Why the FRTB remains critical

Critics of the Basel Committee’s Fundamental Review of the Trading Book are wrong, write John Beckwith and Sanjay Sharma

Golden key: if the FRTB is not implemented, global markets and banking systems will be prone to systemic shocks

As the world approaches the tenth anniversary of Lehman Brothers’ collapse and the ensuing global financial crisis, memories are fading along with the lessons learnt – and the Basel Committee on Banking Supervision (BCBS)’s Fundamental Review of the Trading Book is facing headwinds from many in the industry.

There are two principal arguments for resisting the finalisation and adoption of the FRTB. The first is that regulators and industry have already done enough to mitigate systemic risk, and the FRTB will simply add cost and complexity to an already over-regulated financial industry. The second is that backward-looking regulation, as the FRTB is assumed to be, will not prevent the inherently unknowable drivers of the next crisis. In fact, some purport that positive feedback from comprehensive regulation, combined with hindsight bias, could lead to larger financial bubbles and excesses in the future.

But these arguments do not stand up. Regulations implemented since the 2008 global financial crisis, while laudable, do not address the main legal deficiencies that led to it. If the FRTB is not implemented, global markets and banking systems will be prone to systemic shocks, which will probably stem from identified but unaddressed weaknesses in current market risk frameworks. The FRTB is also a robust, self-correcting, market-based framework for creating stable and enduring trading environments that will persist in the faster, more connected global financial ecosystems of the future.

Criticisms of the FRTB

FRTB sceptics have argued along the following lines:

• Implementation costs are too high;
• It is too complex to implement;
• Excesses in the US housing market that led to the financial crisis have been resolved;
• The FRTB is obsolete and unnecessary because legislative and regulatory developments since the financial crisis have de-risked and simplified bank trading books. Often cited as evidence are Basel 2.5, stress testing, leverage ratios, resolution planning and global systemically important bank (G-Sib) capital buffers.

But these arguments miss a fundamental point: the FRTB is not designed to be simply a new capital calculation engine. Rather, it is designed to transform the measurement and management of trading activities into robust processes that are sensitive to the observability and suitability of risk-factor sensitivities as they change over time. In short, the FRTB, for the first time, incorporates securities-level liquidity into the framework for managing trading risk and its impact on the trading book will be as consequential as Basel II was to the banking capital framework.

Other regulatory developments are not enough

G-Sib buffers, leverage ratios and Basel 2.5 rules principally address bank regulatory capital. But, heading into the 2008 financial crisis, bank capital did not appear to be a weakness. In fact, as late as 2007, it was widely touted as a source of strength.

Table A compares US bank leverage, liquidity risk and size from just after the lending crisis in 2001 to the beginning of the market crisis in 2007. Note that leverage at both large and small banks declined during this period, even while gross assets in the system nearly doubled. The capital adequacy of the banks was not the issue. 

What was the principal contributing factor to the 2008 global financial crisis? It was increasingly illiquid securities held outside of the banking system, funded by short-term borrowings that were backed directly and indirectly by banks. Compare the increase in leverage ratios and short-term funding at brokers and hedge funds to that of banks. As we now know, securities held in the shadow banking system were backed by banks using a variety of off-balance-sheet mechanisms and started to become illiquid in late 2006. Nonetheless, these assets continued to be marked to market, model or myth throughout 2007 and 2008. Many banks temporarily avoided write-downs on illiquid assets by moving instruments from trading books to banking books. Financial participants became wary of the solvency of their counterparties, which ultimately included major regulated banks. 

Increased regulatory capital ratios, or limitations or reformations of specific structures will not avert the next crisis. Innovative traders will create new structures to arbitrage existing rules and market liquidity will inevitably be driven by banks with access to central bank liquidity. Rather, the appropriate lesson is that bank capital deployed against trading book securities must dynamically conform to changes in the observed trading liquidity of these securities.

Global supervisors and central bankers should be given credit for putting in place a myriad of new rules since 2009, which have made the global banking system more secure. Nonetheless, very few of the provisions taken to date address the fundamental challenge of managing liquidity across all asset types and securities. Basel 2.5 does not provide a capital distinction for varying liquidity horizons or unobserved risk factors. Reallocation of instruments between banking and trading remains allowable with relative ease. The FRTB is the only framework that creates a comprehensive, variable system for attributing additional capital to risk factors and instruments as the underlying liquidity in trading assets deteriorates.

Comparing cost of FRTB with fallout from a systemic event

Several studies have estimated the cost of the 2008 global financial crisis, expressed in terms of GDP and employment. According to a summary by the Bank of England, the impact ranged from 1% to 8% of 2010 US GDP. Clearly, the cumulative global impact over time would have been orders of magnitude higher. But even applying the lowest estimate (–1%) to the most recent second-quarter estimate of US GDP ($20.4 trillion) shows that the benefit of avoiding, or even just delaying, the next systemic crisis dwarfs any FRTB implementation costs to the banking industry.  

FRTB versus stress testing

Stress testing is an important tool for prudential supervision, which was not available before the crisis. At the same time, stress testing is cumbersome, costly and limited by the imagination of authorities that will probably not envision every black swan before it appears.

The FRTB framework addresses vulnerabilities built into trading platforms and market systems that still exist today. At its core, the FRTB addresses:

• Diminishing and variable marketability of trading instruments through new frameworks around liquidity horizons, risk-factor observability and non-modellable risk factors;
• The migration of less liquid trading instruments to more banking book loss estimation through the new default risk charge and, for the standardised approach, the residual risk add-on;
• The current ‘all or nothing’ approach to supervisory intervention by instituting a more granular, desk-centric regulatory framework built upon sensitivities at the local level;
• Arbitrage possibilities between banking and trading books by creating a less permeable, more well-prescribed boundary; and
• Misalignment across front-office models and risk models by creating a new framework for P&L attribution and back testing.

Even if the FRTB has a minimal impact on overall capital requirements today, which is the stated goal of the BCBS, the new framework will nonetheless create an environment to capture and capitalise future emerging threats within specific risk factors and securities in real time. The main strength of the FRTB framework, which has not received deserved attention, is that trading constraints become driven by market forces rather than being regulatory measures put into effect after a crisis is under way.

Why the FRTB can be implemented by banks of all sizes

In chapter 11 of our book, The FRTB: Concepts, Implications and Implementation, we outline a 13-step plan in three stages for implementing the FRTB, which can be followed by banks across all geographies and sizes. While the timeframe, resources and cost will vary across banks, we believe the most important aspects of the FRTB’s three levels of implementation can be adopted at a reasonable cost by any bank. Furthermore, we think most banks will find the groundwork required for implementing FRTB – particularly around data integration and model alignment – will become mandatory over the next few years as sales and trading platforms become faster, more automated and more systemically connected. 

John Beckwith and Sanjay Sharma are the authors of The FRTB: Concepts, Implications and Implementation, published by Risk Books. Claim your 30% discount by using code FRTB30 at the checkout.

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• Topics
• Basel Committee on Banking Supervision (BCBS)
• Capital adequacy
• Financial crisis
• FRTB
• Leverage ratio
• Regulation
• Comment