The fundamental review of the trading book (FRTB) will change the way banks manage market risk. Most view the December 2020 deadline and its shifting requirements and conclude they should “wait and see”. Waiting, however, is likely to prove a risky strategy. Here’s why.
Our financial system operates within a highly leveraged, interconnected marketplace. Transactions are transformed and risks are amplified as they move through market layers. In this environment, the need for banks to assess intraday market risk across the enterprise as well as contextually as part of a multilayered financial network is critical. Monitoring counterparty, economic and political risk across the global marketplace is a cornerstone of prudent risk management, competitive positioning and profitability.
A central thesis guiding regulatory strategy is that banks take on excessive leverage without considering the full range of potential risks to their trading portfolio. Regulators believe banks do not sufficiently consider extreme scenarios or analyze market risk in time to mitigate systemic events and put sufficient capital buffers in place. FRTB (sometimes referred to as minimum capital requirements for market risk) is a Basel regulation introduced to change the way banks analyze market risk in the trading book with the goal of addressing systemic challenges.
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Addressing intraday market risk
Assessing intraday market risk begins with data, including details on positions, parties of interest, investment guidelines and risk factors. Currently, granular data is available at the desk-level for each line of business within each geography. This level of detail is not typically available firm wide, on-demand other than in a summary form.
Therefore, the first question to ask is whether banks have the firm-wide, granular data, business processes and solutions in place to analyze and assess market risk intraday.
The answer is that most do not. Batch processes still provide end-of day data that is stale by the time reports are generated, making it difficult to anticipate and mitigate risks as they arise. Failure to anticipate rapid changes in the market intraday may lead to a series of cascading events:
- Inability to monitor critical impacts of market fluctuations. If there is a sudden drop in the market, an inability to monitor firm-wide market risk intraday makes it difficult to mitigate a series of cascading events.
- Reduced value of collateral. Collateral against loans might drop in value, resulting in margin calls. Some counterparties may refuse to renew repo funding.
- Margin calls impact liquidity. Demands for additional collateral or partial loan repayment can force a sell-off of positions and collateral.
- Cost of hedging rises. When firms run into liquidity challenges their cost of issuing derivatives or hedging their positions rises, affecting margins.
- Impact on equity. Higher costs of issuing derivatives are a closely watched metric that can have an immediate, negative impact on the value of the institution’s equity.
Immunizing a portfolio and balance sheet against cascading events, such as the scenario described above drawn from recent history, begins with an assessment of the bank’s market risk across positions, lines of business and geographies. Regardless of any regulatory requirement, the ability to anticipate intraday spikes in market risk and mitigate challenges is central, if not essential, to the core business.
Two sets of challenges need to be addressed - the business requirement for banks to assess market risk intraday and the regulatory requirement to assess both firm-wide and contextual risk.
FRTB – part of a global regulatory strategy
From a regulatory perspective, market risk impacting any given firm may lead to cascading events across multiple firms causing systemic challenges. Connectedness and the threat of contagion keeps regulators up at night, driving global regulatory strategy. Conflicting political pronouncements aside, this strategy is clear and it will move inexorably forward.
FRTB should be viewed as one measure in the context of a broader, global regulatory program. We already know this program will include firewalls and additional capital buffers as well as ring-fencing that will force lines of business to stand on their own. These requirements and the cost of implementation will lead banks to reassess capital allocation and possibly retrench selected lines of business. Going forward, business processes, workflow and technology will be further impacted by increasingly frequent regulatory spot checks by examiners requiring firm-wide market risk assessments within minutes.
The danger of a wait-and-see approach
As these two waves inevitably converge, waiting to see what happens will turn out to be both risky and expensive.
Risky because failure to manage market risk intraday will put firms at a competitive disadvantage while exposing them to an unacceptable level of risk. Expensive because reacting to each new regulation without a coherent plan has resulted in regulatory costs (as a percentage of operating expenses) of 4-6 percent. Continuing along a reactive path for new regulations will double this to 8-12 percent.
Clearly, from either a risk management or cost management perspective, this is not a sustainable model. Instead, plans to implement FRTB should move forward now while also laying the groundwork to address current and impending regulations.
FRTB next steps – mind the gaps and assess the impact
Banks should begin by identifying gaps in current versus required capabilities as well as the potential impact of FRTB on the firm’s business model. They also need to consider requirements such as ringfencing and spot checks, which are sure to follow. Conversations with our customers reveal the following as some of their main concerns regarding gaps in their capabilities and the potential impact of FRTB on their business:
Gaps causing concern with FRTB implementation:
- Overnight batch processing of data will need to migrate to near real-time, enabling analytics and reporting on demand.
- Existing systems may not scale. FRTB scenarios with longer liquidity horizons may require up to 15,000 simulations per trade.
- Model risk management may need enhancements including centralized governance, a view of interconnectedness and modeling of external parameters including counterparty, economic and political risk. Testing and control gaps for new models can result in significant losses.
- Can the data gap be addressed with a data management solution to meet FRTB requirements as well as other accounting or regulatory imperatives such as expected credit loss or stress testing?
Assessing the impact of FRTB at each desk and line of business:
- What analytical risk/finance environment would allow the bank to deal with what-if questions?
- How will new FRTB standard approach(SA), and internal model approach (IMA) market risk modeling scenarios affect capital?
- Is there a critical mass of desks, justifying investment versus cost, that may be moved to an IMA?
- Will separation of the banking and trading book affect margins, credit ratings or liquidity? Should any form of retrenchment be considered?
- Should the firm assess the potential cost/benefit of migrating toward cloud-based compliance-as-a-service based on usage?
A final word – competition
A handful of leading international banks and investment managers that have proactively addressed the challenges of assessing intraday market risk – including JPMorgan Chase, Goldman Sachs and Blackrock – cite benefits such as improved risk management, capital optimization and balance sheet immunization.
To compete with these best-in-class firms, a wait-and-see, reactive approach to new regulations will prove to be too little, too late. Financial institutions need to proactively improve enterprise risk and capital management, automate their workflow to provide on demand intelligence and address compliance with a lower cost structure. Along the way, they will derive data and information to create new sources of revenue and achieve their business objectives.
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