U.S. Regulators Lag on FRTB as Europe Deadline Approaches

Rules stemming from the Basel Committee on Banking Supervision's Fundamental Review of the Trading Book (FRTB) market risk guidelines, initiated more than a decade ago, become effective in Europe this fall. In the U.S., however, it remains uncertain which banks will be impacted and to what extent, although those subject to its requirements will inevitably face challenges.

European banks must start reporting under the FRTB's standardized approach (SA) to determine capital requirements for trading-book assets by the end of September. And following the expected adoption of regulatory technical standards this year, banks can seek regulatory approval to adopt the internal models approach (IMA), which is more operationally intensive but potentially more capital efficient.

An anticipated Federal Reserve notice of proposed rulemaking may soon clarify which banks will be subject to SA and IMA requirements, along with an implementation timeline. But the Fed's Supervision and Regulation Report in April did not list FRTB among the supervisory priorities for large financial institutions, leaving questions about how it will be interpreted in the U.S.

Eduardo Canabarro, who was Morgan Stanley's global head of risk analytics and model risk during the financial crisis and held a similar position at Barclays from 2016 to 2019, said in an interview that FRTB was prompted by banks' trading of complex, structured products. But under post-crisis requirements like the Fed's Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Tests (DFAST), “they dismantled the complexity of their trading books, which are now very plain vanilla.”

“You can't hold structured products in the trading book anymore, because the capital charges are too high,” said Canabarro, who was part of an ISDA working group that advised the Basel Committee on FRTB, and who is now managing his family office.

Reduced Burden

Canabarro believes that with their strong capital positions and simplified trading books, banks are unlikely to see significant changes in capital requirements. The Fed may thus promulgate a version of FRTB that is less laborious to implement and affecting fewer banks.

“We understand that the Fed will want to do FRTB in a way that is relatively faithful to Basel while also being pragmatic for the banks it supervises, but we don't know exactly what that will entail,” said Daniel Mayer, FRTB lead at Deloitte.

The Fed may focus on addressing shortcomings and inconsistencies in the current Basel trade-risk capital framework - known as Basel 2.5 - that “has evolved in a somewhat piecemeal manner since its inception,” said Shaun Abueita, Ernst & Young's U.K head of financial services traded risk consulting.

The central bank could also reduce the variability of risk-weighted assets (RWAs) across banks and jurisdictions. There is currently a range of modeling practices and assumptions that different banks apply to the same activities, “generating variability in corresponding risk exposures and RWAs,” Abueita said.

Varying Effects on Banks

Whatever path the Fed takes, U.S. banks with market risk exposure will likely have to implement new data and analytics. The largest U.S. banks and investment banks supporting numerous types of financial products face the most extensive changes, while regional institutions' challenges will vary depending on their trading books.

As currently in place, the SA is essentially a straightforward formula to calculate capital requirements, and the IMA is a more complex framework that must be approved by regulators. Eugene Stern, Bloomberg's head of market risk product, said that because today's SA is capital-inefficient, most large and regional banks use the IMA. It has significant needs for data and analytics, generated in-house or outsourced at least in part.

Under FRTB, the IMA becomes even more operationally complex, as does the SA, which for the first time will incorporate risk sensitivity to more accurately measure an institution's risk exposure and corresponding capital requirement. Today it is more one-size-fits-all.

“The new SA under FRTB is meant to be much more viable as a capital model,” Stern said, adding that “virtually every medium-size and large U.S. bank has been using the IMA, and Bloomberg anticipates many moving to the new SA. “Under FRTB, the gap between SA capital and IMA capital is much smaller than under Basel 2.5.”

Speaking on May 11 during the International Swaps and Derivatives Association annual general meeting, ISDA chairman Eric Litvack called Basel measures including the FRTB and revised credit valuation adjustment (CVA) capital rules “a critical last piece of the capital jigsaw, so it's important it fits well with everything else and doesn't create incentives that skew the picture.”

