A Guide to FRTB and Why It’s Important

A Conversation with SIFMA’s Peter Ryan

The Fundamental Review of the Trading Book (FRTB) was initiated by the Basel Committee on Banking Supervision in the years following the 2007-2009 financial crisis with the aim of completely revising the approach of calculating risk-based capital requirements for trading activities.

In this podcast,  SIFMA’s Chief Operating Officer, Joseph Seidel, sits down with Peter Ryan, Head of International Capital Markets and Prudential Policy, to provide a high-level introduction to the FRTB, describing what it was designed to do and why we are hearing more about it now, and explain what is contained in the package of reforms.


 

Their conversation builds on SIFMA’s recent post, The Fundamental Review of the Trading Book (FRTB): An Introductory Guide, which discusses the origins of the FRTB and the objectives of the regulators that designed it, why the subject is receiving increasing attention as implementation moves ever closer and provides an overview of the core elements of the reform package. These complex series of reforms will likely have far-reaching impacts not only on the trading business models of large banks, but also on liquidity provision in key funding markets and therefore the ability of certain non-financial end-users to raise funds.

 

Transcript

Edited for clarity

Joe Seidel: Hi, thank you for joining today’s episode in SIFMA’s podcast series. I’m Joe Seidel, SIFMA’s COO, and today’s host for the podcast. I’m joined today by Peter Ryan, our Head of International Capital Markets and Prudential Policy, to give us a high-level introduction to the Fundamental Review of the Trading Book. The Fundamental Review of the Trading Book was initiated by the Basel Committee on Bank Supervision in the years following the 2007 – 2009 great financial crises with the aim of completely revising the approach of calculating risk-based capital requirements for trading activities.

This complex series of reforms will likely have far-reaching impacts not only on the trading business models of large banks, but also on liquidity provision in key funding markets and therefore the ability of certain nonfinancial end-users to raise funds. This is critical given that an estimated 73 percent of the funding for U.S. nonfinancial corporations is generated by the U.S. capital markets and because banking organizations remain crucial providers of capital market services to non-financial end-users.

Given these potentially far-reaching impacts, it is important for us to first understand what the FRTB was designed to do, why we are hearing more about it now, and what is contained in the package of reforms. So with that I’d like to open it up by asking a basic question, Peter, what are the origins of FRTB and what were the regulators’ original goals in designing it way back when coming close to 10 years ago?

Peter Ryan: Well, thanks, Joe. I think the use of the word “fundamental” to describe these revisions was quite intentional. The FRTB was designed by regulators to be a comprehensive root and branch overhaul of the way capital charges for market risk is calculated. As background the great financial crisis, or GFC, of 2007 to 2009 highlighted several core problems for the existing framework for calculating market-risk capital.

The significant trading book losses incurred by banks during the crisis demonstrated that the overall quantum of market-risk capital was simply inadequate to absorb losses during periods of major market stress. Part of the reason for this is that while the value of risk modeling approach in that framework did a pretty good job of modeling risk during normal conditions, it ended up doing a pretty poor job of capturing extreme market events, or what we typically call tail risks.

As a result, some banks were left with inadequate capital to absorb trading book losses that they experienced during the crisis. Capital levels were also lower than they should have been because too many credit positions were held in the trading book instead of the banking book, which was a consequence of more favorable capital treatment for credit positions in the former. And this proved to be a problem during the crisis as credit ratings changed, credit spreads widened, and the usual events occurred, which resulted in big trading book losses.

I think related to this there was, and still is, a general concern that the boundary between the banking and trading books was too fuzzy and the institutions would be engaging to some degree in arbitrage between them to obtain the most favorable capital treatments. And then there were other structural problems with the existing framework that the crisis uncovered. For example, the pre-crisis framework made a general assumption that trading assets could be liquidated within a 10-day period.

Even though this assumption was wildly inaccurate for many markets during normal periods, let alone during periods of stress where liquidity is often in short supply. And finally, regulators became much more concerned about the use of internal models in the post-crisis era, and this applies across the board, not just in the FRTB but in other areas as well.

There was a sense that there was a lack of comparability and transparency between banks and across jurisdictions and a recognition that there were few incentives for large banks to use the relatively risk insensitive standardized approach to calculating market-risk capital.

Joe: Thank you, Peter. That’s great, that’s an excellent description I think of what the regulators’ original goals were as they were crafting this thing. I guess from there then what are some of the details to address these concerns? How did they want to go about it?

Peter: So to address all these concerns the Basel Committee agreed to a package of reforms known as Basel 2.5, or Basel Two and a Half. Its primary purpose was to raise the overall quantum of market-risk capital which it achieved through a handful of reforms to the existing framework. These included the introduction of a so-called stressed VaR approach to modeling that better accounted for tail risk events and an incremental risk charged that will capture risks from credit-sensitive parts of the trading book.

