies (“QIS”) have not painted a representative picture of the capital add-ons associated with non-modellable risk factors under FRTB. Consequentially, it has been rumoured that a fifth QIS will be launched, although there is no definitive decision or time scale on if or when this will be initiated.

Current FRTB Timeline

At New Link Consulting we believe that banks with sufficient trading activity should view FRTB as an opportunity to re-evaluate and improve their end-to-end business infrastructure, deriving the benefits of enhanced capital, cost and operational efficiencies.
The revised FRTB timeline should provide enough time for banks to get their trading houses in order and implement the requirements strategically.

In the initial phases of the FRTB delivery banks should be mindful of the following challenges:

Upfront Involvement of Technology and Architecture

FRTB compliance is a very large undertaking and will have extensive impacts upon the business processes, controls, systems and data of the bank. Business processes and controls appear to be clearly domiciled within their own workstream, however, the engagement channel to IT seems less clear. The IT work will be a very significant component of the final solution and, by its inter-connected nature, is one that carries complexity and considerable uncertainty.

Approach to Challenge: Early engagement of IT teams and their inclusion within key governance forums. This will alert key IT teams to the existence, size and scope of the FRTB initiative and give them a sense of scale and timeframes. In turn, this will enable them to assess the impact upon their own organisation, to contribute to key debates and also to be able to adjust their own resources in order to be able to respond in time for the initiative to be delivered successfully

The Importance of Data

Availability, accuracy, timeliness and aggregation of data will be key. In preceding regulation in other risk areas (e.g. BCBS 239), we have seen the increasing importance attached to these attributes of data by regulators.

Approach to Challenge: Understand the FRTB reporting required to regulators and others and ensure that the dependent data models, flows aggregation and distribution capabilities required to produce those reports are factored into work plans.

Appreciate the data integration challenge that will be presented in pre-live testing & live operations including: the number of feeds, sensitivities, P&L, market data for the real price test and so forth. This represents a very large planning and management challenge across the Front Office and Risk Management environments.

Incomplete Regulation

Changes in the regulation may impact delivery plans. The latest iteration of the FRTB regulation “Minimum capital requirements for market risk” was published in May/June 2018. Whilst this provides more detail of the proposed regulation, it is by no means the final level of detail. Changes to the regulations may well have further impact upon delivery timeframes.

Approach to Challenge: Scrutiny of the evolving regulations and the development of strong relationships with key bodies influential in its development including regulators, industry bodies etc.

An initial view on desk structure and optimisation should be formed using prototype models and desk eligibility test results. The aim of an initial strategic analysis cannot be to find all the answers, but rather to define an approach and toolkit for ongoing optimisation and secure agreement across the bank as to the scale of change required.

Senior Stakeholder Engagement

A key risk on large change initiatives is lack of progress due to inadequate senior stakeholder engagement. Practically this translates to a judgement by senior stakeholders that the initiative is (at least currently), not of sufficient priority to warrant investment of their time and potentially resources.

Approach to Challenge: Secure executive sponsorship of the programme early. Ensure sponsorship is accompanied by a clear message from the executive that engagement with the FRTB programme must be a priority at all levels across the bank. Effective communication with senior business stakeholders at appropriate levels of detail is critical, as they will rapidly become extremely interested in the potential impacts of the new capital requirements upon their respective businesses.

Senior Stakeholder Engagement

A key risk on large change initiatives is lack of progress due to inadequate senior stakeholder engagement. Practically this translates to a judgement by senior stakeholders that the initiative is (at least currently), not of sufficient priority to warrant investment of their time and potentially resources.

Approach to Challenge: Secure executive sponsorship of the programme early. Ensure sponsorship is accompanied by a clear message from the executive that engagement with the FRTB programme must be a priority at all levels across the bank. Effective communication with senior business stakeholders at appropriate levels of detail is critical, as they will rapidly become extremely interested in the potential impacts of the new capital requirements upon their respective businesses.

Incomplete Regulation

Changes in the regulation may impact delivery plans. The latest iteration of the FRTB regulation “Minimum capital requirements for market risk” was published in May/June 2018. Whilst this provides more detail of the proposed regulation, it is by no means the final level of detail. Changes to the regulations may well have further impact upon delivery timeframes.

Approach to Challenge: Scrutiny of the evolving regulations and the development of strong relationships with key bodies influential in its development including regulators, industry bodies etc.

An initial view on desk structure and optimisation should be formed using prototype models and desk eligibility test results. The aim of an initial strategic analysis cannot be to find all the answers, but rather to define an approach and toolkit for ongoing optimisation and secure agreement across the bank as to the scale of change required.

