G-Sibs eye simpler market risk calculations in Hong Kong

HKMA may need to ease rules on NMRFs to incentivise use of internal models

Global banks in Hong Kong are treading a fine line in seeking a simplified standardised approach to calculating market risk capital for their trading books – and avoiding the use of internal models because of limited potential cost savings for local subsidiaries.

But the Hong Kong Monetary Authority (HKMA) may not be aligned with their thinking – and Hong Kong’s small group of global systemically important banks (G-Sibs) might need to reconsider.

“Some of the G-Sibs are indicating that they want to use a simplified standardised approach, but will the regulator allow it? I’m not all that sure,” says Kishore Ramakrishnan, a partner at consulting firm Temple Grange Partners.

Under Basel’s Fundamental Review of the Trading Book, banks have a choice of methods for calculating capital: a sensitivities-based approach (SBA) set by their regulator; a simplified standardised approach; or – if trading desks pass certain tests – an internal models approach (IMA).

However, the FRTB says the simplified standardised approach should only be reserved for smaller entities with non-complex books – a view supported by the HKMA in the FRTB consultation paper it published in June.

Banks must tell the regulator by early next year if they plan to use the simplified standardised approach for calculating market risk, which is why the issue has now started to surface.

Hong Kong looks set to be an early adopter of the FRTB, which may result in the local subsidiaries of G-Sibs implementing the new capital rules before their parent banks, with implications for global risk management policies

Banks using their own models to set market risk capital requirements could face punitive add-ons for risk factors that don’t meet the threshold for stable and observable pricing – so-called non-modellable risk factors (NMRFs).

One of the internal tests measures how accurately a trading desk can model its profit and loss – the P&L attribution test. Hiving off NMRFs could make it easier for banks to meet this test, which is a prerequisite for using internal models under the FRTB.

NMRFs are only a relevant issue for banks using the internal models approach

HKMA spokesperson

“NMRFs are only a relevant issue for banks using the internal models approach. For such banks, the natural alternative would be the standardised approach, which they have to calculate anyway,” says a spokesperson for the HKMA, adding that since G-Sibs will be expected to calculate their capital requirements at a consolidated level, they should be able to calculate the standardised approach at their Hong Kong entity level as well, which would feed into group figures.

However, Ramakrishnan says this stance from the regulator hasn’t stopped some banks from at least wondering whether some concession might be forthcoming.

He says that at a trading desk level, a number of global banks could meet the other conditions for using the simplified standardised approach; chiefly that market risk-weighted assets must not exceed HK$1 billion ($127 million) or 2% of total RWA, and the aggregate notional of non-centrally cleared derivatives must not exceed HK$6 trillion ($767 billion).

These banks may simply be hoping the HKMA waives the G-Sib requirement, says Ramakrishnan.

There are currently only two European (HSBC and Standard Chartered) and one US (Citi) G-Sibs that are incorporated as full subsidiaries rather than as branches, and therefore will be subjected to Hong Kong’s FRTB rules. HSBC, StanChart and Citi declined to comment for this article.

The HKMA plans to finalise its new FRTB framework in the first half of 2020, taking onboard comments it received during the consultation period, which closed at the end of September. The regulator also plans to run another quantitative impact study before the end of the year. Ramakrishnan says that following this study, it should become clearer in terms of whether the regulator is likely to grant any NMRF relief.

The problem surrounding how FRTB should treat market instruments for which there is insufficient data is a long-standing one, and particularly relevant to Asia, where certain instruments – such as longer-dated bonds and certain currency pairs – trade only infrequently.

Revisions to the FRTB framework introduced earlier this year sought to ease the NMRF burden: factors are now considered non-modellable if there are fewer than four price observations in 90 days, or 100 observations in the previous 12 months. But banks such as HSBC and Standard Chartered say there are still some instruments in Asia that will fail this test.

Patchy reception

Not only do NMRFs result in higher capital charges themselves, but also risk factors that dip in and out of modellability could result in an entire trading desk failing the backtesting of its internal models. Regulators would then require the desk to be moved on to the standardised SBA. Too many NMRFs make it harder for banks to pass the P&L attribution test and relying on patchy pricing data can result in banks passing the test at one point in time only to fail it a few months later.

“If it was me running this business, I would be worried about a trading desk where I thought there was a substantial risk that at regular intervals it would fail its P&L validation test,” says Simon Gleeson, a lawyer for Clifford Chance, based in London. “Regardless of whether the desk manages to pass the P&L test, if the bank is not convinced it would remain modellable for an extended period of time, then it will have to set aside the standardised amount of capital for that desk, come what may.”

Simon Gleeson

By separating the Asian trading desk from trading desks in Europe or the US, global banks may be hoping the difficulty of modelling factors for certain trades does not impact on their ability to use internal models elsewhere in the business.

“Although the Asian trading desk will add to the global figure anyway, by segregating that activity you’re minimising the risk that the Europe desk or the US desk will fail P&L validation and be thrown back on to the standardised methodology,” says Gleeson.

The obvious fallback if internal modelling does not reliably yield capital benefits that justify the heavy systems costs is to adopt the standardised SBA. However, Hong Kong banks appear to favour the more basic simplified standardised approach, because the SBA would require them to make significant investment in new systems to collect risk sensitivities data.

“A lot of these entities onshore do not have a local risk and technology infrastructure to do the number crunching and run the engine. It is all in their global desks in London or elsewhere,” says Ramakrishnan. “The simplified standardised approach doesn’t require this complex technical infrastructure to run these numbers or do the number crunching.”

He adds that the HKMA is reluctant to allow local trading desks to rely too heavily on systems based in the parent jurisdiction: “The HKMA is always insisting on local accountability if something goes wrong. When it comes to traded risk or technology risk, they want people to be accountable here in the region.” 

Moreover, the perceived capital benefits of SBA over the less cost-intensive simplified standardised approach are comparatively small. Gleeson says bankers describe the SBA as “a very long run for a very short jump”.

I don’t think any bank should adopt the simplified approach, considering the poor impression that it would give its regulatory body on the bank’s ability to manage risk

Head of risk at one regional bank

“I also think that some of it has to do with predictability. From a capital manager’s perspective, what you want to know is how much capital you have to commit. If you are a trader, you only take positions if you are confident that you liquidate them when you choose – not when the reg cap model changes,” adds Gleeson. “Consequently, from both perspectives, there is a positive business value to stability, and that is what simplified standardised gives you.”

But other banks will be closely watching what the HKMA does in terms of NMRF relief for G-Sibs in case setting up a subsidiary in the territory allows them to manage their FRTB capital more efficiently. Over the past few years, banks have been increasingly looking at setting up regional booking hubs in either Singapore or Hong Kong to escape the impact of Brexit and some of the EU’s more onerous legislation.

Global banks will have to be careful about the extent to which they arbitrage the FRTB framework in Hong Kong, however, for fear of falling foul of their home regulators.

“I don’t think any bank should adopt the simplified approach, considering the poor impression that it would give its regulatory body on the bank’s ability to manage risk,” says the head of risk at one regional bank. “As such, I am surprised to hear that G-Sib banks would even consider it.”

And while it may therefore be difficult for a G-Sib to justify using the simplified standardised approach for its entire local risk book, the debate over NMRFs in Asia is unlikely to go away.

According to one market risk manager from another bank, regulators in Asia are going to have to look quite closely at whether they can find ways to ease the burden when they implement the Basel framework locally.

 

Editing by Louise Marshall