..... database and enhancement of market risk-related
The way forward on FRTB implementation Minimum capital requirements for market risk July 2016
Contact us: Nageswara Sastry Ganduri
Kshitij Bhatia
Director, Risk & Analytics
Director, Risk & Analytics
[email protected]
[email protected]
Santhosh Kumar Associate Director, Risk & Analytics
[email protected] www.crisil.com/gra
Table of contents FRTB – The New Minimum Capital Requirements for Market Risk ..................................................... 5 Questions confounding practitioners ................................................................................................... 6 FRTB implementation charter ............................................................................................................... 8 The way forward on FRTB implementation .......................................................................................... 9 CRISIL GR&A is a preferred partner in FRTB implementation .......................................................... 10
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FRTB – The New Minimum Capital Requirements for Market Risk The new minimum capital requirements for market risk is commonly referred to as Fundamental Review of Trading Book (FRTB). FRTB marks the emergence of a new regime, where banks will be compelled to think about reoptimizing their businesses to minimize capital requirements. The new framework makes capital charge calculations a function of market moves, acknowledges the severity of tail events, and ensures banking and trading book boundaries are impermeable.
The revised components Under the FRTB, banks have to move away from reporting at the legal entity level to the desk level. All desks have to calculate capital charges based on the Standardised Approach (SA), irrespective of whether they are eligible for Internal Model Approach (IMA) or not. Desks where IMA is rejected or approval is withdrawn have to fall back on SA for capital calculations. As per the latest quantitative impact study (QIS), the Standardised Approach is expected to be more punitive on capital charges than IMA. However, implementing IMA is more challenging because of the stringent approval process involved.
The Standardised Approach The SA has three components of capital charges that are aggregated – 1. Sensitivity-Based Charges 2. Default Risk Charge (DRC) and 3. Residual Risk Add-on. Sensitivity-Based Charges cover both linear and non-linear risks across asset classes. While linear charge includes delta and vega risks, the non-linear one is the curvature risk. DRC measures the rise in default risk. In SA, it is calibrated to the credit risk treatment for the banking book. DRC is calculated separately for securitization (for correlation trading portfolio, or Sec CTP, and non-correlation trading portfolio, or Sec Non-CTP) and nonsecuritization. Residual risk add-on uses a simple notional-basis calculation.
The Internal Models Approach The IMA has three components of capital charges that are aggregated – 1. Expected Shortfall (ES)-based Market Risk Charge, 2. Value at Risk-based Default Risk Charge, and 3. Stressed ES-based Stressed Capital Add-On. ES aims to capture tail risk, and, along with Stressed ES, replaces VaR and Stressed VaR in IMA. ES affords elbow room to handle illiquidity by incorporating varying liquidity horizons. As for Default Risk Charge in IMA, it is VaRbased. The granular model approval process requires monthly back-testing and daily P&L attribution. IMA desks also need to identify modellable (MRF) and non-modellable (NMRF) risk factors because additional stressed capital addon charges apply to the latter. IMA is also subjected to stringent regulatory approval process failing which desks will have to fall back on SA. The approval process includes back-testing, stress testing and P&L attribution tests, which desks have to pass, along with stringent qualitative standards and internal and external validation.
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SA and IMA: Key changes owing to Minimum Capital Risk standards Approach
Standardised Approach
Components
Previous framework
Minimum capital requirements framework
Metric
Risk-weighted exposure
Sensitivity-based approach Default Risk Charge Residual Risk Add-On
Linear summation of RWA per asset class
Risk-weighted sensitivities summed per asset class Worst of the calculations based on three levels of correlations to be chosen
Calculation
Perimeter
Metric Internal Models Approach
Calculation
Trading book not considered for IMA
Trading book under IMA to be considered as a fallback and a benchmark
VaR at 99% Stressed VaR at 99% Default, Migration based on VaR
Expected Shortfall at 97.5% (MRF) Stressed ES at 97.5% Default Risk Charge
Daily shocks multiplied by √10
Liquidity Horizon (up to 120 days) MRF, NMRF treated differently
IMA is applicable not at a desk level but at overall trading book level
Desk Level Model approval subject to passing of PL attribution & Desk back-testing tests on regular basis
Perimeter
Questions confounding practitioners Industry experts are facing many unanswered questions and there is no clarity on the best way forward. Here are some of the vexing issues:
Organisation of trading desks
Currently most banks follow the Volcker Rule-based trading desk structures
In order to optimize capital charges at the firm level, a reorganization of desks may be needed
Transition to a new desk structure may not be smooth and straightforward in most cases
FRTB might change the capital charge landscape within different desks of a banking entity. From the perspective of managing the internal structure of a bank, this will throw up new challenges.
