INSIGHT APRIL 2016 FUNDAMENTAL REVIEW OF THE TRADING BOOK THE NEW MINIMUM CAPITAL REQUIREMENTS FOR MARKET RISK.

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1 INSIGHT APRIL 2016 FUNDAMENTAL REVIEW OF THE TRADING BOOK THE NEW MINIMUM CAPITAL REQUIREMENTS FOR MARKET RISK.

2 The first Basel Committee publication of 2016 was the highly anticipated BCBS 352 1, minimum capital requirements for market risk. Due for implementation in 2019, the regulation aims to tighten the loopholes of the current Basel 2.5 regime and ensure that banks are able to withstand any potential market crash. The new revised framework Background and context In the wake of the 2008 financial crisis, the Basel Committee decided to implement Basel 2.5 as a short-term response in order to strengthen Market Risk capital base. The Fundamental Review of the Trading Book (FRTB) aims to be the long term solution to Market Risk by addressing the persisting issues and allow supervisory authorities to better compare institutions: predominantly the boundary between the banking and trading book being too lenient and the internal model approach being inconsistent. Furthermore, the standardised approach is not risk sensitive enough to constitute a credible alternative to the internal models introduced by the banks themselves. The Fundamental Review of the Trading Book (FRTB) imposes the most stringent capital requirements of any regulation to date, and will involve significant required challenges for the Risk department, and the trading activity of banks. The FRTB amends the existing Basel market risk rules in the following areas: Increasing controls on the boundary between the banking book and trading book Removing Value-at-Risk in favour of Expected Shortfall Strengthening the relationship between the standardised and internal models approach The key theme of the review is to safeguard against banks window-dressing their regulatory reporting and ensure that firms have in place sufficient risk management practices to verify their intraday exposures are never excessive. If banks fail to meet the capital requirements at any point, the national regulator can force banks to take remedial action. Although the impact on overall capital levels across the economy is not yet clear, and is subject to final calibration, it is likely to lead to punitive capital increases in certain business lines, and will potentially cause some key markets, such as the trading of securitised products, to become uneconomic. Certain credit products could see capital requirements increase by up to six times, while a sovereign downgrade could increase capital charges by 73%. This could lead to lower liquidity and increased financing costs for borrowers 2. In this article we will explain the incoming changes and discuss the impact on banks existing trading accounting practices. The banking book frontier The new regulation aims to reduce the possibility of arbitrage across the trading book and the banking book. This means that Internal Risk Transfers (IRT), internal derivative trades between the banking and the trading books, will be subject to approval from the regulator and must be publically disclosed. National regulators are instructed to only approve these transfers under exceptional circumstances, for instance a major bank restructuring or a change to accounting standards. The FRTB has prescribed a non-exhaustive list of instruments that will belong to each book, outlined in the table below. As a guide, any instrument leading to a net short credit/equity risk position in the banking book must be included in the trading book. TRADING BOOK VS BANKING BOOK INSTRUMENTS Trading Book Short-term resale Profiting from short-term price movements Locking in arbitrage profits Hedging risks Correlation trading portfolio Net short credit/equity position Underwriting commitments Banking Book Unlisted equities Securitisation warehousing Real estate holdings Retail and SME credit Equity investments Derivative instruments Hedging instruments Source: Sia Partners Banks will need to provide evidence that instruments held in the trading book are held for the purpose of giving rise to a financial or equity asset or liability; if banks do not provide enough evidence then the supervisory authority would require the bank to reassign the instrument to the banking book. Furthermore, the supervisory Sia Partners INSIGHT FUNDAMENTAL REVIEW OF THE TRADING BOOK April

