The Basel Committee on Banking Supervision (BCBS) recently issued its revised market risk framework which covers the internal models approach for market risk, a revised standardised approach for market risk and a move from VaR to expected shortfall measures of risk under stress. Baringa Partners’ Thomas Ehmer offers his views on some key questions arising from this update from BCBS.
Q. What has been the general reaction from financial institutions following the release of the revised market risk framework?
The revised market risk framework was one of the last major items on regulators’ post-crisis agenda. The process to review the existing framework, referred to as the “fundamental review of the trading book (FRTB)”, was kicked-off in 2009. In response to the inadequate capital resources held by banks, as highlighted by the 2007/2008 financial crisis, BCBS made changes to the existing capital framework, Basel 2; however, Basel 2.5 was an interim measure and it was recognised that it did not address a number of issues. During FRTB, BCBS issued three consultation papers, some of which included significant changes from earlier proposals, and four quantitative impact studies. I believe this has led to a level of fatigue across the industry and that there is a degree of relief that we have received from BCBS the final text and firms are moving towards implementation.
Of course, there are parts of the revised framework for which the industry would have liked to see further revisions. Indeed, the term “Basel 4” has been mentioned in this context, highlighting the view held by some within the industry that further amendments will be necessary. The on-going quantitative impact assessments (QIS), which the regulators have promised will take place during 2016, likely will highlight the need for further revisions. But this should not be an excuse for inaction by firms at this point and they must focus on implementing the revised framework. Especially as some of the issues arise from inherent conflict in the objectives of the market risk framework, for example that the standardised approach should both be risk-sensitive and (relatively) simple.
Q. What is the biggest change or changes outlined in the new framework?
Compared to the current framework, in my view, there are four key areas of change:
Trading book / banking book boundary
The new rules adopt a more explicit definition of “boundary” between banking book and trading book, which was supported by industry and brings it more in line with risk management practices. The new definition includes a list of instruments presumed to be included and excluded from the trading book (deviations from this list require supervisory approval); the aim of the list is to stop banks from moving positions between trading and banking book.. On a practical level, this means banks need to think very carefully upfront where they book a particular trade as reclassification is unlikely to be an option. There are also a number of new reporting requirements, e.g. on inventory ageing.
Revised Standardised Approach
Banks will have to calculate capital figures using the new standardised approach irrespective of their internal model approval status. The output of the standardised calculations will act also as the basis for a potential capital floor for firm’s internal model and will be disclosed on a desk-level. The revised standardised approach will be the only available approach for securitisation exposures. One could say that the new approach is like a simplified internal model, mirroring the internal model approach with individual capital charges for the sensitivities-based method (delta, vega and curvature risk), default risk charge and a residual add-on.
Revised internal models approach
Market risk capital requirement calculations now are required at desk level. Together with more rigorous model approval process, supervisors will be able to remove internal model permission for individual desks. The entire framework also adopts expected shortfall (ES) with asset class specific liquidity horizons as the key risk measure, and so moves away from 10 day value at risk (VaR) measure. The market risk capital charge under the revised internal model approach is the sum of ES, the default risk charge (DRC) and the stressed capital add-on (SES) reflecting non-modellable risk factors (NMRF, see below) There remain some key issues to be addressed in the calibration exercises planned for 2016, including back-testing and P&L attribution requirements for desk-level model approval.
Residual risk & non-modellable risk factors
The new framework introduces a residual add-on in the standardised approach. Under the advanced internal models based approach these risks are captured by so-called NMRF. Both of these charges seek to harmonise the treatment of what some jurisdictions currently implement as “risks not in VaR”. The results of earlier QIS, suggested that both charges were much larger than expected. The final text introduced some additional guidance in terms of definitions and scope. Also, it incorporated some of the industry’s feedback on NMRF, for example in relation to correlation assumptions, which according to regulators reduce significantly both charges.
Q. How does the new framework impact market participants? Are there any surprising revisions or changes in the new framework or unintended consequences?
It depends on whether it is a, usually larger, bank using the internal models based approach and, usually medium and small. banks using the standardised rules.
Larger banks (currently using the internal models based approach) will have to start calculating capital under the standardised rules in parallel to running calculations through their internal model. This causes a number of challenges in terms of technology, processes and organisational structure.
