To calculate the cost of capital for new trades and collateral optimization activities, financial institutions need timely access to client and trade data. This data is also essential to support both FRTB and SA-CCR compliance requirements. In a Q&A, Alexandre Bon, Senior Solution Architect at Murex discusses the growing urgency for an enterprise view of data.
Q. For years, banks have been warned that the silo structure is not efficient for multiple reasons. Why does it make sense for firms to increase communication across internal silos (e.g. front office with risk departments) to support the new BCBS market and credit counterparty risk requirements (FRTB and SA-CCR)?
A. Improving communication across silos is always a step in the good direction. Looking at what is driving firms’ profitability in Capital Markets today, the key issues are liquidity, the cost of credit, and the cost of capital. Banks need to manage and optimize these better, and they are all issues that can only be solved effectively at the enterprise level.
First, institutions want to analyze the profitability of traditional businesses in this new post-crisis regulation-heavy environment. Less profitable business lines are generally those carrying more leverage or risk and consuming more regulatory capital – the FRTB, SA-CCR and leverage ratio are certainly expected to continue to drive up the capital requirements for trading activities. With this information, the institution can then opt to outsource some activities, to exit from unprofitable business segments (as we saw some top tier institutions exit from Fixed Income, for instance), or to reinvent a business model that will let them improve their use of capital and funding resources across synergetic business silos. Pricing the incremental cost of capital for new transactions is such a way to incentivize Front Office desks.
Another significant trend, has been the regrouping of collateral and margining businesses under central Collateral Trading units, since new regulations are imposing systematic overcollateralization of derivatives and collateral assets are becoming a scarce resource. To make this work however, firms need to make the link between how collateral management operates on the ground and how trading desks will price the effect collateralization on the credit, funding and capital impact of new transactions. In the end, it’s all about developing collateral allocation and trade optimization strategies so that, at the point of pricing, a trader can see whether it is more efficient to execute the trade with one entity or another, taking into account the cost of initial margin (IM), credit, funding & capital valuation adjustments (XVA).
To do that, you need to bring together people from credit, collateral management, treasury and the trading department, across all asset classes, develop cross-domain expertise and, of course, you need to pool the information in a way that is efficient across departments and systems.
One last example of a regulation-related strategic decision that necessitates a well-orchestrated cross-silo dialog, is the definition of what will constitute a trading desk under FRTB. As the IMA approval will be granted at a desk level, a less granular definition of the trading desk may reduce the risk of failing the backtesting or P&L attribution tests. On the other hand, should the desk lose its approval the capital impact will be larger. Deciding on the granularity and scope of the regulatory trading desk, whether specific product or risk-factors can be carved out of a desk to secure the IMA approval, or how capital use will then be attributed back to the traders are inherently enterprise-level questions.
With the new BCBS requirements, banks ultimately need to move to a view of their regulatory capital positions that is much closer to real time, as one will want to explain, anticipate and potentially hedge variations in capital requirements. The business will need full transparency in the data and the calculations they are trying to run. This can only be achieved if you can align the different departments around the way they work, the way they share data, and how they pool information; if you sort out the data ownership questions, and create an infrastructure, which will be shared across all these business units.
“To comply with FRTB properly, you need to solve a number of the organizational and computational challenges that stand in the way of building an enterprise view of risk and capital. The good news is that because it is needed for compliance, budgets are currently available for many institutions, even though it is a big undertaking.”
Q. Do you think that FRTB and SA-CCR are in some way catalysts for getting firms to start looking at an enterprise-wide perspective, or to integrate silos?
A. They can be, especially FRTB. To comply with FRTB properly, you need to solve a number of the organizational, data management and computational challenges that stand in the way of building an enterprise view of risk and capital. The good news is that because it is needed for compliance, budgets are currently available for many institutions, even though it is a big undertaking. A number of institutions are going to try to capitalize on their investment for FRTB, to develop the organization and the infrastructure in a strategic way.