3 authority is able to enforce that instruments which are lacking evidence that they are not held for asset gains to be reassigned to the trading book. A further requirement of the banking book review is that banks are now required to have clearly defined policies, procedures and documented practices for categorising instruments into the correct book for the purposes of calculating regulatory capital, ensuring compliance with market risk criteria and taking into account their internal risk management capabilities. The internal control functions must conduct an ongoing evaluation of all instruments, with an internal audit on this control function available to the supervisor for periodic review. For example, all trading desks in a bank must publish the following to the regulator: Inventory aging reports Daily limit reports Reports on intraday limits, respective utilisation and any breaches Reports on the assessment of market liquidity The revised capital charge calculation the relevant risk factors were experiencing a period of stress. Then banks must create a separate internal model to measure the default risk using a VaR calculation to measure the probability of loss due to an obligor s default as well as the potential for indirect losses that may arise from a default event. In addition, this must recognise the impact of correlations between defaults among obligors. Banks must also now produce a hierarchy ranking their preferred source of Probability-of-Default (PD) and Loss-Given-Default (LGD) to avoid cherrypicking parameters. Finally, banks must have comprehensive stress testing programs in place at both a trading desk level and a bank-wide level. This is to identify any events that could create extraordinary losses or gains in trading portfolios, or hinder the control of those portfolios. Incorporating both market and liquidity risk, the criteria should identify any plausible stress scenarios and ensure the capacity of the bank s capital can absorb large potential losses and identify steps the bank can take to reduce its risk and conserve capital. THE INTERNAL MODELS APPROACH Global Expected Shortfall + Default Risk Charge + Stressed Capital Add-on The internal model approach Modellable Risk Factors Non - Modellable Risk Factors Banks will now be subject to strengthened requirements for their internal models, whereby banks develop their own in-house mechanism for calculating their market risk. Firstly, a bank s supervisory authority will only approve the use of an internal models approach if the risk management system is rigorous and there are sufficiently skilled staff to operate the requisite sophisticated models; furthermore, the bank must have a proven track record of accuracy in measuring risk. The revised internal method follows a three stage approach. Firstly, an expected shortfall must be calculated daily on a bank-wide level and for each trading desk the bank wishes to include in the internal model for regulatory purposes. The multiplier is now set to 1.5 of total capital charge. The expected shortfall must be calculated at a base liquidity horizon of 10 days and a 97.5th percentile (approximately equal to a 99% VaR), one-tailed confidence level. In calculating the expected shortfall measure, the bank must replicate a charge that would be generated on the current portfolio if The FRTB sets out numerous qualitative standards which banks must adhere to post-implementation. An independent risk control unit must be in place to conduct regular back testing and profit and loss (P&L) attribution at trading desk level. The Board of Directors and senior management must be actively involved going forward in reviewing the internal risk models, supported by daily reports from the Risk department. This should also bring into line regulatory and internal risk models, using the same risk factors, in conjunction with a rigorous programme of stress testing. The standardised approach Source: Sia Partners All banks will now need to calculate and publish the results of the standard-model calculations for assessment on a monthly basis to the national supervisor. The requirement is for a modelmanagement infrastructure to handle inputs into and outputs from standard models. This requires Sia Partners INSIGHT FUNDAMENTAL REVIEW OF THE TRADING BOOK April

4 the sophisticated use of tools for modelling market risk. This must not be too costly for banks to implement and straightforward to maintain - the flat capital reduction from standard models means there is no potential capital upside for banks using them. The introduction of a mandatory standardised approach has set a new floor, meaning that the regulator will use this measure if the internal method calculation gives a lower capital charge. There are three components of the revised standardised approach which must be aggregated for securitisation and non-securitisation exposures. The Sensitivities Based Method The aim of the Sensitivities method is to create a consistent and risk-sensitive framework that can be applied uniformly across a wide scope of banks. Capital charges for delta, vega and curvature risk factor sensitivities are calculated within a prescribed set of risk classes: Interest Rate Risk (IRR), Credit Spread Risk (CSR) for securitisation and non-securitisation, Foreign Exchange Risk, and Commodity and Equity Risk. There in an increase in the residual risk change, set at 1% notional, applied to the trading of exotic instruments (including longevity risk, weather, natural disasters and future realised volatility). Risk weights for interest rate and foreign exchange risk factors have been increased for banks using the standardised approach. The Default Risk Charge While allowing for some limited hedging recognition, the charge is calibrated to the credit risk treatment in the banking book to reduce the potential discrepancy in capital requirements for similar exposures across the banking and trading books. To calculate the capital charge banks will need to complete the following for nonsecuritisations, securitisations and the correlation trading portfolio: I. Determine the Jump-To-Default (JTD) loss amounts for each instrument subject to default risk II. Offset JTD amounts of long and short exposures III. Discount net short exposures by a hedge benefit ratio IV. Apply risk weights To limit excessive risk-taking and regulatory arbitrage incentives in addition to those already captured by the sensitivities based method and the default risk charge, the residual risk add-on applies risk-weights to notional amounts of instruments with non-linear payoffs. Sensitivities Based Method THE STANDARDISED APPROACH + Default Risk Charge Source: Sia Partners As all market participants will have to demonstrate compliance to the standardised approach, this will now be the applicable minimum capital requirement. Challenges faced in the implementation Prior to implementing a target framework, the main task will be to calculate existing capital at desk level, as the removal of compensation between trading desks will require a major culture and computational change for banks. Banks will now have to revise their risk measures and tools to ensure they are able to collate the correct data at the appropriate granularity. At present, most Risk departments are organised at group level, utilising data which has been collated centrally; however, due to the new rules there will be at least six subtrading books, which will all require their own risk reporting. Banks will have to consider how they restructure their data architecture to enable reporting at source level. SUB-TRADING BOOKS + Residual Risk Add-on Source: BIS.org 3 Residual Risk Add-on Sia Partners INSIGHT FUNDAMENTAL REVIEW OF THE TRADING BOOK April