Litvack, a SociÉtÉ GÉnÉrale managing director, cited a European Central Bank survey last year that found that 40% of banks then using the IMA intended to “ditch it in favor of the new standardized approach under the FRTB, with another 20% undecided. There are various reasons for that,” he said, “for example, the introduction of a complex P&L attribution test and the rules on non-modellable risk factors. But I personally find that statistic shocking: It means nearly two-thirds of banks that currently use sophisticated risk models may stop in favor of using a blunter, less risk-sensitive tool instead.”

IMA Experience Helps

Banks operating in Europe and those using IMA today should have a leg up, though new data sources and analytics will be needed for the U.S. For example, a bank with exposure to a fixed-income fund, whether through a direct holding or derivatives, must look through to the fund's constituents when they model the exposure for capital.

“Unless the bank can give at least some indication of what's in the fund, FRTB-SA treats the fund as a generic equity holding, with the highest possible risk weight,” according to Stern.

Stern said regional banks can have significant exposures to securitizations as well as callable bonds, asset classes requiring more complicated models.

“There's a lot of data that has to be fed into them, as well as pricing analytics,” Stern said, and while large banks have more resources to address the challenge, “the upside is that every bank will end up having to raise its game.”

One lesson learned in Europe, Deloitte's Mayer said, is that the input data, including that produced by front-office systems for the SA model, as well as reference data, may be entirely new for some banks, or will have to be modified.

“Input data can be a significant issue, and I've seen it drive very large discrepancies in results in terms of SA,” Mayer said. “Where there were mistakes in reference data, you can have a big change in output.”

Validation, Governance and Accuracy

Another significant challenge will be in implementing the operating model. Mayer cited the code to calculate the SA number, as well as policies and procedures for who will handle issues such as data errors, missing reference data, and ensuring the results' accuracy.

Another issue that “I think a number of banks have not fully grasped is the model validation and governance that will need to be applied in the SA,” Mayer said. He added that FRTB is ambiguous on the issue, but other regulations will likely require banks to submit SA models from across their trading portfolios for validation, and to monitor them regularly to ensure ongoing validity. “And that's a non-trivial task for models as complex as this.”

Shifting from IMA to SA should be easier, Mayer said, but several of the data inputs for the new SA are not required by today's value at risk-type IMA models. In addition, the new SA gives different priority to reference data, and it is a parametric model compared to the historical-simulation approach most banks now use.

ISDA chairman Litvack said, “The new FRTB standardized approach is much more risk-sensitive than the standardized approach previously used for market risk capital, which is an important and welcome development. But standardized approaches are, by definition, a one-size-fits-all tool that can be used by everyone.”

He warned of undesirable herd behavior if all banks take a similar approach with standardized models, and stressed that “as national regulators develop their rules, it's important to ensure the overall framework is risk-sensitive, appropriate and coherent. A key driver, especially in the wake of the COVID crisis, should be to avoid any unnecessarily detrimental impact on market liquidity, and ensure banks can continue to lend to the real economy and provide crucial risk management services.”

From VAR to Expected Shortfall

For the largest banks continuing with IMA, the basic concept hasn't changed, Stern said, but the statistical risk model will shift from value at risk to expected shortfall, and passing muster with the regulators will be “substantially more challenging.”

Banks will have to prove that the data going into models corresponds to actual markets, requiring a risk-factor eligibility test, Stern said, and there will also be a requirement to calculate multiple levels of expected shortfall, depending on different sets of liquidity-based risk factors.

In addition, FRTB imposes stringent requirements to align risk models with the analytics used by front offices for trades. “So you can no longer calculate your P&L for the bank one way, and risk with a totally different model,” Stern said. “Now there's a P&L attribution test that forces banks to align them, and that's created a lot of challenges for some institutions.”

Smaller U.S. institutions with limited market-risk exposure should take comfort. Mayer noted that while the shape of U.S regulations remains unclear, Basel FRTB guidelines as well as Europe's SA regulations provide banks with trading books below a certain threshold with a solution that's easier to implement.

“It is likely the Fed would also allow smaller banks to use a simplified SA, which is much more like the current SA,” Mayer said.