By Zoe Schiff
If you thought BCBS 239 would be a challenge, you should take a look at the proposals currently being formulated as part of the Basel group’s Fundamental Review of the Trading Book (FRTB). Happily, this will be part of what we’ll be talking about next Tuesday, when A-Team hosts a webinar on risk data analytics. And by way of homework, you can check out a great paper from our friends at Wolters Kluwer, available for free download here.
In October 2013, the Basel Committee on Banking Supervision (BCBS) released a consultative paper outlining a series of potential regulations that are expected to take effect in 2017 regarding the maintenance of firms’ trading books — how risk is calculated, how assets are defined and whether they are mobile between books, how inconsistencies between proprietary models will be managed, and how liquidity horizons will change as a result of risk measurements shifting. The key components to focus on are trading book boundaries, the standard models approach, the introduction of a new liquidity risk schedule, new parameters for risk diversification and hedging, and new risk categories.
Before drawing the boundaries between books, one must first consider whether an instrument belongs in a trading book. The BCBS proposes two main methods of determining whether a holding belongs in the trading book: Estimate whether the changes in the fair value of an instrument bear a risk to regulatory and accounting rules, and a new boundary approach that ascertains how a position is risk managed. Boundaries will be drawn between banking books and trading books by classifying assets as either bank book holdings or trading book holdings, and the designation will grant the holding a differing capital cover and risk factor. In order to transfer holdings from the trading book to the bank book or vice versa, firms will need to seek approval from regulators.
Under the current regulations, banks that choose to engage in proprietary trading have two options when they measure their risk levels and apply them to capital adequacy calculation: They can either create their own proprietary risk measurement rules and submit them for regulators’ approval before they proceed to base their risk and regulatory capital levels on them, or they can use a standardized, pre-approved model. As the former option yields lower capital requirements, thus giving banks spare change to use for further investments, banks are more likely to choose it. Due to this likelihood, the diversity of models in the market leads to a difficulty in regulation: When regulators go to review risk and capital levels, they discover frequent inconsistencies. These inconsistencies make it difficult for peers, competitors, counterparties, and investors to draw accurate comparisons, as well.
The Fundamental Review of the Trading Book proposes that firms be evaluated on their proprietary models from trading book to trading book to measure consistency. Following this line of reasoning, there must be a standardized model for capital calculations, which will become the basic requirement for capital calculations, which will, in turn, become the basic requirement for market calculations. It is suggested that regulators will see the process of calculations for these standard results in order to compare them to the results of the banks’ risk and capital levels.
Typically, liquidity horizons stand at ten days with the Value-at-Risk (VaR) calculation to measure risk. Banks have functioned under this basic assumption—that assets will be marked off within ten days. However, it has been noted that holdings have not been marked off within this ten-day period, and thus liquidity targets have been created for each risk position. Positions are variable under the FTRB, and depend upon risk measurement calculations. Differing liquidity horizons will make it difficult to calculate the impact of individual assets on the total risk of the trading book.
Recognizing that diversification can reduce capital requirements, the BCBS has determined that it is prudent to propose a method of diversification calculation. Under existing circumstances, firms have no means of demonstrating the diversification of their holdings within their trading books. The BCBS is assigning a level of risk to hedged positions, and any shift in a hedged position will cause changes to the level of diversification in the trading book. The overall changes caused will also have an effect on the required capital coverage.
The FRTB will be introducing a new batch of risks, including credit and default risk, to the asset-based categories (equities, commodities, etc.), bringing the trading book’s risk categories up to par with the banking book’s.
The regulations outlined within the FRTB are not yet finalized, but with 2017 as its tentative completion date, it is best to heed it. In order to prepare for its realization, changes to infrastructure are suggested, especially in the development of technological, regulatory, and risk expertise.