By Mahim Mehra, Senior Risk Advisor, AxiomSL.
With the original introduction of the Fundamental Review of the Trading Book (FRTB), the Basel Committee on Banking Supervision (BCBS) completely rewrote the rules used to determine how much capital financial institutions must hold in order to adequately capitalize their exposure to market risk. The previous FRTB changes replaced the existing standardized approach with a new calculation methodology, changing the way in which model approval was granted and monitored. Value-at-risk (VAR) was replaced with expected shortfall (ES) and the boundary between the banking and trading books was literally hard coded.
There have been changes yet again to the original rules and the deadline for the new FRTB implementation is 2023. However, certain jurisdictions (i.e., CRR2 in Europe) may have to report market risk under the new FRTB guidelines sooner. So, while full FRTB implementation may seem far away on the Basel journey, it is not. Financial institutions must meet several requirements as they prepare for full compliance with Basel IV and at national levels before the final deadline — and these need to be addressed immediately.
Double, Double Toil And Trouble
As per guidance from regulators at the national level, firms will soon be expected to implement processes and begin capitalizing and reporting according to these new FRTB standards. Financial institutions can do this according to Standardized Approach (SA), or the Internal Model Approach (IMA). As they prepare for major changes in their calculations and struggle to accommodate Basel IV and the recent FRTB changes, organizations are faced with critical decisions about data governance, risk management, calculation changes, and efficiencies. Unlike the witches of Macbeth, they can’t simply make these problems go away by casting a spell.
The new approach essentially overhauls the existing one to, arguably, better reflect the level of market risk to which individual financial institutions are exposed. It is much more detailed and sophisticated and requires firms to perform more calculations, resulting in increased data requirements. And whether they want to or not, most will need to increase capital in order to support their trading activities.
As they cope with FRTB changes and address how to accommodate them, institutions are asking critical questions, including:
- Can our current architecture handle the large volume of valuations and reconciliations required to determine the appropriate IMA-related profit and loss attribution?
- Can we accommodate both IMA and SA calculations?
- Are we making business decisions based on sound risk and governance principles or are we reacting to the output floor?
- Are the new required data sets (including the relevant sensitivities) under SA integrated seamlessly into our calculation engine and reporting requirements?
- Can we absorb the additional IT / finance / risk and resource burden?
One Fell Swoop
With the extensive Basel III reforms, now referred to as Basel IV, financial institutions are faced with tackling a multi-faceted problem all at once.
Could this be a chance to strategically address several critical questions in one fell swoop?
Financial institutions require transparent data, robust analytics, a scalable, technology-driven approach, and end-to-end processes that enable confident compliance. And as global financial markets adjust to a new normal after COVID-19 disruptions, it is even more important than ever for financial institutions to have transparency into their data, calculations and risk, be able to optimize efficiencies, and be prepared to manage change across their organizations.