
Fundamentally fraught: the chaotic last weeks of the FRTB
Quick fixes should have no place in a sweeping three-year reform project

So, after more than three years of work on new trading book capital rules, this is how it ends: a confused, chaotic sprint to meet an arbitrary deadline; vital questions left unanswered; impacts unknown.
That's how the banks see it anyway. Of course, if you listen to banks, this is how every rule-making process ends – so the furore about the Fundamental review of the trading book (FRTB) might at first appear to be the usual case of a frustrated industry making a final, desperate roll of the dice. What's different this time is that some of the complaints are echoed by regulators who have been involved in the process.
A final round of changes to the FRTB was made when the Basel Committee on Banking Supervision belatedly decided to run a fourth quantitative impact study (QIS) in July. This, in itself, was evidence of the pressure regulators were under – it would have been more normal to consult on the changes, then to issue QIS instructions. But with the committee apparently under instructions to finish the rules this year, wholesale changes had to be made with no public consultation.
So, out went the asymmetric treatment of correlations – an element of the draft standardised approach that had produced a huge capital uplift relative to modelled numbers in the third QIS. In its place suddenly appeared an add-on for residual risk, in the form of a 1% charge on the notional of more exotic products. It had more or less the same effect as the mechanism it replaced – banks say it ended up accounting for almost half of the standardised charge. Where did the add-on come from? One regulator says: "There are people at the committee level that are very fearful of models. So they looked at this and said 'One percent of notional: why not? This is all the exotic stuff: what are they doing in this space anyway?' It was a quick and easy fix."
Based on the results of the fourth QIS, the impact of the add-on is expected to be scaled down – regulators say it should ultimately account for around 10% of the standardised capital total. Another quick fix.
But the FRTB was not supposed to be about quick fixes. It was an attempt to replace Basel 2.5 – an entirely necessary post-crisis repair job – with a coherent set of rules. Conceptually, a lot of it makes sense, and even banks would probably concede regulators are taking aim at the right targets, but there was a lot to do. And the banks are right to complain it has been rushed.
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