What is the FRTB?
The Fundamental Review of the Trading Book (FRTB) was introduced in January 2016 by the Basel Committee on Banking Supervision with the aim of strengthening capital reserves across the industry.
Before the financial crisis in 2009, banks held large exposure on their banking books without sufficient capital to cover potential losses. New regulations were brought in to ensure that banks hold sufficient capital in line with the risk profile of their assets using the concept of Risk Weighted Assets (RWA). The objective of the FRTB is to overhaul the market risk framework and in turn create a more robust and resilient banking sector.
What are the challenges?
- Portfolio Review
The actual implementation of the FRTB in 2019 will present several key challenges for banks; firstly, they will need to review their current portfolios to determine whether their allocation of assets between the banking and trading books is correct. This could lead to internal book migrations which are operationally intensive and costly. Banks will need a framework in place to clearly define and maintain the boundary between the highly liquid trading and the illiquid banking books.
- Valuation Model Updates
The FRTB states that banks must adapt their model for calculating risk, moving away from a Value at Risk (VaR) approach and towards an Expected Shortfall (ES) approach. ES incorporates tail risk, a more conservative approach than VaR as it includes outcomes that have a small possibility of occurring, which results in banks having to hold greater capital reserves. ES forms part of the Internal Model Approach (IMA), this allows banks to create their own internal models to calculate risk; however, first they must gain regulatory approval for each model. Banks will need to demonstrate their ability to report on desk-level risk whilst undergoing an independent model assessment.
The standardised approach (SA) is a fall back for smaller banks who may fail to have their internal models approved by the regulator. The SA is set by regulators and establishes how much capital is necessary to cover potential losses. Internal models are approved at a trading desk-level, banks will need to factor in the added cost and complexity of an IMA over SA before deciding on one over the other. Most banks will adopt a combination of IMA and SA, however SA must be calculated for all trading desks. If there is a breach for a particular desk using IMA, then it must immediately adopt the SA.
- Data Management
The FRTB will also create several data management challenges, any incorrect data that creeps into models could result in additional capital charges. The FRTB will require firms to consolidate data from both internal and external sources. Market Data must be up-to-date and reliable as any internal model that fails due to poor data, will result in the bank having to fall back on the SA approach and potentially higher capital charges. The increased amount of data caused by the FRTB could also pose a data storage and governance challenge for some smaller banks.
- Regulatory Deadline
Although banks appear to have plenty of time before the first national standards are implemented in January 2019, there is significant planning, developing and testing which needs to take place prior to the deadline. Being a practitioner-led consultancy with extensive first-hand experience, New Link Consulting is able to offer expert help and advice to ensure your organisation meets national standards and has infrastructure in place to meet the demands of the FRTB.