These changes increased market-risk capital by about two to three times for most banks, an increase that addressed the immediate concerns about capital inadequacy. But it was widely acknowledged to be a stopgap measure, and there was a clear sense that the entire framework needed to change at a more fundamental level, so that is where the FRTB comes in. The FRTB is designed to completely overhaul the existing framework by doing a number of things.

First, it’s designed to create a clear regulatory boundary between the trading and banking books. Secondly, it replaces that VaR modeling approach to risk measurements, you know a more comprehensive metric that’s supposed to capture a wider array of risks and approach as expected shortfall. Third, it revises the standardized approach to make it much more risk-sensitive and allowing it therefore to be a more critical fallback to the internal models approach, or IMA.

And I apologize, there are a lot of acronyms here so we’ll try and keep them to a minimum, but IMA is one to remember. Fourth, it replaces the static 10-day liquidity horizon assumed under the VaR framework with liquidity horizons that vary within the IMA. Fifth, it creates a mechanism to account for low levels of liquidity in thinly traded markets, and it does this in the form of a capital add-on charge under the internal models approach or IMA, and that’s known as the non-modellable risk factor charge.

And finally, it creates an even more robust approvals process for obtaining regulatory approval for IMA use and requires that these approvals be obtained at the level of individual desks rather than granting firm-wide approval. One thing I’d highlight is that unlike Basel 2.5, the FRTB was not designed with the explicit intent of increasing the quantum of market-risk capital in the system.

But the FRTB almost certainly will lead to significant capital increase across the industry, some estimates put the aggregate capital increase at two to two and a half times current levels, and will have major impacts on a variety of different markets. So while raising capital may not be an explicit goal in this process, it’s an almost driven outcome of FRTB implementation.

Joe: Interesting, so the FRTB even at a time when the banking industry has proven itself to be extremely resilient through crises, through multiple stress tests last year, even with all of that, this is our new requirements that will lead to even further increased capital costs for banks. What are some of the real-world impacts of these reforms and what they will create?

Peter: That’s a great question, Joe. There will be impacts in every single section of the capital markets with the implications for the ability of a wide variety of end-users to finance their activities. Just to pick a couple of examples, the Basel FRTB framework does not allow securitization exposures called in the trading book to be internally modeled. This is going to result in significant capital increases for banks engaged in securitization trading and could lead some institutions to fall back from market-making activity.

That ultimately leads through to increased financing costs for businesses and consumers. In other areas, in the corporate bond market, many smaller corporates may find it harder to raise funds, both generally just because their bonds were thinly traded and failed the modelability test included in the FRTB. Those higher capital charges for banks make it less economical for them to engage in market activity in those types of corporate bond markets.

Emerging markets [unintelligible] of the implementation of the FRTB, their capital markets are not only far less liquid than they are in the United States, and other developed countries, and thus also more likely to fail the modelability test included in the FRTB. This could discourage international banks from participating in those markets and force domestic banks to rely more heavily on the capital-intensive standardized approach, again raising financing costs for businesses and consumers. As a result, one concern is that this could inhibit economic development in some of those countries.

So those are a few examples as I know that it impacts the effort to be in every market across the globe. And as new markets and products emerge, they’re also going to be shaped by the FRTB. For example, a recent study showed that the reform package could negatively impact the emerging carbon and credit trading markets by imposing a more punitive risk charge on carbon certificates, and more generally penalizing banks for carrying these positions on their books.

If that isn’t fixed then obviously they [unintelligible] climate change. So we’ll examine those impacts, and I know there’s more detail in future blogs of the podcast on the FRTB so for our listeners, be on the lookout for those in the coming weeks.

Joe: Well, thank you, Peter. Thank you for that very helpful background. So now that we have some better understanding of the FRTB’s purpose and potential impact, can you provide us with a little more detail on its core components?

Peter: Absolutely. As I see it the FRTB standards decreed by the Basel Committee in 2019 can be broken down into four main components or changes. The first is the standardized approach. As I just mentioned, the FRTB completely overhauls the standardized approach to make it significantly more risk-sensitive. It does it primarily through something known as the sensitivities-based approach, or SBA, and I know I said I’d keep the acronyms to a minimum so we’ll try and do that here.

The sensitivities-based approach is essentially a parametric VaR model with regulatory rates. It involves a complex series of calculations that will be discussed in more depth in the blog. The standardized approach also includes a Default Risk Charge which captures credit risks spread, it’s the credit spread risks and residual risk add-on charge that captures a variety of other risks not fully accounted for by the sensitivities-based approach.

