EU lawmakers delay FRTB capital charges

Leaked paper potentially pushes market risk capital charges beyond Basel’s 2022 deadline

European Union legislators have agreed to strip out revamped capital charges for market risk from a review of bank capital rules, introducing only a reporting requirement initially. The decision potentially delays full implementation beyond the 2022 deadline set by the Basel Committee, and could well dampen banks’ preparation efforts.

“There is a provisional agreement on the approach that essentially introduces reporting requirements before the FRTB [Fundamental Review of the Trading Book] becomes capital-binding for banks,” says an industry source. “It is a way forward trying to come up with the appropriate process in the next couple of years to ensure consistency and alignment with the Basel Committee on Banking Supervision standards.”

In December 2017, the Basel Committee postponed implementation of the FRTB from 2019 to 2022. However, Basel’s announcement in March 2018 of revisions to key parts of the FRTB – which sources expect to be completed in January 2019 – put the EU in an awkward position. Midway through transposing the FRTB into bank capital laws known as the capital requirements regulation (CRR), EU legislators risked implementing an outdated version of the FRTB, or introducing new rules that were still under consideration at Basel and lacked a full impact assessment.

In a leaked document seen by Risk.net outlining a “political agreement” between the three legislative bodies – the European Commission, Council of the EU and European Parliament – following trilogue negotiations, capital charges have been dropped from the revised CRR (known as CRR II).

The agreement sets out that EU banks will at first only report the results of the methods used to calculate capital under the revised FRTB: the sensitivities-based approach (SBA) and internal models approach (IMA). Data from those reporting requirements can then be used to convert them into capital charges during a future review of CRR – already dubbed CRR III by bankers – for which the EC must submit draft proposals by June 30, 2020.

The political agreement was endorsed by the council in a meeting on December 4, but trilogues will continue on the package to finalise technical details in CRR II to ensure the political agreement translates the highly complex requirements accurately into law.

The compromise means it will be a long time before FRTB capital charges see the light of day in Europe. CRR III will be a colossal package of reforms, implementing international standards on operational risk and a new standardised output floor on the minimum amount of capital banks must hold when using internal models.

It will also be more politically charged than CRR II because it alters capital requirements for economically crucial credit products such as mortgages and corporate loans, and will hit different EU member states disproportionately depending on local market characteristics. Nordic and Dutch banks have already berated the output floor’s treatment of mortgages as unfairly penalising their business models.

How long it takes for the FRTB to become capital requirements will really depend on how the new EC tees up the next CRR

Jouni Aaltonen, Association for Financial Markets in Europe

“How long it takes for the FRTB to become capital requirements will really depend on how the new EC tees up the next CRR,” says Jouni Aaltonen, a director at the Association for Financial Markets in Europe. “It is going to be a much larger package and is already politically contentious on credit risk. They could fast-track the FRTB and convert the reporting requirement to a capital requirement at the same time as the internal models reporting goes live, but that depends on how important the parliament, council and commission finds [it] keeping to the Basel Committee’s deadline.”

Sources say the IMA reporting requirements are likely to enter into force at the end of 2022 (see box: Two waves of reporting), which would still miss the Basel Committee’s deadline for jurisdictions to transpose the FRTB by January 2022. But a delay of months is better than years. Amir Kia, a managing director at consultancy Newedge Capital Advisory, does not expect banks to capitalise market risks under the FRTB until at least five years from now, while one source previously suggested the capital charges might not come into force until 2025 if implemented with the rest of CRR III.

Ditch the backstop

Before trilogue negotiations, parliament had called for the FRTB to be implemented as a capital charge on January 2022, in line with the Basel schedule. There had been fears its version of CRR II risked implementing elements of the old FRTB, as it didn’t lay out a method to alter the rules in line with the revised Basel version.

One industry source does not believe that was ever parliament’s intention. Instead, the deadline was set in order to provide a backstop that would ensure the EU met the Basel Committee’s deadline, and the plan was always to make the appropriate technical changes before full implementation.

“I don’t think parliament requiring implementation of the old FRTB was ever a real scenario,” says the industry source. “Everybody around the table agreed Europe shouldn’t implement an outdated version of the FRTB. The parliament proposal was more of a political stance that they were committed to the timeline announced by the Basel Committee. It didn’t set out how the new FRTB would be implemented but it was more of a general approach.”

But the parliament’s backstop has not made the final cut at the trilogue stage. “Given the Basel text is not out yet, it would have been unreasonable to expect the EU to do more than put in some practicable timelines,” says a capital manager at a UK bank.

