Fundamental Review of Trading Book for Banks and Financial Institutions
The regulators on trading and operations monitor banks and financial institutions continuously to meet with the latest minimum capital requirements for market risk. In order to mend the gaps in the market risk capital framework, there are enhanced prudential standards set by the regulators to safeguard the customers’ money and the economy of the country.
The Bank for International Settlements (BIS) hosts and supports a number of international institutions engaged in standard setting and financial stability and one of them is the Basel Committee on Banking Supervision (BCBS), guided by the central bank governors of the Group Ten Countries. The Global Financial Crisis (2007-09) has exposed weakness in the banking system and the level of capital required for trading book exposures was insufficient to withstand the losses. The banking sector entered the financial crisis with too much leverage and inadequate liquidity buffers and the dangerous combination of these factors was demonstrated by the mispricing of credit risk and liquidity risk. As part of BASEL III regulation, the BCBS has now introduced the Fundamental Review of Trading Book (FRTB) to the capital market.
BCBS published the FRTB, a regulatory requirement to strengthen the Banks Capital Standards for market risk by prescribing enhanced capital and liquidity adequacy regulations. It introduced various changes to Basel 2.5 market risk capital rules. The overall revisions are listed below.
- Revised internal model-based approach.
- Revised standardized approach.
- Trading book/banking book boundary.
Revised Internal Model-Based Approach
The objective of internal model-based approach is to estimate the amount of capital required from all sources of risk to mitigate the potential losses in future period of stress. The risk calculation method is changed from Value-at Risk (VAR) to the Expected Shortfall (ES) in order to provide a better measure of tail risk during the stressed period. The approach includes identifying and capturing all material risk factors and providing a common treatment of exposures to the risks.
The framework provides a clear process to identify the trading activities that are eligible for internal model-based capital treatment. The model approval process is broken into small steps at each trading desk. There are a set of quantitative tools applied to measure the performance of these models. Firstly, P&L attribution process provides the risk factors that drive the losses and secondly, daily back testing framework reconciles the actual losses with forecasted losses.
The capital requirement would be an aggregation of the below methodologies and individual risk analysis would include modellable and non-modellable risk factors:
1. Expected Shortfall (ES): Equal weighted average of diversified and non-diversified ES for specific risk classes and modellable risk factors.
2. Default Risk Charge (DRC): Default risk of equity and credit trading books for modellable risk factors.
3. Stressed Capital Add-on: Aggregate regulatory capital measure for non-modellable risk factors.
The bank will apply the revised standardized approach to calculate the capital requirement, in case the trading desk fails to do these methodologies for that particular desk.
Revised Standardized Approach
The objective of the revised standardized approach is to provide consistent, comparable and transparent market risk reports across banks and jurisdictions. This can be done by identifying robust methods for calculating the capital requirement for banks with appropriate business models. There should be appropriate fall back plan in case the bank’s internal market risk model could not provide adequate results.
Under the revised standardized approach, the traded instruments in the asset classes are decomposed into notional positions and grouped into risk buckets based on combination of statistical analysis and expert judgement. In case the instrument is not classified, it is placed under the residual bucket. The specific risk weights are applied to these notional positions and the correlation parameters are used to recognize diversification and hedging. The standardized risk measure for each bucket is calculated using the risk aggregated formula. The calibration of these buckets is done in a way that it ensures convergence with the internal model’s approach.
There are three main components of standardized capital requirement for securitized and non-securitized exposures in trading book. Read below:
1. Sensitivity Based Method: The financial instruments are grouped under different risk factors and shocks are applied to calculate the capital risk charge for individual risk factors. The delta, vega and curvature risk sensitivities are captured for various instruments and the risk-class level capital charge is then determined at aggregated level.
2. Standardized Default Risk Charge: The capital charge is applied to securitized, non-securitized and correlation trading portfolios.
3. Residual Risk Add-on: Risk weights are applied to notional amounts of instruments with nonlinear payoffs.
Trading Book/Banking Book Boundary
The financial instruments are grouped under trading book or a banking book depending on the trading intent and valuation of the instruments. The boundary is aligned with the bank’s own risk management practices relative to the valuation-based approach. The trading positions are shown under either of the books as per the regulatory capital requirements.
There are two approaches followed to classify the boundary, they are:
1. Trading Evidence Approach: The boundary is defined not only by the intent to trade but also by their ability to trade and manage the risks on a trading book.
2. Valuation-Based Approach: The boundary is defined based on the fair value of the instruments and the risks posed to the bank’s regulatory capital resources.
The Importance of FRTB for Banks and Financial Institutions
FRTB has innumerous advantages in the banking sector and financial institutions. The following are a few of the reasons it has become an important and integral part of this industry:
- The principles of FRTB strengthen the market risk practices across the global banks and financial institutions.
- FRTB optimizes the capital utilization in various trading activities and the efficiency of the trading desks is improved.
- FRTB improvises the bank’s methodologies, effectuates data management and streamline processes to meet the prudential regulatory standards.
- The banks follow more accurate and efficient methods of risk valuation and models through technical and business enhancements.
- FRTB imposes a lot of implementational challenges in data sourcing on sensitivity, market data and risk calculations.
Do you agree that FRTB revolutionizes the banking and financial services industry?