Fundamental review of the trading book
The first Basel Committee publication of 2016 was the highly anticipated BCBS 352, 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
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, please see the full version of this article.
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 sub-trading 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.
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.
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.
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.
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- Due to for implementation in January 2019, BCBS 352 stipulates the new minimum capital requirements for banks
- The regulation aims to increase controls between the banking book and the trading book and will replace the existing VaR calculation with an Expected Shortfall
- In addition the standardised approach will now be mandatory for all banks to report, creating a new capital floor
- Supervisory authorities will now require reporting on an intra-day basis at desk level; this will pose significant operational challenges for banks and will lead to a review of the Risk organisation