As we move from ‘VaR’ to ‘Expected Shortfall’ regime driven regulations coupled with a focus on Liquidity as never before, I thought of sharing a perspective on one of the hottest regulation around the corner - Fundamental review of trading books (FRTB). This results in a lot of efforts for banks on beefing up systems and processes and at the same time opens up multiple career avenues for market risk professionals. Happy to know views and questions. Happy Reading!
What is it? FRTB is sequentially a succession for Basel 2.5 which continues the BIS accord of making a more stricter regime with much less discretion on the part of banks. The focus areas continue to be economic capital and its adequacy but with a perspective of Market Risk including stress testing, exposure and sensitivities. Few already term it as Basel IV.
Who is impacted? initially front line banks with largest assets are covered. This includes likes of Credit Suisse, Nomura, Bank of America, JP Morgan, etc.
Deadline? while the final draft is due on Jan 2019, the regulation will be applicable by end of 2019 as per the current accord. No delays & waivers are anticipated on this front. Having said this, banks have already started making progress on this front.
What’s New! compared with existing market risk regulatory capital rules (Basel II/III), FRTB incorporates the following key gradients:
• Expected Shortfall – FRTB exclusively focuses on tail risk component and hence replaces VaR with Expected Shortfall. The change requires computation of 97.5% expected shortfall as against 99% VaR in Basel 2.5. Mathematically (w.r.t percentile) this results in a 25% higher charge.
. More standardized rules for defining the boundary between trading and banking book. The ultimate aim to have a more synchronized ground to compare the results across different banks so that there is little discretion left with banks obscuring the provisions by taking advantage of its local regulations and on-going risk practices. This is what is commonly known as “Regulatory arbitrage” wherein banks tune the regulatory provisions to their advantage and this is where the Regulator wants to step hard.
. Risk factor buckets – for the very first time risk factors are categorized as being modellable vs. non-modellable. This is to ensure liquid traded factors are charged at a lower rate compared to non-modellable factors having limited data history & liquidity ( data ‘quality’ is key).
. Liquidity buckets – while earlier Basel accords did speculate some form of liquidity horizon calculations, the FRTB calls for multi bucket segmenting which magnifies the risk charge by the factor of time (capped at 120 days).
. Internal model multiplier – a new multiplier is set to 1.5 against 3.4 in Basel 2.5.
. Securitised instruments – these are to be exclusively handled under Standardized approach only.
. PL attribution – these are fresh set of ratios to evaluate model differences between’s banks risk/internal model to market PL. The back-testing requirement continues as in earlier Basel rules.
. Incremental Default Risk (IDR) – a new requirement designed to test the jump to default scenarios for debt and equity trading positions.
. Stress testing – a stressed expected shortfall is required for non-modellable factors plus an additional capital add-on for using internal approach.
To summarize the theme that FRTB brings along is a more sophisticated standardized approach leaving less room for bank’s discretion coupled with a strong focus on tail risk supplemented by expected shortfall regime, stress testing, IDR and long liquidity horizons.
