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19 Dec

The Questions Facing FRTB

In response to the global financial crisis of 2008, The Basel Committee on Banking Supervision has been working with global regulators to create new guidelines that ensure the banking sector has stronger capital standards for market risk and is more resilient in the face of any future crises.

The new standards include a more defined boundary between banking and trading books, a ‘Standardized Approach’ to risk metrics and a trading desk-level model approval process for ‘Internal Model Approaches’.

Despite the FRTB’s good intentions, it has faced scepticism and criticism as banks have been working to implement and test the new methods ahead of the deadline of 31st December next year.

Is it worth the cost?

No:

Some are struggling with the financial impact of FRTB where the costs involved in the complex implementation and maintenance are high and the capital requirements and new rules on managing trades could impact profitability.

There are reports of significant reductions in inter-bank trading and the number of banks with active trading books. Some suggest that the costs inflicted by FRTB are a result of panic and not relative to the scale of the issue, suggesting there are quicker and cheaper fixes.

Yes:

The Bank of England has estimated at its most conservative figure, the financial crisis cost in excess of $20 trillion. The knock on, global effect is significantly higher. Some consider the cost of changes that protect against a global economic disaster to be completely insignificant and totally justified.

John Beckwith and Sanjay Sharma, authors of ‘The FRTB: Concepts, Implications and Implementation’, even believe that FRTB can be adopted at a ‘reasonable cost’. FRTB can be more cost effective than existing methods such as stress testing and operationally, a lot of the work required in the implementation would have needed to have been carried out anyway as technological development leans more on data integration and model alignment.

Has FRTB been rendered obsolete before it’s even begun?

Yes:

The trading world, going into 2019 is much different to 2010 when FTRB was first discussed. Since then other regulatory models such as Basel 2.5, stress tests, VaR, IRC, leverage ratios, resolution planning and capital buffers have significantly reduced risk. Value at Risks (VaRs) are now only a third of what they were back in 2007.

No:

Beckwith and Sharma strongly believe that FRTB plays a critical role in the future protection of our financial services, correcting areas that are currently left exposed.

While they appreciate that regulation brought in since the financial crisis has made important steps forward, they don’t address the vulnerabilities that allowed it to happen in the first place. They say that weaknesses in market risk frameworks have been identified but not addressed which leaves ‘global markets and banking systems…prone to systemic shocks.’

FRTB goes beyond existing new capital calculations and is designed to, ‘transform the measurement and management of trading activities into robust processes that are sensitive to the observability and suitability of risk-factor sensitivities as they change over time’.

Addressing capital requirements is not enough when existing rules are open to manipulation by creative traders. Illiquid securities were ultimately responsible for the financial crisis and FRTB allows banks to attribute additional capital to risk factors as liquidity in trading assets decline.

Banks currently testing Internal Model Approaches (IMA) are experiencing failure rates of up to 79% when reconciling forecasted and actual losses, which shows that there is a need for tighter controls.

Some question that with so much focus on past activity, how adept FRTB will be at protecting the future but an under-recognised benefit of FRTB is that it is the market forces that drive the trading parameters, not the subsequent regulation after an incident has occurred.  The new framework captures emerging threats in specific risk factors and securities in real-time.

Are banks going to meet the deadline next year?

Yes:

FRTB has been on the table since 2012 and banks appear to have been making good progress with their impact assessments and initial implementation this year.  They have the whole of 2019 to test the new risk models and are steadily working towards meeting the deadline at the end of next year as required.

No:

While banks within the European Union are further ahead, many experts believe that full implementation of FRTB won’t be in place until 2025. In December 2016 the draft European legislation published by the EU in relation to FRTB said that the proposed amendments would start in 2019 ‘at the earliest’, that the date of application would be two years from 2019 and further still there would then be a three year phase-in period.

FRTB brings with it huge operational challenges. One of these is the requirement to source and calibrate 10 years of market data. Risk and finance have typically been separate functions and where the former looks at the future and the latter the past, it could take some time to bring the two together.

Will America ever actually adopt FRTB?

Yes:

David Lynch, Deputy Associate Director with the Fed has been very clear that the US are going to implement FRTB. While admitting that the original version caused capital concerns, he is confident that their data quality and testing is now more on track.

He has said that the Basel Committee will complete its consultation and finalise rules this year, allowing enough time for feedback and adoption to meet the delayed implementation date of 2022.

No:

Shortly after President Trump was elected, he issued an executive order for the US Department of the Treasury to review the American financial regulatory system. The Vice Chairman of the Financial Services Committee in the US House of Representatives had issued warnings on international rules and Congressman Patrick McHenry said that agreements like the Basel III accord ‘unfairly penalised the American financial system’ and that increases in capital requirements had led to slower growth in America.

Following this, a report issued in June 2017 advised US regulators to hold off on FRTB while it was investigated further. Later in December, the Basel committee on Banking Supervision decided to postpone international implementation until 2022. The enquiries and delays have caused people to question the US’s commitment to FRTB which has led some banks to take their attention away from it.

To conclude

We have seen an interesting mix in views. The drive to secure a more resilient banking sector has to be supported but those at the helm are raising important questions. Whatever your view, FRTB is going to be an important part of 2019 and Hiring Managers are building their teams accordingly. If you need support in hiring people with the right skills and experience for this task, please get in touch.

  • Author

    Ruaridh Brown-Hovelt

    Associate Partner, Head of Risk and Quant Practice

    View profile