New Link Consulting FRTB Offering

As a practitioner-led consultancy with experience in executing large-scale and complex regulatory change initiatives throughout the full programme lifecycle, New Link Consulting is a proven partner to meet FRTB requirements.
Our Risk Management service offering for FRTB includes:
Subject Matter Experts
Market Risk Expertise
• Market Risk domain specialists with expertise in risk factor modellability assessment, NMRF capitalisation, default risk charge and risk residual add-on capital charges.

• Market Risk IT specialists, with expertise in defining risk architectures and managing delivery of risk technology platform components, often across multiple vendors.

• Front Office Quants to validate risk factors & pricing models.

• Model Development & Validation specialists with expertise in capital charge calculations.

• Product Control subject matter experts with Back Testing & P&L Attribution expertise.

• Operating Model & Policy specialists to restructure desks and execute required desk level instructions.
Risk Activities
New Link Consulting can perform the following Risk specific activities: Stress Testing, Risk Analytics, Regulatory/Waiver Preparation, Risk modelling including VaR, SVaR, Risks Not in VaR (RNIV), Credit Value Adjustment (CVA), Future Value Adjustment (FVA) and IRC, across all asset classes in the bank’s trading book.
Vendor Selection Decision Tools
With demanding time scales to implement FRTB, many industry participants are seeking the most efficient path towards compliance, with pre-built and cost-effective services provided by third party vendors offering a potentially valuable shortcut over in-house development. As specialists to the finance sector, with strong links to market vendors, New Link Consulting has a deep understanding of the current vendor landscape. Combining this with the execution of a comprehensive review of the clients’ existing architecture & business strategy, New Link Consulting make bespoke recommendations customised to each clients’ unique requirements.
Risk Factors Mapping Tool
A risk factor that is non-modellable under the IMA carries a punitive capital charge based on a stress test and is not included in the ES calculation. New Link Consultants have experience in creating transaction-to-risk-factor mapping libraries for a broad set of risk factors. Furthermore, New Link Consulting also has experience in applying frameworks to decompose risk factors into smaller modellable components, reducing the overall risk of non-modellable risk factors.

Where a modellable risk factor lacks sufficient time series data during the historical period used for stressed calibration (e.g. 2007-08), proxy data can be used. This is conditional on the justification and documentation of the approach for replicating missing data being performed as part of the independent review of the internal models, as well as being approved by the bank’s supervisory body. At New Link Consulting we have experience in working with client teams to apply their methodologies to reduce NMFR capital charges & supplementary artefacts, which can also be utilised to support the FRTB model governance process.
Change Delivery Management
Change Delivery Management
New Link Consulting’s blend of practitioner expertise along with deliver and change management skills, enables us to tailor our deliveries to the explicit requirements of our client, enabling a collaborative approach to problem solving and the execution of complex change initiatives.
PMO
New Link Consulting has developed a team of highly experienced PMO specialists with extensive industry knowledge and a proven track record of running successful PMO teams.
Defining FRTB Rules & Reqs
New Link Consulting can be leveraged to engage with the business to review requirements and complete business analysis: including an in-depth impact analysis of the FRTB rules as they continue to evolve. This can be used as the foundation for establishing/amending FRTB workstreams to ensure that all facets of the globally impacting regulation are understood and addressed appropriately.
Operating Model Design
New Link Consulting can be leveraged to perform detailed analysis to identify the required business operation capabilities and strategic technology platforms required in the target state. Furthermore, New Link Consulting will establish the appropriate governance to support the target operating model to include review/enhancement of policies and procedures, identify a full suite of controls and coordinate the execution of regulatory assessments and approvals.
Roadmap to Implement
New Link Consulting can create a comprehensive roadmap to implement FRTB requirements. With the costs of infrastructure expected to exceed the hundreds of millions it is crucial that the benefits and expenses for each asset class, geography, and group of trading desks is carefully considered within the scope of the delivery.

Need any help?

New Link Consulting has the expertise and practical experience to help you move forward as a GDPR compliant organisation.

Our modular approach can be used to customise assistance where appropriate. Gaps in compliance may already be clear and if so our trusted execution experience will allow the gaps to be closed with confidence.

Our consultants have many years of experience dealing with regulatory and data implementations across the financial sector and beyond. By drawing on a wealth of practical experience we can assure our clients a first rate service.

We can also include assistance from our legal partners to interpret the regulation according to your bespoke needs. Translating these interpretations into requirements that fit your business. Our cyber-security partners are well placed to provide expertise surrounding data storage, usage and security