When the Basel Committee on Banking Supervision completed its Fundamental review of the trading book (FRTB) in January 2016, the hard work began for the banks. In practice, the final rules for each jurisdiction have yet to be drafted, and there are still many fine points that need clarifying to facilitate implementation.
At the time of writing, the industry is waiting on a frequently asked questions (FAQ) document from the Basel Committee to provide some of that clarification. Even a brief and incomplete list of questions is daunting. Most important is the profit-and-loss (P&L) attribution test, which decides whether banks can use their own internal models to calculate market risk, or whether they must revert to the regulator-prescribed sensitivity-based approach (SBA). Industry studies suggest the SBA will lead to a capital charge 2–6.2 times higher than the internal models method. Yet the final FRTB standards presented two different ways of carrying out the P&L attribution test, and banks need to know which one will apply.
Further questions surround the concept of immaterial risks mentioned in FRTB. Banks face a capital add-on for any risks they are unable to model due to lack of data. Often those risks are a very small part of the bank’s trading book to which they are rarely exposed – hence the lack of data. So banks are hoping that an exemption from calculating capital requirements for risks deemed immaterial could reduce the size of the capital add-ons. But again, the Basel FAQ may shed more light on whether this is acceptable.
Even the raw materials for calculating market risk capital – market prices – are in question. FRTB requires banks to input ‘committed quotes’ into their risk models but, as yet, there is no firm definition of what qualifies as a committed quote.
This question shows how FRTB may extend the reach of prudential regulation beyond the banks themselves. Dealers typically source much of their market risk data from third-party vendors. The cost to the bank if data proves unreliable – potentially, the loss of approval for internal model use and the resulting increase in capital requirements – could be substantial.
Vendors are already responding to the challenge and looking to work with clients to ensure a level of data integrity that can pass muster with supervisors. There are also initiatives to pool market risk data among banks, but these must overcome dealers’ natural concerns over sharing proprietary and market-sensitive data with competitors.
The systems needs, even for the standardised SBA, are particularly burdensome for smaller players. The European Commission has consulted on whether to apply FRTB at all to banks with limited trading desk operations, and industry associations report similar concerns among investment banks in emerging markets.
This may prompt smaller players to hesitate before beginning FRTB implementation projects. But with the Basel standards due to enter into force from the beginning of 2019, no-one can afford to wait too long to start their preparations. As several of the contributors to this report outline, the scale of the transformation is considerable. Alongside the trading desks themselves, risk, finance and technology divisions will all be drawn into the mix. Even if we do not yet know every minute detail of the final regulations, banks will need to identify today the tasks they must perform – and the resources required to perform them – to be ready for 2019.