In terms of technology, most banks are considering moving to a single platform for the standardised and internal models based approach – allowing side-by-side comparisons and avoiding, where possible, complex reconciliations of data..
In terms of processes, it is still to be seen how banks and (if disclosed) the market will react to managing different capital requirements under the standardised and (advanced) internal models based approaches. It is certainly an intention of the regulator to drive convergence and reduce the variability of capital requirements across banks. For example, if a bank’s internal model produces consistently lower numbers (relative to the standardised approach) than the internal models of peers, I would expect the regulator to look at that very closely.
Finally, from an organisational perspective, responsibility for the regulatory capital calculation usually has sat within the finance function in many banks. Now many banks are taking a closer look at the division of tasks between the finance and risk functions. The move to desk level calculations and the associated processes for backtesting and P&L attribution will require banks to professionalise and where possible automate processes if they want to achieve the ambitious cost savings targeted at many institutions. For banks using different models and infrastructure in the front office and for risk and regulatory purposes, it might be the time to consider moving to a more harmonised approach / platform.
Small and medium sized banks (currently using the standardised approach)
The new standardised approach is more complex than it was before and I believe this will raise significantly the barriers to entry. The less sophisticated market participants will want to examine very closely whether it is worth building and maintaining the required complexity for very limited trading book activity. So, we see also potential opportunity for vendors to enter this market providing “out of the box” solutions.
On the other hand, medium sized banks could benefit from the fact that the revised standardised approach will be the only acceptable approach for securitisations going forward, levelling the playing field between them and larger banks previously using internal models. Depending on the market’s reaction to larger banks’ disclosure of standardised capital figures, this effect may even come to apply to other products as well. In general, the more risk-sensitive standardised approach might help these medium sized banks to compete more effectively where the current less risk-sensitive rules might incentivise taking higher risks to generate adequate returns.
While in relative terms a more risk-sensitive standardised approach might offer some opportunities for medium sized banks, BCBS highlights in an explanatory note issued with the final regulatory text that capital requirements across a sample of 21 banks would see a median increase of 80% when calculated using the revised standardised approach. This is compared to a median increase of 28% between current and the revised internal model based approach based on a sample of 12 banks with large trading activity. Ultimately, if standardised capital charges turn out to be punitive, this could lead to trading being further concentrated with a few large players in the industry and more activities being pushed into the shadow banking sector.
Q. How do people need to respond? Do you expect, for instance, that financial institutions will start working towards complying with these new requirements?
Some banks which had participated in the last QIS in 2015 have immediately started to mobilise an FRTB program in the last quarter of 2015 to hit the ground running in 2016. Banks do not need to be fully compliant with the new requirements until 2019; the regulator learnt from the experience of Basel 2.5 where the two year timeframe for implementation ultimately had to be extended and has allowed three years for implementation of the revised market risk framework. FRTB. That said, there is no time to lose as the reforms will be time consuming, complex and expensive to introduce.
We already are seeing a lot of activity at tier-1 banks and a lot of requests from tier-2 banks for supporting in implementing the reforms. While the requirements for the largest banks might be significantly more ambitious depending on the work they have already completed and the significance of their trading activities, our view is at a minimum all banks with trading activity should complete two key activities in the first half of 2016. These are:
Regulatory impact assessment
All banks need to assess the impact of the new market risk framework on its strategy and trading activities. One of the objectives of FRTB was to reallocate capital which ultimately creates “winners and losers” both on a product and entity level. The assessment should both include qualitative factors covering systems, processes and people as well as the quantitative impact in terms of capital. We encourage banks to perform these assessments on a thematic basis. The impact assessment can serve also as a useful preparation for further QIS expected later in the year and I believe is the best way to start building internal capabilities and identify problems early.
Front-office and senior management engagement
The revised market risk framework will not only change how market risk capital is calculated but in many ways change how trading desks operate and the responsibilities of the individuals involved. An example includes the more prescriptive definition of a (regulatory) trading desk and the associated roles and responsibilities – a concept similar to the trading desk definition introduced by Volcker. Banks need to start engaging their traders, business or desk heads and senior management to raise awareness, secure buy-in, educate and train where necessary and to involve the front office in defining ways to implement most effectively the new framework.