FRTB – Getting the fundamentals in place

It’s Sunday March 8, 2020, the eve of one of one of the wildest weeks of trading in modern financial markets. The chief risk officer (CRO) of a large regional bank has an idea of what’s in store, after a deal between major oil producing nations to bolster slumping crude prices amid fears of looming final Armageddon from Covid-19 collapsed in acrimony on Friday evening, prompting a working weekend of sleepless nights.

The lender is a sizable one, with a sophisticated markets business; most of its trading desks have opted to model their own market risk capital requirements under the Fundamental review of the trading book (FRTB), which entered force on schedule in 2019, rather than relying on regulator-set standardised approaches.

But the CRO is nervous. The bank is still getting used to the operational mechanics of the new regime: running and passing the backtests required to maintain approval to use internal models, which give its regulator the comfort the bank can accurately gauge the risks it faces; reliably pulling the right data from trusted sources in a timely manner in order to feed the model engine; and marshalling the army of validators and risk managers charged with overseeing the new setup – and the quants, traders and desk managers who make the whole thing work – ensuring everything performs as its supposed to.

With volatility relatively benign since the regime entered force, the new setup has yet to be tested in anger; the bank also chose not to join any industry-wide data pooling services designed to help firms source prices which can serve as model inputs for hard-to-value trades, instead banding together with local peers to share data on the main markets it operates in. It is also seeking several new model risk chiefs, with many of its best quants who helped the bank get set for FRTB and know its systems inside out since poached by larger players.

Fast forward to the end of April, and every market the bank operates in from equities to agricultural commodities is crashing and whipsawing. The firm has suffered more than 30 backtesting exceptions, sending its trading desks crashing out of eligibility to model their own capital requirements, and forcing it on to the static grid-based approach, with pre-defined risk weights for different asset classes – almost all of them higher – forcing them to jettison positions and sell inventory into a firestorm, right at the moment clients most needed them to act as a market maker.

The capital relief its local regulator is offering as a makeweight in the interim after the loss of IMA approval is time-limited, and the bank will soon see requirements balloon to the point where making markets on even vanilla products is uneconomic, worsening the ongoing liquidity slump seen since the advent of Covid, and leaving markets exposed to further extreme bouts of volatility in the event of further outbreaks.

Welcome to a future alternate reality, in which FRTB entered force in time for the current Covid crisis, but few banks were properly ready for it.

The sole saving grace for the CRO is that, in part by forcing capital higher to begin with, FRTB would have nixed some of the procyclical effects of the previous market risk capital regime – the consequence of a double-counting effect that persists between two measures of trading book risk contained the previous regimes under Basel II and 2.5 – but most market risk experts suggest that wouldn’t be enough to negate the attendant jump in requirements that will come with an enforced switch back to the standardised approach.

Throughout FRTB’s troubled gestation, regulators were warned that making the internal models approach too operationally complex and capital-intensive would mean few outside the biggest banks wanted to use it – with the potentially dire consequence that all mid-sized and even some larger banks would wind up focussing liquidity provision solely on liquid benchmarks – leaving them all exposed to the same risks and underlyings when asset prices collapse.

Many warned at the time that such flaws were a consequence of an aggressive timetable when writing the rules, and would lead to suboptimal outcomes – and so it proved. FRTB’s initial timetable proved unworkably optimistic; it was hived off from the rest of Basel III; then cracked open and rewritten under a new Market Risk Group led by the Bank of England’s Derek Nesbitt, under whom banks report having earned a fairer hearing for their concerns.

Already, the start of the new regime had been pushed back to 2022; with final implementation now delayed to 2023 along with the rest of Basel III as a consequence of Covid, gauging the final impact remains a way off – and even then, its true cost will not become clear till it gets a thorough road-test in the next market meltdown.