And there are obvious synergies between the SA-CCR, FRTB and CVA capital charges. They require a much closer integration of the regulatory calculations with trading applications (proper classifications of risk factors, collateral balances and the associated margining agreements details, a trade repository with sufficient granularity to support adequate transaction taxonomies for mapping positions to regulatory rules, etc.).
The BCBS-IOSCO initial margin requirements can also act as a catalyst in this regard, as they produce the same business need for transparency and cross-silo data integration (especially the SIMM methodology proposed by ISDA, which is very close to FRTB-SA).
Amongst these regulations, SA-CCR has the first truly compelling implementation deadline for many institutions. Some firms are thus using their investment in SA-CCR as a first step in a strategic re-platforming for regulatory capital management. Others have started building a tactical solution limited to regulatory reporting but plan to build this infrastructure for the FRTB and later extend it to manage Initial Margins, SA-CCR and the CVA charge as well.
Q. What are the challenges that firms face in integrating departments such as the front office and risk teams? Is this the age of data integration?
A. Firms face both technical and organizational issues. Integrating data across a multiplicity of fragmented front office, collateral and risk systems—which all run slightly different versions of calculations based on different vantage points—poses a first major challenge. Often, disparate results are aggregated and reconditioned into global exposure reports, since there are quality issues from the start. Data sets are incompatible or out of date. Data is duplicated across different departments with inconsistencies. Many institutions still do not have well-defined data repositories, or unified instrument or trade taxonomies. Some firms have built regulatory reporting systems on top of data warehouses, which do not have the granularity required for all the new trading book calculations. Reporting technology is also often outdated, having been set up in the early 2000’s or earlier—and is not able to support things like real-time aggregation.
Fixing that infrastructure is paramount, as is putting in place clear ownership of the different data sets. Firms must define golden repositories, and establish clear data management processes so they can maintain, on an ongoing basis, clean consistent data across the enterprise.
Thinking strategically, firms can then use this information to rationalize their processes, see which businesses are most profitable, and ultimately divest those that are not. Beyond compliance, firms can develop genuine enterprise-level risk measures and tools to analyze positions and capital data in a more proactive way. This is a key step towards developing new cross-silos business models and finding innovative ways to deal with the high cost of regulation – think balance sheet optimization or managing the total cost of trading, for instance.
However, moving towards a more enterprise view of the business also presents organizational and cultural challenges. Whenever you try to bridge silos, or to merge business lines—like we have seen with the creation of central collateral trading units over the last few years—priorities must be set from the top. Senior management buy-in is key when countering internal resistance to change.
Unfortunately, you can’t implement a new centralized infrastructure, break down rules, reshuffle business units, and create new departments without a period of discomfort. People will temporarily lose features, functionalities, or ease of operation in some areas. These issues need to be understood and planned for. Management must drive these sorts of transformations forward, educating departments on the need to collaborate, or changes will not happen.
“Unfortunately, you can’t implement a new centralized infrastructure, break down rules, reshuffle business units, and create new departments without a period of discomfort. People will temporarily lose features, functionalities, or ease of operation in some areas. These issues need to be understood and planned for.”
There has been progress. Five or ten years ago, front-office traders would not have understood the details of how collateralization would work. They didn’t understand credit risk. They would have had an idea of capital consumption, but would not have tracked it closely. Today, they have a much better grasp on these topics, because they drive their P&L, and they are generally much keener to work in close cooperation with collateral desks, risk departments or XVA desks.
But with the new regulations that are coming, we still need to see much closer cooperation between finance, risk, and vertical silos like trading desks, especially among smaller institutions and in emerging market contexts.
When it comes to centralizing data aggregation and processing in a regulation calculation engine*, you need to have a strong owner that is driving this transformation. At least one department—be it risk or the front office—starts the process and drives it in the right direction. Once the infrastructure is there, everyone benefits from it.
*You can hear more on this topic via our SA-CCR webinar.