5 Due to the removal of compensation between desks, it may no longer be profitable under the revised capital requirements to continue with all existing trading activities. Banks will have to conduct a review of their current undertakings and may find they have to merge certain desks or cease some of their trading activities as they are no longer profitable. 2 NAL.pdf 3 Copyright 2016 Sia Partners. Any use of this material without specific permission of Sia Partners is strictly prohibited. Distributing new business between trading and banking books requires a comprehensive audit trail capability all new trading book business will impact the risk profile of the overall book. The audit trail will need to take into account the volume of trades and more widely the number of books involved. Furthermore, it is essential to understand the component risk elements on a historical basis this also applies to the diversification requirement. Banks will have to demonstrate adequate internal controls for each of their trading books. This will require firms to put in place a management structure to overseas activities around each trading book. Moreover, this will include actively managing the risk on portfolios with multiple liquidity horizons this will be particularly challenging due to the complexity of the calculation and the lack of data to input, making consistency difficult to maintain across multiple liquidity horizons. Conclusion The Basel Committee estimates that the new rules will result in an approximate median capital increase of 22% and a weighted average capital increase of 40% 1, compared with the current framework. Although the capital requirements are overall not as severe as initially anticipated, banks still have considerable work to undertake over the next 3 years to demonstrate they are meeting these obligations. The complexity of the new rules are such that there is likely to be a complete review of the Risk organisation within many banks, in order to ensure compliance to the increased multitude of reporting calculations. In conjunction with this, banks will review their trading strategies to verify that each trading desk will remain independently profitable in the medium-to-long term. Sources 1 Sia Partners INSIGHT FUNDAMENTAL REVIEW OF THE TRADING BOOK April

6 YOUR CONTACTS TEWFIK DRIDI Manager tewfik.dridi@sia-partners.com CHESCA VEAL Consultant chesca.veal@sia-partners.com ABOUT SIA PARTNERS Founded in 1999, Sia Partners is an independent global management consulting firm with over 600 consultants and an annual turnover of USD 120 million. The Group has 16 offices in 13 countries, including the U.S., its second biggest market. Sia Partners is renowned for its sharp expertise in the Energy, Banking, Insurance, Telecoms and Transportation sectors. For more information visit: Follow us on Asia 701, 77 Wing Lok St, Sheung Wan, HK T.+852 Hong Kong 3 Pickering street # Singapore T Singapore Level 20 Marunouchi Trust Tower-Main Marunouchi, Chiyoda-ku Tokyo Japan Tokyo Europe Barbara Strozzilaan HN Amsterdam - Netherlands T Av Henri Jasparlaan, Brussels - Belgium Amsterdam Brussels Princess House, 4th Floor, 27 Bush Lane, London, EC4R 0AA United Kingdom T London Tour Oxygène, bd Vivier Merle Lyon - France Via Medici Milano - Italy T bd Montmartre Paris - France T Via Quattro Fontane Roma - Italy T Lyon PO Box Shatha Tower office 2115 Dubai Media City Dubai, U.A.E. T Milan 14, avenue Mers Sultan Casablanca - Morocco T Paris Middle East & Africa Dubai, Riyadh, Abu 115 Broadway 12th Floor New York, NY USA Dhabi T de Maisonneuve Boulevard West, Suite 2200 Montreal, QC H3A 3J2 - Canada Casablanca North America New York Montréal Rome Sia Partners INSIGHT FUNDAMENTAL REVIEW OF THE TRADING BOOK April