Overall cost of model maintenance
Stringent regulatory restrictions and desk level monitoring of models for internal model approach poses new difficulties for model maintenance.
P&L attribution test, back testing and stress testing tests need to be passed at the desk level to continue to enjoy the benefits of IMA, failing which banks need to switch to the punitive SBA approach.
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Switching from VaR to ES
Major stakeholders in the finance and risk functions are very familiar with VaR as a risk measure. Moving from VaR to ES would mean that many internal and external stakeholders will have to grapple with painful teething issues.
Also, a complete understanding of the differences in capital impact requirement between SA and IMA for each individual desk is lacking. The impact of capital floors is also not well understood.
Imagine a hypothetical situation where you are preparing to board a flight and the security authorities insist that it is not enough to wrap whole suitcases, but each and every item inside, for safety. Desk-level approvals are akin to this. And under the FRTB regime, that’s a real situation and not a hypothetical one.
Explosion of data
Increase in granularity and information intensity of capital calculation leads to an exponential increase in the amount of data to be processed.
Most banks may not find it economically feasible to maintain huge data infrastructure on their own.
New businesses surrounding pooling of data and maintaining common platforms are the future. The industry is yet to understand the true price of data for modellable and non-modellable risk factors.
The immediate focus for 2016 is largely to get the data foundation stronger, perform comprehensive impact study of various aspects of the regulation and draw up an implementation charter. CRISIL GR&A is helping banks in gap studies, drawing up roadmaps, and ramping up teams with the required skillsets to handle increased operational challenges in an optimized manner
All Aspects Of Industry Conduct May not be Cast in Stone During The Initial Years of FRTB
It would be an understatement to say that FRTB has put pressure on an industry already struggling to save their top and bottom lines. In addition to obvious costs such as rising capital requirements, banks also incur hidden costs (such as creating meta data infrastructure). Then there is the risk of pushing existing investments to sunk costs. Banks have been working out different tactical solutions to manoeuvre around. But as of today, there is no silver bullet available.
The industry might keep looking for answers even after the 2019 kick-start. For example, if IMA fails for some reason, then the corresponding desk needs to fall back on SA with a bulked up capital charge. Will this affect the price of products traded by the desk? Extrapolating this scenario might lead to a rosy picture for simpler products in the short run. CRISIL GR&A feels that all aspects of industry conduct may not be cast in stone during the initial years of FRTB implementation. It is going to be a long journey in a changing regulatory landscape - and not about that one amber signal before a hairpin bend.
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FRTB implementation charter Based on our experience of working with large banks in FRTB programs, we have seen that change management can be categorized in three stages -- Definition and Planning, Assessment, and Execution. Execution is expected to be characterized by lengthy implementation of alternative designs and architectures, involving huge investments in resources, with the exercise mostly concluding close to the final deadline. Expectedly, the scope to correct errors will be minimal by the end of the Execution stage, which amplifies the importance of getting all things right in the first two stages. So it is quite likely that the first two stages could be repeated back-to-back in an iterative manner.
