Fund-linked structured products face extinction under FRTB

Global market risk capital standards carry sky-high charges for fund derivatives

A few years from now, trading book capital standards threaten to do to fund-linked structured products what humans did to the dodo more than three centuries ago: wipe them out. And just as extinctions in the natural world tend to affect other animal and plant species, banks warn they will not be the only ones feeling the pain.

“The way the FRTB is written, the consequence will be to kill the business,” says a senior equity derivatives trader at a European bank. Three other industry sources make the same point.

In simple terms, it comes down to the difficulty of using one of the two allowed methods for calculating the amount of market risk capital a bank needs to cover its exposure to funds – the internal models approach (IMA). The alternative, sensitivities-based approach (SBA) then becomes the only option but it typically leads to much higher capital charges than those produced both by the IMA and existing, Basel 2.5 rules.

The contrast with today’s capital levels is particularly stark: in some cases, the SBA will force banks to hold 75 times more in risk-weighted assets (RWAs) for their fund exposure than now.

The IMA is out of reach mostly because banks do not have access to the kind of regularly updated information on funds that the method requires – in the FRTB jargon, they are not able to “look through” to funds’ underlying assets and work out capital charges as if the positions were held directly by the banks. The advent of the FRTB from 2023 is unlikely to change that.

Shoehorned into the SBA, banks may well abandon most of the products, which offer clients gains and losses linked to the underlying fund’s moves. Fund derivatives with a capital guarantee or protection against a specified level of losses are most at risk. If they disappear, retail investors will have to content themselves with surviving products that provide no protections or invest directly into funds and bear all the risks. Others will stop investing into funds altogether.

“All the actors will be impacted by banks leaving this business,” says the equity derivatives trader. “The clients will not be able to access the products anymore and the funds will not be able to reach those clients.”

But this species of product could still be saved, banks say. They suggest two possible changes to the FRTB: one is to automatically allow dealers to model their capital requirements for exposure to certain well-run funds and the other is to lower the RWAs spewed out by the SBA, by treating funds more like index products.       

Closely guarded secrets

The Basel Committee on Banking Supervision published the final version of what is known in full as the Fundamental Review of the Trading Book in January this year and gave local regulators till January 2022 to implement the standards through national legislation. Though still behind that schedule, the European Union is the furthest ahead in the process, with the FRTB’s capital requirements likely to come into force in 2023. Other jurisdictions are yet to draft their own regulation.

For banks, the danger is that local regulators will preserve the Basel Committee’s strict conditions for using the IMA. First, dealers must be able to allocate equity investments in funds to the trading book, rather than the banking book which produces much higher capital charges. There are two routes into the trading book: a bank must either regularly receive information on a fund’s individual components or have access to daily price quotes for the fund and to the details contained in the fund’s mandate.

Banks say the first, look-through route is tricky. That is because they receive the necessary information too infrequently for all funds apart from exchange-traded funds. What frequency the FRTB requires is actually a mystery because the latest version simply calls for “sufficient and frequent information”. The previous, 2016 iteration of the standards mandated a daily look-through.

Risk.net asked the Basel Committee how often banks must receive updates but the committee did not respond.  

Sources at three European banks think they will still need the information daily. A senior risk manager at a fourth European bank and Jouni Aaltonen from the Association of Financial Markets in Europe (Afme) disagree, saying the minimum frequency is unclear but is unlikely to be daily. And Samuel Chesnel, partner at financial consultancy Axis Alternatives, gives an approximate range. 

“There is a general feeling among banks that monthly is likely not enough,” he says. “So you need somewhere between daily and monthly information to be able to use the look-through, but it is hard to tell at the moment where supervisors will eventually set the cursor.”

How does all this compare to banks’ current access to the information?

The senior risk manager at the fourth bank says the firm can obtain monthly updates on funds’ composition, albeit with a delay, and in some cases weekly updates are available if the bank has a good relationship with the fund manager.

Sources at the other three banks that spoke to Risk.net for this article say they receive the information less often than monthly and also with a delay.  

You need somewhere between daily and monthly information to be able to use the look-through, but it is hard to tell at the moment where supervisors will eventually set the cursor

Samuel Chesnel, Axis Alternatives

The lack of clarity in the FRTB text could be deliberate, aimed at nudging banks to pressure asset and fund managers to disclose composition details as often as they can.

“Daily is not obtainable and we let the Basel Committee know that,” says the senior risk manager at the fourth bank. “The Basel Committee removed it without writing anything else, and my assumption would be that they are waiting to see how asset managers’ business evolves the closer the FRTB gets, so in case asset managers post the composition of their funds more frequently. Two years down the line they might allow us to have it weekly if asset managers publish information that frequently.”

If a bank cannot look through to a fund’s assets often enough, it will still be able to allocate its investments to the trading book, via the second, easier route: if it has access to daily price quotes for the fund and to its mandate. But no look-through ability also means no IMA because, if the bank is in the dark, it must use the SBA to calculate capital charges for the fund.