The second pillar of the FRTB is the revised internal models approach. As I already mentioned, the FRTB changes the internal models or IMA framework to make it more conservative and harder to qualify for. It makes the framework more conservative principally through the substitution of the VaR model with an expected shortfall approach, which regulators think and is generally viewed as being better at capturing more extreme market risks scenarios.

As we’ve already referenced, it has a new charge for so-called non-modellable risk factors, that is, as its name suggests, risk factors that are unable to be modeled. And this most often occurs because there is a lack of readily available data, something that typically occurs in less likely markets. The new package of reforms in the FRTB also makes model approval vastly more difficult.

First, it requires the models be approved at the level of individual trading desks, which is a change, it used to be firm-wide approval, and that’s a far more resource-intensive process for banks. Second, model approval is made more difficult going through a variety of rigorous performance testing requirements, the most notable of which are daily P&L attribution tests, and that’s a topic that we’ll also discuss in future blogs, as well as vigorous backtesting requirements.

Failure to pass these tests can lead to a loss of IMA approval. In short, as you might be able to guess, the intended effect of all of these changes to both the standardized approach and the IMA approach is to move more firms and desks out of IMA and into the standardized approach. Beyond the changes to both the standardized and internal models approach, the FRTB also creates a clear boundary between the banking and trading books through a variety of new rules, including intense trade requirements and through the creation of a presumptive list of trading book assets in trading desks.

And finally, and this is sort of the fourth pillar as I see it, and this is less of a substance than a process change, the FRTB will require vast increases in the amount and granularity of market risk data that firms are required to gather, test, and monitor, with many tests, such as the P&L attribution test I just mentioned, required to be performed on a daily basis. As a result, FRTB implementation will require firms to invest large sums into huge technological builds to meet these new requirements.

So that’s the 10,000-foot version of what was an immensely complex set of standards.

Joe: So one last question then is, as we approach this proposal and the U.S. implementation of it, what is the plan, when will the FRTB actually be implemented here in the U.S.?

Peter: Well, we don’t have a definitive answer, but we can make some educated guesses. When the Basel Committee agreed on the final standards in 2019 marking the end of what was an almost seven-year process, they set January 1, 2022, as the date by which national regulators needed to implement the reforms. That always seemed like an ambitious date given the complexity of the changes and the amount of time firms will need to build the infrastructure and systems to implement them.

The COVID crisis made achieving the implementation date even less feasible, so as a result the Basel Committee agreed to a one-year extension to their original timeline moving the implementation date to January 1, 2023. While some jurisdictions have definitely made progress in incorporating at least parts of the standards international rules, most are still a long way from finalizing rulemakings let alone implementing the standards by the end of 2023.

And, of course, of greatest relevance to us, U.S. banking agencies have even yet to release an FRTB proposal. Assuming that the U.S. banking agencies release a proposal this fall, likely in conjunction with all the elements of the so-called Basel III endgame package, the rule itself is unlikely to be finalized until the end of 2022, then that’s really just owing to the vastness of Basel III reforms and then complex interactions between different parts of those.

That makes implementation of most parts of the package in 2023 feasible and most likely means implementation in the U.S. will extend into 2024 or beyond.

Joe: And then given the relative size of U.S. capital markets, will the U.S. need to be first, or how do you see the U.S. implementation dovetailing or working with… Is the goal to have everybody do it all at once or in some type of staggered setting across the globe?

Peter: The goal is to have everyone do this at once. And I think institutions really want to avoid fragmentation and inconsistent rules between different jurisdictions. Obviously, there are differences in the markets and that will be reflected in national expression and in the implementation of the FRTB, but I think overall there was a feeling that seeing the trading that’s regulated that make jurisdictions should implement this at the same time. So I think that there will be a move to try and coordinate that implementation date.

Joe: Okay. Well, thank you, thank you, thank you very much for walking us through all of this. It’s clear from this conversation that the FRTB represents a truly sweeping overhaul of the way banks calculate their trading risk capital charges and will have wide-ranging impacts on the business models of banking organizations and funding markets for many years to come.

As U.S. regulators move closer to a proposed rulemaking, we will be releasing here at SIFMA a series of blogs and additional podcasts on some of the important outstanding issues that still need to be addressed prior to implementation so please visit SIFMA.org to follow along. Thank you again, Peter, for joining me today, and thank you very much to the audience for listening. Have a good day.

Peter Ryan
Dr. Peter Ryan is Managing Director and Head of International Capital Markets and Prudential Policy for SIFMA.

Joseph Seidel
Joseph Seidel is Chief Operating Officer of SIFMA.