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FRTB’s First Steps and Stages

The Fundamental Review of the Trading Book (FRTB) regulation being instituted by the Basel Committee on Banking Supervision (BCBS) in January 2019 is the de facto successor to the global banking supervision organisation’s Basel III guidelines on market risk and capital adequacy.

Financial services firms are beginning to consider the demands FRTB makes on their trading operations and working to understand the fundamentals of FRTB. Intelligent Trading Technology spoke with Charlie Browne, head of market data and risk solutions in the London office of GoldenSource, the enterprise data management solutions provider. Browne shares his thoughts on what firms should learn about FRTB obligations, how they can prepare and what GoldenSource is offering to meet FRTB needs.

“You have two stages in any new regulation — interpretation and implementation,” says Browne. “In the interpretation stage, policy people go through the terms of the regulation with a fine-tooth comb, trying to understand the impact on capital and the bank. There tends to be a little panic there that if they don’t get it right, it will have a huge impact on capital.”

Firms tend to prefer a steady course on implementing a FRTB solution, according to Browne. “They don’t want to be the most aggressive, or the most prudent. They don’t want to set aside more capital than anyone else or less capital than anyone else,” he says. “They want to be in the pack. It’s an uncertain implementation framework. It’s really difficult to decide to spend $50 million on a FRTB framework and build it prescriptively. You know it will take some time to pin down.”

Financial firms are thinking about how to calculate risks relevant to FRTB, so GoldenSource works with partners who specialise in calculating those risks. “We have clients saying that whether partners do the calculations or they do the risk calculations themselves, they need providers who are good at handling data and understand exactly what the data requirements are for FRTB,” says Browne. “It doesn’t matter how good your calculation logic is, if the numbers are wrong.”

Standard and Broader Methods

There are two main approaches to calculating capital under FRTB, according to Browne. The standard approach uses prescriptive rules and weightings that banks may apply to open positions, he says, while the internal models methodology allows banks to use their own expected shortfall calculations. These calculations are based on time series data for historical positions and determine the amount of capital a firm must have, adds Browne.

The internal models approach is broader and can catch more, he explains. “Instead of looking at point-in-time position data, you’re trying to use historical movements in prices to determine what future movement of prices will be,” says Browne. This is a switch from the standard approach using point-in-time positions and aggregation of current positions. Internal models calculation considers risk sensitivities and profit-and-loss (P&L) figures.

The consideration of P&L happens through a test which “uses approximations of the front office’s calculated P&L,” says Browne. “It has to do these calculations so many times for simulation purposes and other reasons, so the P&L attribution test makes sure the risk-based calculations are aligned very closely with official calculations. So it looks at P&L over the past year, as calculated within the risk system. It looks at P&L calculated in front-office systems and checks the differences between the two. The calculations don’t allow much room for difference between risk P&L and front-office P&L.”

Risk sensitivities can be measure through a Value at Risk (VaR) “back-test,” he adds, which “goes back over the past year and see if you lost more than you should have over a number of occasions. If you did, your VAR model isn’t working and the back-test will fail. If it fails, you don’t have enough capital.”

Since FRTB is an update of Basel III and BCBS 239 risk data aggregation rules, firms can use elements of work done for compliance with those rules as a foundation for FRTB compliance plans, according to Browne. “If your BCBS 239 project has gone in and you have proper risk aggregation processes and underlying data management principles in place, you should take advantage of that,” he says. “Everyone should be able to aggregate risk using a common set of attributes in a common way. The incremental effort of delivering these risk-based solutions for these risk-based regulations should be minimal. You don’t need to build a risk aggregation platform for every single regulation.”

Bridging Approaches

GoldenSource’s contribution to FRTB compliance addresses firms’ set up of risk factors, as related to risk aggregation processes, links market data that is evaluated using the standard approach for calculating capital to historical prices that are used to inform internal models methodologies, and, finally, making the calculations of risk within all of those parameters.

“We can link external market data to the bank’s own position,” says Browne. “Those positions must be categorised using risk factors, but we allow banks to set up those risk factors and link them to risk positions. At the same time, we have connections to market data vendors who characterise if the prices were real historically.  We’re probably uniquely positioned to tie up those internal risk positions to the external real price data.”

So, FRTB compliance, as Browne sees it, is best achieved with a careful and considered plan that values both the latest market data and historical information, seeing these as having equal merit — and seeing ways that using different models can combine to produce a layered, better informed view of capital adequacy and risk. The pieces necessary are not so hard to find, since many may already be available and running to address previous capital adequacy regulations that are forerunners to FRTB.

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