»We are your sparring partner for strategic and operational decision-making. We never lose sight of the key influencing parameters, and we provide support when it comes to choosing the best model.«

Christian Behm, Partner LPA

FRTB

The FRTB standards have far-reaching implications in terms of the complexity of IT systems, for example. We support you from the analysis and design phase through to realignment.

A summary of our services for FRTB

Overview and timeline up to 2022

The Fundamental Review of the Trading Book (FRTB) is a comprehensive suite of new standards developed by the Basel Committee on Banking Supervision (BCBS) that governs the minimum capital requirements applicable to market price risks (BCBS 352) at an international level. FRTB is therefore a component of the new Basel IV framework (or Basel III, depending on terminology).

The core features of the reform are as follows:

  • Revised (and more robust) banking book/trading book boundary
  • Overhaul of the Internal Models Approach (IMA)
  • Overhaul of the Standardised Approach (SA) to risk measurement in order to increase risk sensitivity
  • Move from Value-at-Risk (VaR) to Expected Shortfall (ES) measurement
  • Incorporation of the risk of market illiquidity

The final standard was published in January 2016 following a consultation phase lasting several years. In December 2017, the original date of initial adoption of 1 January 2019 was formally put back to 1 January 2022.

The prescribed models are currently being substantiated and re-calibrated in consultation phases, during which the model parameters for the standard approach will also be revised. These were published by the Basel Committee in March 2018. (https://www.bis.org/press/p180322.htm).
Transposition into European law will take place via the Capital Requirements Regulation (CRR 2), which is expected in 2021 at the latest. The corresponding draft version was published by the EU Commission in November 2016.

New rules on the minimum capital requirements for market risk in the trading book

The significance of the internal market risk model is diminishing

In December 2017, the finalised Basel III reforms (BCBS 424) were published. The question of choosing an optimum model (internal model or standard approach) arose at the latest with the introduction of the “global output floor” in the above-mentioned reforms. The floor will be introduced gradually in the years up to 2027, whereupon the minimum capital requirements will be set at 72.5% of the standard approach. The floor will have global effect and extend to all risk categories (market risk, credit risk, operational risk, etc.).

As such, the issue of economic viability does not rest solely on the positions in the trading book that are exposed to market risk and on the efficacy of the internal model, but also – and essentially – on the bank’s portfolio as a whole. This applies, in particular, to the models used in the field of credit risk and to the relative proportion of market risk to the bank’s total risk.

Non-modellable risk factors

In addition to the impact of the global floor, requirements of model validation and the identification of non-modellable risk factors have significantly compromised the benefits of the internal model. Full modelling of all risk factors will seldom be possible, especially in the case of complex positions or exposures that are not traded very often (by the bank). Market players have used data pools in an attempt to bolster existing data sets and thus increase modellability, but this could not solve the problem entirely. In extreme cases, non-modellable risk factors can account for well over 50 per cent of the total, and the punitive add-on charges (SES) they attract can substantially increase capital requirements in the internal model. Indeed, in some cases, the capital requirements can even exceed those in the standard approach. For this reason, many banks are switching completely to the standard approach at individual trading desk level.

That said, the option of fully netting opposing risk positions plus the associated hedging benefits mean that the standard approach is becoming a more attractive proposition. This applies to both macro and micro-hedge strategies. In certain cases, this can produce positive capital effects for banks that have no or only few risks in their own books or have largely externalised these risks.

Impact of FRTB on the front office

The adjusted models have implications for trading and hedging strategies in the front office and from the perspective of the business model. Through the respective capital requirements, the models have a serious impact on the capital costs of the different strategies. Especially in the case of long-term and complex strategies, banks will need to ensure – prior to the initial application of FRTB – that individual transactions are recoverable and remain so. From the capital requirements point of view, the significance of the standard approach for hedging strategies is increasing because such strategies are normally driven to a greater extent by the SA than by the IMA via the global output floor. It is therefore important that the strategic implications for the front office are analysed now and appropriate solutions implemented.

Organisational requirements

Aside from purely quantitative and qualitative requirements on risk modelling, organisational requirements must also be suitably mapped to the front-office processes.
This includes the structuring of internal risk transfers (IRT) from the banking book to the trading book. In contrast to previous practice, the transfer of risk, e.g. interest rate risk, must take place via a special IRT portfolio unless a micro-hedging strategy is being used. Otherwise, the external hedges will not be considered as risk-reducing factors when capital requirements are calculated. The associated operational requirements must be implemented accordingly, and the implications for existing trading and hedging strategies analysed and mitigated.

Additional requirements on trading-desk structure in terms of strategy and risk management require, at the very least, that banks carefully review their existing documentation. Thanks to a certain easing of requirements in the final standards, however, we do not expect that trading desks will need to be substantially re-designed (other than with respect to the above-mentioned IRT requirements).

Major increase in requirements placed on IT

The introduction of the sensitivity-based standard approach constitutes a significant change for many small and medium-sized financial institutions. Whereas the previous calculation methods in the standard approach were relatively simple, the introduction of sensitivities is serving to increase requirements substantially, particularly in the case of more complex products. As a result, demands on the systems needed by risk management to calculate capital requirements are increasing.

At the same time, corresponding models for projecting future capital costs must be developed. Even in the standard approach, computing the CVA for derivatives requires that future sensitivities be simulated at single-trade and portfolio levels. Experience shows that in cases such as these, factors such as accuracy, suitable approximation methods, and IT processing power required must be considered very carefully.

In addition, appropriate methods and applications will be needed to analyse the effect of individual trades quickly and precisely, and this will require the adjustment of the pre-deal checks and capital cost cockpits used. Here too, the increasing significance of portfolio effects will lead to a rise in complexity and the need for a suitable pre-processing concept for intra-day analyses; otherwise, a computation will not be compatible with trading reality.

The situation is exacerbated by the obligation to use front-office models, which means that calculations are continuously becoming more accurate; this requirement is currently prompting many banks to reconsider their existing infrastructures. Shared utilisation of models and IT infrastructure by both the front and the back office is set to increase in the future. At the same time, technical developments such as the increasing use of APIs will lay the foundations for further optimisations in IT infrastructure.

Our services

As a strong partner in all aspects of FRTB, we place our profound expertise in the strategic implementation of regulatory requirements at your disposal, moderating between the stakeholders in risk, treasury, front office and IT.

Our range of services includes:

    • Impact analyses and strategic re-alignment of the front office
    • Analysis of the economic viability of the internal model
    • Design and implementation of the new models in risk management
    • Computation of sensitivities for complex financial instruments (LPACalc)
    • Strategic realignment of IT systems and transformation projects

Would you like to know more?

We will be happy to advise you.

Christian Behm
Christian Behm
Ihr Ansprechpartner für
Risk & Quant Consulting

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Christian Behm
Christian Behm
Ihr Ansprechpartner für
Risk & Quant Consulting
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