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:
- 1. The Trading Book and Banking Book Boundary
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.
- 2. Treatment of Credit
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:
- Securitization Exposure: Instead of allowing banks to use their “Internal Models” approach, the committee will require banks to use a “Revised Standardized Approach”. This will also be applicable to “Correlation Trading activities” in the trading
- Non-Securitization exposures: To justify the Non Securitized products to match the right capital requirements (taking into account the default risk and spread risk), the committee has proposed a separate incremental default charge (IDR), that will
increase the capital requirements for the trading books.
- Credit Valuation Adjustments (CVA) charges: Basel III had introduced the concept of CVA for including the counterparty credit risk valuation. The BIS Committee has proposed that the CVA will be kept separate from the Market Risk calculations for
now, and the two will be calculated separately.
- 3. Approach to Risk Management
- Stressed Calibration: The capital framework will be calibrated to a stressed market condition time frame.
- Move from “VaR” to “Expected Shortfall”: Current VaR does not capture the tail risk. The new FRTB rules proposes to capture the average of the expected risk in the tail, with a 97.5 percentile confidence interval. This is the expected VaR, which
will become the norm.
- 4. A Comprehensive incorporation of the Risk of Market Illiquidity
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.
- 5. Treatment of Hedging and Diversification
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:
- For “Internal Models based approach”, the diversification effects will be recognized with some constraints
- For the “revised Standardized approach”, the recognition of hedging and diversification will be significantly increased relative to the current approach
- 6. Relationship between internal models-based and standardized approaches
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:
- Establish the link between capital calculated by the two approaches
- Require mandatory calculation of capital using standardized approach by the banks
- Making the Standardized Capital as the floor for the capital requirements or introduce a surcharge on the models based approach.
- 7. Revised Models based approach
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:
- Break the Model approval process into smaller steps
- Set of quantitative tools to measure the performance of models. First, a P&L attribution process that 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
for reconciling forecasted losses with actual losses. Where a trading desk fails these tests, the bank would be required to calculate capital requirements for that desk using the standardized approach.
- Limit diversification benefits, move to an ES metric and require calibration to periods of market stress that are particularly relevant to banks’ own portfolios.
- 8. Revised Standardized approach
Revised Standardized approach must exhibit the three attributes:
- First, it must provide a method for calculating capital requirements for banks with business models that do not require a more sophisticated measurement of market risk.
- Second, it should provide a credible fall-back in the event that a bank’s revised market risk framework (FRTB) internal market risk model is deemed inadequate, including its potential use as a surcharge or floor to an internal models-based capital charge.
- Lastly, the approach should facilitate transparent, consistent and comparable reporting of market risk across banks and jurisdictions
- 9. Where are we heading next
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.
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