Four months have passed since the FRTB was finalised but there are few signs funds are becoming more willing to reveal their breakdown in sufficient detail and regularly enough to help out their bank investors.    

“We have started this discussion with some asset managers and we know it is going to be super-difficult to get,” says the senior equity derivatives trader at the first bank. “They just don’t want to hear about it.”

Fund and asset managers have an interest in playing ball because otherwise banks may no longer be able to offer derivative products linked to their funds. However, the counter-argument is that such cooperation may harm their competitive position.

For instance, banks sometimes offer structured products that mimic a fund but without making any investment in the fund. A fund may fear that, if a bank knows its exact composition, it will stop investing in the fund and just offer its own product replicating the fund’s positions. 

Many funds are also bound by a commitment to treat all unit holders equally. So if they start becoming more transparent with banks, they will have to do the same for other investors, which could include direct competitors such as funds of funds.

If, despite all the hurdles, a bank is able to demonstrate sufficient look-through to qualify for internal modelling, to hold onto this right it must pass the so-called profit and loss (P&L) attribution test on an ongoing basis.

Seen by many as the hardest FRTB provision to implement, the P&L test has required banks to build new systems and make other preparations – heavy work many firms are still doing. Few if any banks have run the test on real portfolios and are therefore unsure whether they will pass it in practice.

Death by capital

Banks barred from modelling then fall into the clutches of the standardised SBA.  

“That creates a much bigger capital impact for the banks … and makes a lot of this [fund] activity unviable from an economic perspective because it becomes so expensive,” says Aaltonen, who focuses on prudential regulation at Afme.

Jouni Aaltonen

He cites one of two ways banks can apply the SBA to investments in any funds that do not closely track an index benchmark. In this application, a bank must treat such an investment as an unrated equity exposure, which attracts a steep 70% risk weight. For comparison, this is the same risk weight required for exposure to a small firm in an emerging market.

Banks argue 70% is far too high.

“Funds are extremely diversified, so it would be as if the thousand names that are part of the fund all lost 70% of their value simultaneously,” says the senior risk manager. “A 70% loss in value – you are talking about junk equity, an emerging market and high-volatility single name. This is not what we are talking about and here it is saying that a thousand names are losing 70% of their value simultaneously. It doesn’t happen.”

At his bank, such treatment would lead to fund portfolios attracting 21 times more capital than today. “We cannot sustain 21 times more RWAs for this business,” he says. “That will kill the business – simple as that.”

His bank is already responding to the looming rules. The firm plans a gradual repricing of new fund products as FRTB implementation nears and he warns that the eventual prices, once the rules are in force, may be too high to sustain the market. Other European banks are doing the same, while some have also stopped offering products that expire after 2023.  

The first bank found an even bigger increase in capital for the business: 75 times its current level.

The magnitude of the SBA’s effect on capital levels depends partly on the product, with options hit particularly hard. For instance, a senior trader at the second European bank found that some at-the-money options will carry a 50% risk weight under the first SBA method.

“On an option on a fund sold to clients and due to the magnitude of the shocks applied, we end up assigning RWAs equivalent to something close to 100% of the delta,” says the senior trader, referring to the sensitivity of an option price to the price of the underlying asset. “So if you have an at-the-money option with a delta of 50%, you end up with 50% RWA on that. It is harsh when you look at it in economic terms.”

The capital hike is amplified for options due to the curvature charge, which accounts for any changes in the value of the option caused by factors other than changes in the value of the underlying, known as convexity.

The second method of calculating capital under the SBA requires banks to assume that the fund is invested to the maximum extent allowed under its mandate in those assets that attract the highest capital charge, and then progressively in assets that imply lower risk weights.

Take, for example, a mandate stating that the fund manager can invest up to 60% of the fund in emerging market equities, while keeping at least 2% in cash to make repayments. The exposed bank must then assume that 60% of the fund is indeed allocated to emerging market stocks, 38% to safer assets, and 2% is held in cash.

This approach, which is subject to approval by the bank’s local supervisor, is only marginally less punitive than the first SBA method and does not reflect how funds invest their money in practice, banks say.

“A lot of asset managers want to give themselves optionality in terms of asset managing,” says the senior trader at the second European bank. “They don’t want to be bound by a very restrictive prospectus and so they usually allow themselves to add up to 70% sectoral concentration. When you look at that and take the worst possible allocation, you end up with very similar numbers.”

He adds that funds’ monthly factsheets on their sectoral and geographical breakdown show they do not tend to concentrate too much on a single sector even if their mandate allows that.

“We went through a few of our fund exposures… For example, we could see 20% of industrial, 30% of energy, 10% of software and so on. Putting concentration in the highest risk weight at 70% is too punitive.”

Adding further to the RWA increase under both SBA methods is a ban on the netting of fund exposures in banks’ portfolios against each other, meaning dealers can no longer rely on diversification between different funds. This also means any hedges are not recognised.

Banks also have to begin accounting for the risk of a sudden default by obligors in both bond and equity funds, whereas currently they capitalise the risk only for bond funds.

