The finalised version of the Basel Committee’s market risk capital framework reveals some important wins for the banks, but they certainly did not get it all their own way. By Justin Pugsley.
What is happening?
On January 14, the Basel Committee published its finalised market risk capital framework, which contained some good news for the banks, making its application somewhat less capital intensive than originally anticipated.
This text, which covers the fundamental review of the trading book (FRTB), had been causing considerable concern for the largest banks, who fear it would place serious constraints on their trading operations.
Some of the concessions to the banks are important. Indeed, the committee’s own analysis shows that the revised framework will result in a 22% increase in risk-weighted assets (RWAs) attributable market risk relative to Basel 2.5. However, that is still better than the 40% increase anticipated from the 2016 framework.
To further put that 22% increase into context, the committee says the share of RWAs attributable to market risk only accounts for 5% of bank RWAs. That, however, is an average. For globally systemically important banks (G-SIBs) the figure is higher.
Among the changes in the revised framework is a simplified standardised approach (SA) for banks with small, non-complex trading portfolios and clarifications on exposures subject to market risk capital requirements.
These contained some important concessions to banks, along with a more risk-sensitive SA, greater sensitivity in the SA for foreign exchange, index instruments and options-related risks, and revisions to SA for risk weights applicable to interest rate risk, foreign exchange risk and selected credit spread risk exposures.
The committee also refreshed the assessment process for determining if a bank’s internal risk management models appropriately reflect the risks of individual trading desks, the so-called profit and loss attribution test, and revised the requirements for identifying risk factors that are eligible for internal modelling and the capital requirement applicable to risk factors that are deemed non-modellable.
Why is it happening?
The revisions came about because of pushback from the banks over some aspects of the market risk capital framework. The committee relented on some aspects because the banks managed on this occasion to present more credible data and stronger arguments to support their case.
What do the bankers say?
While bankers feel they won some important concessions, they readily acknowledge that they did not get everything they wanted. Some still see FRTB as an essentially flawed requirement that does not properly reflect risk.
Among the concessions is a softening of the language around non-modellable risk factors (NMRFs), which changed the classification of an instrument becoming non-modellable after 30 days of no trading to a requirement for four observations in 90 days. This covers seasonality gaps, making it less likely that an instrument becomes non-modellable and therefore attracting extra capital charges.
The pass/fail tests for the use of own models has been eased. The so-called traffic light system, with ‘green’ being a pass and red a ‘fail’, now has an ‘amber’ zone. The parameters of the amber zone have been widened, making it easier for banks to fix glitches within their own models. However, many thought the committee did not make them wide enough and are now hoping for some concessions from national regulators when the framework goes live in 2022.
Another important concession is that the committee has revised the additive nature of NMRFs, which means that if there are a number of them they can accumulate into a big capital charge. Some leeway has been made around un-correlated positions, thereby recognising the benefits of a diversified portfolio.
Will it provide the incentives?
The revisions make some aspects of FRTB easier and less capital intensive for banks, but still penalise more exotic instruments. The framework as a whole also remains very demanding to implement and comply with.
However, the more risk-sensitive SA was widely welcomed by banks of all sizes. Many tier-two and tier-three banks are likely to use it instead of their own in-house models, which require a great deal of testing and validation and are expensive to develop. Others may simply outsource their trading functions to a sophisticated G-SIB.
Some industry sources believe the revisions do make a good balance between internal models and the standardised approach and that the framework more or less establishes the right boundaries between the bank book and the trading book. Others are yet to be convinced.
