An alternative trading book
The current market risk capital framework has insufficient risk sensitivity, and the benefits of diversification and hedging need to be emphasized through three main areas:
- The updated standards will force clarification between banking and trading book treatment
- Firms will be required to adopt a more sensitive standardized approach that accurately links the capital requirements with the level of risk
- The compliance process for obtaining approval to use the internal model approach (IMA) will become more sophisticated and challenging.
The new Fundamental Review of the Trading Book (FRTB) regulation seeks to bring greater consistency in capital treatment and less variation between banks, specific markets, and products. The scope of the regulation cuts across Rates, Credit, FX, Equity, and Commodity asset classes.
When the FRTB regulation is implemented in January 2022, the shortcomings of Basel 2.5 revisions from 2009 will be addressed and accounted for. However, firms implementing IMA must run their models in advance for a year and receive approval from regulators. Therefore, from an FRTB implementation perspective, mid-2020 becomes a key deadline and there are some requirements that are phased in from January 2022 to January 2027.
In November 2016, the European Commission released proposals for CRR2, which implements the FRTB regulation in Europe. The proposal includes a number of amendments to the original BCBS requirements and in particular is likely to result in a delayed implementation vs. BCBS deadlines. It proposes an initial three-year phase-in period during which a haircut will be applied to the minimum capital requirements. Though this buys time for firms, it does increase the risk that the regulation will not be implemented consistently globally.
Non-Modellable Risk Factors
Once banks have passed the P&L attribution and backtesting requirements associated with using IMA, they need to identify whether their risk factors are either modellable or non-modellable (NMRFs).
If a risk factor does not have at least 24 “real” prices with no more than 1-month between each observation it is classified as Modellable. “Real” prices include executed trades and committed quotes.
For OTC markets with little transparency, the process of collecting “real” price data becomes a significant challenge.
Of all the new incoming regulations, few will have a greater impact on financial institution’s trading business than Fundamental Review of the Trading Book (FRTB).The new FRTB requirements from Basel Committee on Banking Supervision (BCBS) pertain to capital requirements for banks. In fact this is a critical update to the current Basel 2.5 framework, which introduces stricter rules for the treatment of market risk across national jurisdictions and addresses some of the weaknesses of the current framework. In practice it could result in higher capital requirements to protect against their trading book positions.
By seeing BCBS 239 as the starting line and not the finish line, banks will not only be better prepared to handle future market events, but will be able to do business differently.
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