A Robust Change Management Plan and Implementation
Stage III Execution • Target state definition, design and Implementation
Stage II Assessment Stage I Definition and Planning • Identification of all stakeholders who would be part of the implementation charter • Organize workshops and trainings for all involved parties/employees – Objectives, scope, responsibilities and approach are defined and sensitized • Prepare an agile based modular approach
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• Iterative assessment and review of MR components in light of FRTB guidelines – Book boundaries, model and data infrastructure, risk factor modellability, P&L attribution, backtesting and reporting • Different analyses – Gap analysis, Impact analysis, Deep dive analysis – Preparation of BRDs and FSDs • Tactical initiatives towards exploring technological and operational innovations
• Data Models - A robust risk data infrastructure aligned with pricing framework, expected shortfall implementation and risk factor modellability framework • Desk level Model Risk Management and performance monitoring Infrastructure • P&L Attribution and Backtesting – Desk level threshold monitoring
• Reporting – Model assumptions, threshold breaches, intra-day desk level reporting • Desk re-organization or realignment
The way forward on FRTB implementation We have studied the operational and infrastructural challenges for FRTB across its components under three factors: 1. Data, 2. Model & Calculation, and 3. Reporting •
SA
SBA
Identification of risk factors for risk classes
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Risk factor definition
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Maintaining consistency across desks and jurisdictions
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Defining DRC sub-bucket criteria
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Managing risk data aggregation
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Increased computational requirements
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Model development for SA - DRC calculations
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Model validation and frequency
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Incorporation of additional charge for exotics and non-exotic instruments
DRC
Add On
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Identification of instruments with exotics and other residual risks
Data •
ES
IMA
Reporting framework for aggregated capital charge across all desks (irrespective of IMA use)
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Governance structure
Model & Calculations
Reporting
Market Risk
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Historical simulations
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Enhancing VaR and SVaR models to generate ES and Scaled ES Model enhancement to account for revised/scaled liquidity horizons
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Exception monitoring framework
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Fall back process for IMA desks, breaching prescribed limit
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Liquidity horizons mapping
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Sourcing and validation of historical market data
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DRC data integrity to account for stressed data period
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Model development for IMA – DRC calculations
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Reporting framework for disclosure to regulators
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DRC validation using stress tests, sensitivity and scenario analysis
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Governance and monitoring
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Historical simulation based on full revaluation method
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DRC
Add On
Risk factor classification (MRFs Vs. NMRFs)
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Hypothetical PL – Full revaluation
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Risk-based PL
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Hypothetical Vs. Risk-based database
We have observed that firms are studying and taking a combined approach for key regulations such as FRTB, uncleared margin requirement (UMR) rules, etc. Firms are increasingly seeing this as an opportunity to repurpose their infrastructure end to end. To be sure, the extension of deadline for FRTB has given some breathing space. Listed below are some of the key components that banks need to incorporate in its implementation roadmap to ensure that challenges are addressed in a systematic and strategic manner:
Key aspects in strategic FRTB implementation program Data
Models and calculations
Reporting
Totally integrated data architecture
Calculation intensive
Centralized infrastructure -- for massive storage, retrieval and audit of data
Infrastructure to report real time at desk level
Sort data into risk buckets and classes
Implementation and calibration of ES and DRC models
Robust governance structure and processes
Maintain accuracy, traceability and integrity
Precise classification of risk factors for modellability
Development of P&L attribution and back-testing infrastructure
Fall back process to SA 9
CRISIL GR&A is a preferred partner in FRTB implementation CRISIL GR&A is working with multiple firms and is a preferred partner for end-to-end FRTB implementation support. Our vast experience right from the inception of FRTB -- including support to banks in their quantitative impact studies -- has made us an industry leader. Our team of experts, with rich experience across model development and validation, data management and change management, have helped leading banks and financial institutions meet their regulatory objectives within prescribed timelines As a part of our change-management offering, we are helping firms in drawing up a comprehensive implementation charter across various regulations including FRTB. Firms are clearly seeing this as an opportunity to repurpose their overall risk and reporting infrastructure. Our proven strategic partnerships with banks in designing and implementation of regulatory reform projects have given us opportunities to engage early with them on FRTB implementation. We support implementation and setting up of FRTB infrastructure, including centralized risk database and enhancement of market risk-related models. We are also working on developing SA templates for various asset classes and for Default Risk Charge, and developing ‘functional prototypes’ for overall strategic implementation programs. As a part of this, we are engaging with firms in revamping P&L attribution and independent price verification processes. In risk and analytics, we have helped firms conduct quantitative impact studies and benchmark analysis in the early days of FRTB, and are engaging with firms to revamp their risk-management infrastructure to support SA, IMA and DRC model development. CRISIL GR&A works with 17 of the top 20 global banks and several mid-sized/regional banks, supporting them in risk management including model development and validation, data management, and regulatory reporting. Our expertise and experience across banks have helped us execute industry best practices across projects for risk, finance and other key teams at banks.
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