Three sources expect the Basel Committee to publish its final standard in January 2019, and CRR II to be finalised in May at the latest. With the added time contained in the trilogue compromise, the EU will be able to assess the revised FRTB’s impact on European banks before converting it into capital charges.

The whole regulatory agenda and FRTB has lost its momentum in the past two years

Amir Kia, Newedge Capital Advisory

But two sources believe the delay is designed partly to leave the door open for the EU to never convert FRTB into capital charges, if the US does not do so either.

“It is still unclear whether the US will implement FRTB,” says a senior market risk manager at a European bank. “The EU are waiting to see what the Federal Reserve is going to do. My understanding is they [EU legislators] want to keep the option to never implement the advanced models [in the revised FRTB, if the US doesn’t].”

The election of Donald Trump as US president has left European policy-makers doubting the country’s commitment to the FRTB, although US officials have dismissed those concerns as unfounded.

“The EU’s agreement is putting a question mark against the whole FRTB programme,” says Kia of Newedge Capital Advisory. “The whole regulatory agenda and FRTB has lost its momentum in the past two years, due partly to Donald Trump coming to power. This basically says Europe is not going to follow until somebody else will. With this appetite for the new regulation, I don’t see these rules will go live any time soon.”

If the EU were the only jurisdiction to implement the FRTB, Kia warns banks would shift trading activity outside of the bloc to avoid higher capital requirements.

“With the current administration in the US, you never know what is going to happen,” says the senior market risk manager at a European bank. “If at the last moment [before the EU implements the new FRTB] they [US lawmakers] decide to stay on the [old] measure, the Europeans want the same option.”

Time to relax?

The delays in implementation deadlines and planned revisions to both the SBA and the IMA have prompted banks to shrink FRTB implementation projects.

“A trend we have seen in the market for the past six months or so is the reduction in budgets for the FRTB projects,” says Kia. “There is not a specific deadline [when] these things go live, so if you don’t have a deadline there is little incentive to invest immediately. I don’t expect people will shut down the project completely but the teams working on the project will remain small.”

The senior market risk manager at a European bank says it has been prioritising the implementation of the SBA: “We are aiming to complete the SBA soon. I know we have to wait for the EC’s legislation [and final text from Basel] but I don’t expect the text to change much compared to the [March 2018] consultation from the Basel Committee.”

Kia agrees SBA reporting is likely to be a priority for most banks, but there are still elements of the IMA that are being worked on now – specifically, efforts to prove risk factors are modellable.

Under the IMA, banks must apply a capital surcharge to non-modellable risk factors (NMRFs). Risk factors must have 24 price observations a year separated by no more than one month to avoid becoming NMRFs.

Banks and vendors have been gathering data from internal and external sources to help meet the threshold and so avoid the punitive capital surcharge. By concentrating on further developing those pools, banks will be more prepared for the IMA charge and should ease their eventual capital requirement, especially if firms can show supervisors a long set of back-data on risk factors.

“Data pools are a good source of data for the bank. If five years down the line FRTB comes into force, the banks will already have a lot of data for their non-modellable risk factors,” says Kia. “That part of the FRTB program won’t go away.”

Two waves of reporting

Under the political agreement, European banks will start reporting the results of the Basel Committee’s new standardised and IMA capital requirements in two phases to their local regulators.

EU banks will report the results of the SBA on all of their trading desks to local supervisors one year after the EC adopts technical standards that will revise the CRR II text to incorporate the Basel Committee’s revisions to FRTB. The compromise text instructs the EC to do this by December 2019, and sources expect the start date for reporting on the SBA to be December 2020.

Before reporting begins under the IMA approach, the European Banking Authority must first write four regulatory technical standards laying out the IMA within nine months of CRR II taking effect. Those will then have to be adopted by the EC, but no date has been set for that to occur. Banks will begin reporting IMA for those trading desks that have supervisory approval for their models within three years of the EC approving the EBA’s regulatory technical standards.

Jouni Aaltonen at the Association for Financial Markets in Europe expects reporting on IMA to begin at the end of 2022, while a senior market risk manager at a European bank expects banks to begin reporting on the IMA by 2023.

Editing by Philip Alexander

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• Topics
• Basel Committee on Banking Supervision (BCBS)
• Capital Requirements Directive (CRD)
• Council of the European Union
• Europe
• European Banking Authority (EBA)
• European Commission (EC)
• European Parliament
• FRTB
• Internal models approach (IMA)
• Market risk
• Non-modellable risk factors (NMRF)
• Sensitivities-based approach (SBA)
• Trading book
• Regulation