Final FRTB is a game of give-and-take, say dealers

Relaxation in some areas of Basel market risk rules offset by harsher treatment in others

Basel Committee HQ, Switzerland

Despite some last-minute tweaks designed to placate industry worries, banks are not jumping for joy about the final version of the Basel Committee on Banking Supervision’s Fundamental review of the trading book (FRTB).

Compared with earlier drafts, key changes in the January 14 document include a modified residual risk charge for exotics and a reduction in the liquidity horizons for some categories of risk factor. However, these have been offset by an increase in the capital multiplier for banks’ internal models, which is now set at 1.5.

“Between the July document and the final text, lots of changes have been made,” says Ed Duncan, a director in the risk function at Barclays in London. “In some places they scaled down the numbers, and in some places they have increased it. It is very difficult at this stage to glean any sense of what the overall impact is.”

In response to problems suffered during the financial crisis, the FRTB overhauls Basel market risk rules in a range of areas – including by ditching the use of value-at-risk in favour of expected shortfall, redrawing the boundary between banking books and trading books, and strengthening the relationship between the standardised and internal models approach.

The Basel Committee declined to comment for this article. But in an explanatory note to the FRTB, the committee estimated that the rules were likely to result in an approximate median capital increase of 22% and a weighted average capital increase of 40% compared with the current framework. That is lower than what previous assessments have indicated: in an October 2015 analysis by three industry groups, the FRTB was calculated to increase weighted average capital by 4.2 times.

The main culprit for this increase was the residual risk charge – a provision hastily inserted into the rules by regulators as a way to curb exotics trading. Dealers said the wording of the charge, set at 1% of notional, was so broad that it included almost any instrument that contained embedded optionality or gave clients the right to walk away from a trade.

In the final rules, supervisors seek to address the problem by defining two categories: exotics and “other residual risks”. Exotics would remain subject to the punitive 1% charge, while other residual risks would face a smaller charge of 0.1%.

A footnote explained that examples of exotic exposures include longevity risk, weather, natural disasters and – when used as an underlying for a swap – future realised volatility. Carbon emissions, which were considered ‘exotic’ in an earlier document, have now been removed as part of a bid to make the capital regime more environmentally friendly.

The 40% average increase estimated by the committee shows that, although the proposals are much improved, they are nonetheless likely to result in an increase of capital – Manoj Bhaskar, HSBC

Some suggest the Basel Committee’s language is likely to cause further confusion, however. “From what I have seen so far, it is based on examples rather than a detailed list of in-scope and out-of-scope products or list of eligible trades,” notes Amir Kia, a London-based senior manager in the risk and regulation team at consultancy Deloitte.

Barclays’ Duncan agrees: “Further clarity on the definition of exotic underlyings may be necessary – although most of the scope would go to 0.1%, which is likely to be more in line with the risk being targeted than before.”

Under the internal models approach, the liquidity horizons of some risk factors have been reduced, with credit exposures emerging as the biggest winners. For example, high-yield sovereign credit spread and investment-grade corporate credit spread risk has moved from the 60-day liquidity bucket to a newly introduced 40-day bucket. High-yield corporate credit spread and small-cap equity price volatility has shifted from the 120-day bucket to the 60-day bucket, while “other credit spreads” have moved from the 250-day bucket to the 120-day bucket.

However, the potential benefit may be counteracted by the committee’s decision to set a crucial multiplier at a higher-than-expected level. The multiplier is applied to the expected shortfall risk measure to determine the final capital charge for banks using the internal models approach. It was set at 1.5 in the final rules, but was assumed to be 1 in earlier drafts.

“The 40% average increase estimated by the committee shows that, although the proposals are much improved, they are nonetheless likely to result in an increase of capital,” says Manoj Bhaskar, global head of risk analytics at HSBC in London. “With this in mind, it is unclear why they felt it was necessary to introduce an additional 1.5 multiplier. Without this element the framework would be far closer to capital neutrality.”

Even for banks using the simpler, standardised approach, the overall picture is mixed. While risk weights for credit exposures have been scaled down, certain risk weights for interest rate and foreign exchange risk factors have increased.

Elsewhere, dealers have gripes about the feasibility of other parts of the FRTB rules, which could result in greater operational complexity and costs. One important change in the final rules is that banks using the internal models approach will have to measure their risk exposures on an intra-day basis, says Bhaskar. But achieving this in practice is likely to be tough.

“By and large, the most part of the banking industry does not necessarily have true intra-day measurement techniques,” he says. “Implementing this is going to have a significant impact in terms of infrastructure and operations needed to support the trading activity going forward.”

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