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Remember those days when we saw Lehman employees walking out with their personal stuff in cardboard boxes, the manhandling of AIG employees in New York, the demonstrations at Wall Street and Zuccotti Park (New York), and the $ 1 trillion bailout fund that the Congress initially refused to approve?
Yes, to avoid similar situations, the BIS (Basel Committee on Banking Supervision) has been working with regulators globally to come up with prudent capital guidelines, which will allow banks to have sufficient capital to withstand the long stressed market conditions, and still be solvent and not require a government bailout.
The BIS Committee released the first consultative paper in May 2012. The latest deadline for receiving the feedback from the industry was February 20, 2015. After having received extensive feedback from regulators and market participants, the committee has set forth a detailed proposal for reforming the trading book regime.
Key Areas of FRTB Focus:
So far, the banks have been deciding if a book was a trading book or a banking book, and there was an incentive to arbitrage from this determination, as there was a difference in the capital requirements for these books.
The BIS Committee has recommended stricter guidelines for banks to switch from a banking book to a trading book and vice versa. They have also tried to close the loop hole in the capital differential, in the event where switching is permitted. The BIS Committee is calling this as the “revised boundary”, where in FRTB guidelines will focus on reducing the arbitrage, rather than asking for the quantitative justification of including a book in the trading book.
Since the Credit Related products were the main source of losses during the 2009 financial crisis, the BIS Committee has agreed to bring the trading book requirements closer to the banking book. In addition, the Securitized and non-securitized products will be treated differently. Three main points that should be looked at are:
A liquidity horizon is defined as “the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions”.
Under Basel 2.5, a “liquidity Horizon” was introduced, that formed the input to the Incremental Risk Charge (IRC) and the Comprehensive Risk Measure (CRM)
Under FRTB (so called Basel IV FRTB), Banks’ risk factors will be assigned five liquidity horizon categories, ranging from 10 days to one year. To ensure consistency in capital outcomes, and in balancing the trade-off between simplicity and risk sensitivity.
Trading books benefit in Capital reduction by hedging their portfolios and by incorporating diversification in their portfolios. However, in times of stress, diversification benefits go away and the Spread risk increases for the hedging, leading to huge lossed that have not been incorporated in the capital calculation. To mitigate this risk, FRTB regulation proposed the following two main changes:
From empirical evidence, it has become clear that there is a very large difference in capital calculation by banks when they use the internal models vs. standardized approaches. The BIS is trying to bridge this gap and working on proposals that will bring the models based calculation closer to the standardized approach calculations by recommending the following three steps:
The Basel recommendations of 1996 of calculating the Credit Risk or Market Liquidity Risk over a 10 day period proved insufficient during the stressed period of 2009. Keeping this in mind, FRTB proposes the following:
Revised Standardized approach must exhibit the three attributes:
Banks have started looking at FRTB requirements and how it will affect their capital. A lot of changes will come at the Trading Desk level, where they will have to certify their models and how well these models capture the daily P&L. Secondly, the desks will have to reconcile between their forecasted losses vs. the actual losses. We can expect to see a lot of models changes and technology/ data and support services changes at all the trading desks. Basel IV implementation may be a bonanza time for the Risk Consulting and IT Consulting firms over the next three years.
The article is also available at the link: http://iconvexity.com/what-does-frtb-or-fundamental-review-of-trading-book-really-mean
This content is provided by an external author without editing by Finextra. It expresses the views and opinions of the author.
Ellison Anne Williams CEO at Enveil
30 October
Damien Dugauquier Co-Founder & CEO at iPiD
Kyrylo Reitor Chief Marketing Officer at International Fintech Business
Prashant Bhardwaj Innovation Manager at Crif
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