Determining approaches to FRTB: weighing up the capital efficiencies

FRTB implementation: spotlight 2023

The Fundamental Review of the Trading Book (FRTB) will begin replacing existing rules for market risk capital in major financial jurisdictions from 2024, with the US and Europe targeting 2025 as the compliance date. FRTB is intended to be more flexible and to better capture the risk of a bank’s portfolio of trading book positions, but it introduces significant technical and operational challenges for banks on the path to compliance.

Approval for the internal model approach (IMA) depends on passing backtesting requirements and the profit-and-loss attribution (PLA) test. If banks are unable to pass this test, they must use the regulator-set sensitivities-based approach (SBA) as part of the standardised approach (SA), which usually results in higher capital requirements. However, bank simulations suggest the IMA tests will be difficult to pass, prompting fears many trading desks will end up using the SBA by default.

Even when desks qualify for the IMA, some risk factors may be deemed non-modellable (NMRFs), which results in capital add-ons. Banks therefore need to source sufficient transaction data to prove that risk factors can be modelled adequately, which can be very costly. Furthermore, banks are trying to implement their models against a backdrop of regulatory uncertainty and fragmented timelines which is making it much more difficult to seek IMA approval.

Participants must also navigate various pitfalls arising from jurisdictional differences. For example, the new FRTB credit valuation adjustment provides market risk carve-outs for hedges of counterparty credit risk exposures. However, European rules provide no such mitigant for the hedging of funding valuation adjustments, which could result in higher capital charges for dealers.

Industry experts discuss these issues and the considerations for banks in using the SA and the IMA, the burden of investment into data and infrastructure for both, and how vendors are adapting solutions to weigh up the capital efficiencies of both approaches, as well as strategies and tools for PLA and risk factor eligibility tests.

Their views indicate that many banks are aiming to implement the SA first and leave decisions about applying for IMA approval applications until they have built up their capabilities. Some banks are unsure there is a justifiable business case in applying for the IMA. Others want to assess the viability of the IMA for each desk. Vendors are positioning themselves to help banks compare the capital requirements from both methodologies.

Successful implementation of the IMA should allow banks to allocate capital more efficiently. Banks and vendors are trying a plethora of modelling and data tools and strategies to pass the PLA tests and reduce the number of NMRFs but, ultimately, the capital savings might not justify the significant investment in data and infrastructure. Many of these challenges have already been resolved for the SA or are being alleviated; however, the IMA is likely to remain a problematical area in the coming years.

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