For funds that track indexes, a third SBA method is available, allowing banks to use the much lower risk weights mandated for indexes – as long as the difference between the annualised returns of the fund and of the index in the previous 12 months is less than 1% and is checked annually. 

A farewell to funds

Unless fund and asset managers suddenly open up, giving banks the look-through they crave to be able to model fund exposures, banks say they will have to stop offering most fund derivatives, losing a significant revenue stream.

One bank says fund-backed structured products contribute up to 10% of the revenues generated by the firm’s markets business.

The business line has an additional advantage of providing stable returns.

“It is usually low-risk returns,” says the senior equity derivatives trader at the first bank. “It provides diversifying returns with other activities. We have flow activities [on which] returns can be super-volatile, and funds are not volatile.”

To save the products, which serve a purpose not just for banks but also for funds and retail investors, banks have suggested two changes to the trading book capital standards.

One is to automatically allow banks to use the IMA for Europe’s Undertakings for Collective Investments in Transferrable Securities offered by asset or fund managers with large amounts of assets under management. Ucits have to meet certain compliance requirements and are designed to be sold to retail investors.

Due to the high governance standards Ucits must meet, it is enough to trust the management of the fund, says the senior trader at the second bank.

“We are not talking about funds that have been created last week by an unknown start-up. Ucits are managed by strong asset managers that have history in managing funds well,” the person says. “We always have the daily net asset value and we have sectoral information and the main holdings of the fund at least on a monthly basis.”

He argues banks should be allowed to capitalise exposure to Ucits at least in part under the IMA – “at least for the expected shortfall and potentially non-modellable risk factors on some implied parameters” – although they should still use the default risk charge outlined in the SBA because the IMA’s version requires a deeper insight into funds.  

You can make the argument that funds are even more diversified than indexes because they contain many more names

Senior risk manager at a European bank

Alternatively, the trader would like “a less punitive SBA” for Ucits. Other dealers expand on this suggestion, calling for the method to be relaxed for all funds, especially since banks can be easily forced back onto it – if, for example, they fail the P&L attribution test.

These people say banks should be allowed to use the index risk weights for all funds. The weights are set at 15% for indexes with a large market capitalisation and based on companies in advanced economies and 25% for all other indexes.

“You can make the argument that funds are even more diversified than indexes because they contain many more names,” says the senior risk manager at the fourth bank.

But whether rule-makers will offer any reprieve is in doubt.

“The [Basel] regulators have been clear that these are the final rules and that banks should consider their implementation plans,” says an industry source.

 

Who needs look-through anyway?

Up to a point, banks understand the Basel Committee’s rationale for introducing a strict look-through condition for the IMA.

“From regulators’ perspective, they want banks to know what is the underlying of these positions,” says an industry source. “Therefore, by insisting on firms booking the position as if they own the underlying risks puts the emphasis on firms having a proper understanding of the risks of the fund.”

A senior risk manager at a European bank agrees, noting that during the global financial crisis the underlying loans of mortgage-backed securities were rated AAA but in reality many debtors were not in a position to pay off their mortgages.

Requiring banks to have granular information on funds and imposing steep capital requirements on them if they don’t should discourage the behaviour that led to the crisis.

But banks argue this narrative is not relevant for funds as far more public information is available on individual companies than on individual mortgage debtors.

“There is quite a difference between mortgages, securitised mortgages and equity funds,” says the senior risk manager. “We know what funds invest in because we have regular reports and we see exactly how they evolve in time. It is not at daily or monthly frequencies but we see what is in there and additionally we see that it is very well-diversified. We know there are thousands of different names in there. It is not just the mortgages of a certain county in Louisiana.”

Banks receive prospectuses outlining the mandate of the fund but also monthly factsheets detailing the fund’s sectoral breakdown.

Many of the funds that underlie the products offered by European banks are also in Ucits, which have to comply with stringent regulatory requirements and are seen as safe investments.

Even if a bank is able to look through to the fund and use the IMA, its troubles won’t stop there. The FRTB text states that the bank must, in this case, treat the fund “as if the underlying positions were held directly by the bank”.

“One interpretation of the rules is that banks have to simulate the risks of these positions at a granular level in their risk management systems, and although there are different interpretations, it is perceived by some as a high bar to achieve,” says an industry source.

The senior risk manager takes this interpretation, saying each risk factor in the fund will have to be included in the bank’s profit and loss systems and the bank will have to prove it has enough information to model each risk. If a risk factor is found to be non-modellable, then it must be capitalised using a stressed capital add-on.

“For our bank, we are looking at managing up to 20,000 risk factors on our balance sheet, barring funds. Including funds in the way the Basel Committee wants could easily add another 10,000–15,000 risk factors. This is very difficult to handle from an operational viewpoint and a disproportionate effort to compute.”

For pure equity funds it could be relatively simple as the bank is likely to have information on the single-name equities. But the burden becomes much heavier if the fund then begins to invest in derivatives and in other funds. The bank would have to get granular information on the characteristics of those derivatives – something funds won’t want to hand over – and breakdown of the sub-invested fund – information third-party managers also won’t want to hand over.

Editing by Olesya Dmitracova