Marcus Cree, Risk Specialist at Misys explains how the Basel Committee’s proposed consultation on the fundamental review of the trading book, or BCBS 265, will present both challenges as well as opportunities for the treasury function. Hear more via the recent DerivSource podcast.
The Fundamental Review of the Trading Book (FRTB) or BCBS 265 recommends revisions to both the use of internal models and standardized approaches to managing capital and risk types. However, some of the newly proposed practices have come under scrutiny and banks are asking for more time to assess the impact. The largest changes are tied to the so-called expected shortfall (ES) approach to calculate the market risk capital requirement as well as the introduction of liquidity horizons. The main concern is the increase in capitalization because it will reduce the risk taking activities of the organizations and therefore significantly hit their profitability.
The treasury operational perspective – a long ‘to do’ list
Operationally, there will be a lot to do. Even though the new rules have been simplified, new models are being introduced while sequences and buckets are being created that will impact their risk weightings.
One of the biggest and unprecedented operational challenges will be the way liquidity horizons, with their various nuances, will be scaled and floored in terms of correlated risk factors. In the past when new rules have come into force, implementation tended to be incremental but the current draft rules are also requiring an on-demand service of the standardized results. This means that the aggregation point in the process that a bank or financial institution undergoes in order to generate these risk results will require a significantly upgraded infrastructure.
One illustration of this is the cashflow valuation model. Although firms will use cashflow models to price things in the front office, they don’t always push all those cash flows through to where the risk gets aggregated. The new rules coupled with the on-demand service with all of the new buckets and risk weighted techniques, will require a far greater degree of data centralization and aggregation to make this process possible.
On the risk management side, things become interesting due to the specific new calculation which places capitalization into the risk area. These include the GIRR (General Interest Rate Risk), credit spread arrears, the credit and commodity risks. Some of these are leveraged versions of what’s gone before, but as we now have to put things in their appropriate buckets and look at the netting between what’s correlated and what isn’t, there is a quantitative aspect which needs to be digested and built in. The result is a crossover point of the operational with the quantitative and the pure risk management sides.
Most importantly, however, I think will be the impact on the actual profitability and the role that risk management can play. If as feared there is a dramatic rise in capital types, two potential issues could occur – the first is that treasury will have to start looking at optimizing that number to keep the burden as small as possible while the second is overall market liquidity and how that might decrease.
This means that the liquidity stress testing which sits at the heart of the treasury function may have to be re-thought in order to take account of increasingly illiquid markets in times of stress as well as finding additional sources of alternative funding.
In the same way that regulatory compliance becomes the key risk faced by the banks, it’s also true that any kind of paradigm shift creates an opportunity for a properly transformative project to be undertaken. It’s here where I see there being significant positives. The first is data centralization. It is a good thing for the best practice in the bank, and although there is already progress with BCBS 239 risk reporting rules, 265 will be a push forward.
I also think that the idea of cross jurisdiction harmonization and an overall simplification of the standardized rules can be seen as a real foundation for treasurers to build on. They can create a risk core within the institution, which can produce an effective treasury optimization programme. It is quite difficult to put a programme into practice unless you have the data in place and there’s an imperative across the organization to ensure that the quality of the data that’s coming in is well maintained.
In the past, it’s been difficult to manage the intra and end of day liquidity, and as the regulations have been drip-fed into the system there’s a building out on the funding side in a piecemeal fashion. A more holistic way of reviewing the capitalization in terms of how it is stored, the different tiers and the liquidity needs, can give treasures a real shot at treasury optimization which I would define as the process of maximizing returns via the proper use and allocation of capital.
*Comments from DerivSource podcast “BCBS 265 – the Impact on Treasury Operations and Risk”. Listen to this podcast on DerivSource.com or iTunes. A full transcript is also available on the DerivSource podcast notes page – http://development.derivsource.com/content/bcbs-265-impact-treasury-operations-and-risk