Report: Doubt over capital impact of FRTB’s IMA

By Rebekah Tunstead | 13 November 2019

The capital impact of the Basel Committee on Banking Supervision (BCBS)’s Fundamental review of the trading book (FRTB) is still being debated by the industry, according to several bankers, and market participants.

As part of the Basel III reforms, banks must choose whether to calculate their market risk capital requirements using the standardised approach or internal model approach (IMA). While some say there is a lack of incentive to adopt IMA - as the cost to implement the model is high in comparison to the standardised approach - others say few banks have done enough research into the calculation method to understand its benefits.  

The revised framework was published in January this year and will take effect on January 1, 2022. According to a statement by the Bank of International Settlement (BIS) in January, the revised framework was “estimated to result in a weighted average increase of about 22 percent in total market risk capital requirements relative to the Basel 2.5 framework.”

On October 2, the BCBS stated that the minimum required capital would rise 18.6 percent for large European banks upon full phase-in of the Basel III standards. It also showed a considerable decrease in the adoption of IMA under the revised reforms.

Regulators are unclear as to whether they expect banks to model or not, according to the head of modelling at a North American bank.

“It is unclear whether the regulators hold the same view that they did in the past, expecting you to build a model for your value-at-risk (VaR) or expected shortfall.”

To gain IMA status a bank’s desks must be able to pass back-testing and the P&L attribution test -as set by the BCBS - requiring significant costs in updating technology infrastructure, and ongoing data processing, according to Subrat Mishra, vice president, risk management, market risk programme for FRTB at Nomura International. The risk factor eligibility test determines what can be modelled within IMA, versus what isn’t deemed modellable, and therefore is subject to a stressed capital add-on (SES) charge. The alternative is to adopt the more punitive standardised approach.

But too many banks relying on the standardised approach creates excessive systematic risk, says Mishra.

“You are putting every bank into one category which means you are not able to capture risk properly. In another five or ten years when everyone is going in one direction, everyone will feel it at the same time,” says Mishra.

“We are seeing certain cases where regulators are asking banks to do IMA risk analysis, and that means that banks will have no option but to do it.”

On September 2, published figures from an Isda survey which indicated a much larger impact on market risk-weighted assets, with some respondents saying it could be more than three times the estimates made by the Basel Committee.

But the head of modelling says the capital impact of IMA is not as high as some peers may suggest

“I don’t believe the [sampling] data is indicative of what the banks can really achieve if they implemented IMA efficiently… you end up with exaggerated numbers but if you are really working on it to get it done, and investing in it, my belief is you would get different numbers.

“I believe the [capital] impact now is very good. I know you will find others that may believe differently but we’ve gone further ahead on some of the areas that were more uncertain.”

“I believe the impact of IMA is essentially neutral. If you don’t take advantage of the allowances that are given, then anything can happen. If you want to have a portion of your desks on SA and a portion on IMA then you are not going to get the benefit of IMA necessarily. All bets are off if you are not fully implemented on IMA. If you were to implement everything that you can implement on IMA, I’m expecting in the long-term people will find the impact potentially neutral.”

But too many banks relying on the standardised approach creates excessive systematic risk, says Mishra.

“I will be surprised with all the cost that everyone is incurring with regulation that it will be easy to absorb that [IMA] additional cost without consideration from regulators,” says Subrat.

Upgrading technology infrastructure

The capital impact of non-modellable risk factors (NMRFs) can be mitigated - to some extent - based on what individual banks are able to do with respect to the pooling of data by broadening their coverage so more assets become modellable, says Andrew Aziz, global head, financial risk analytics at IHS Markit.

“The regulations allow banks to proxy some of their NMRFs which mitigate some of the impact,” he says. “Of course, there is still a basis that is subject to an SES charge, and which of course would be punitive, but it wouldn’t be on the whole component, it would be on that component which isn’t proxied.”

The re-emergence of complex financial instruments such as collateralised loan obligations could be adding to the increase in NMRF, suggests the head of risk technology at a North American Bank.

In analysis published January 25, the Bank of England  said most market analysts believe there to be around $1.3trn in outstanding leveraged loans. That figure doesn’t include smaller and less liquid loans, according to the central bank, which, when included force the global figure to reach $2.2trn.

A quarterly BIS review published in September, found that the rapid expansion of the leveraged loan market had been accompanied by the securitisation of leverage loans into CLOs. In 2018, the number of outstanding CLOs was around $750bn. “As of June 2019, over 50% of outstanding leveraged loans in US dollars and about 60% of those in euros had been securitised through CLOs,” the review read.

But part of the problem is the required technology for the data aggregation necessary for the implementation of IMA, and the ability to standardise the pooled data, according to Mishra.

“It’s not about just one capital cost investing in the IT system once and it is done. No, with NMRF you have got to have vendor data, you need to consume the vendor data, you need to set an operation to monitor that vendor data, and translate that into something,” says Nomura’s Mishra.

“Even after you have done that you still need to be able to standardise the data you are going to pull in from the vendors, and then you will need to translate your internal definition so that you can convene with your model, so that would be a bit of work that you would still have to do,” he says.

Banks using the standardised approach are given an additional advantage of being prepared for other types of reporting on risk calculations, according to the head of risk technology.

“The problems that banks need to solve [with SA] to some degree is very similar to the problems they need to solve elsewhere, which is having a reliable definition of the instruments they’re trading, having a reliable definition of how they calculate sensitivities, and having an efficient way of aggregating them.”

Yet many banks remain at a model analysis stage agree the banks, with some seeing FRTB moving progressively down the list of priorities.

 “The first time that there was a ‘FRTB now’ kind of conversation was probably five years ago,” says the head of risk technology. “A few years ago, we thought that FRTB was just around the corner, and we were looking at changing our systems.”

“It feels almost as if you are even further away from Basel IV than we’ve been in the past.”

Legislative uncertainty

Due to changes in the implementation of FRTB and their conflict with the EU’s own capital requirements, European regulators agreed it would not be appropriate to implement the FRTB rules as initially proposed by the European Commission because it would oblige institutions to meet requirements subject to change in the short term.

Instead, the European Council, Parliament, and Commission adopted a reporting requirement, which would come into force “once the elements reviewed at international level are introduced via a number of level 2 measures (delegated act for the standardised approach and RTS developed by EBA for the internal model approach),” the EU Commission said in a press release published on April 16.

Europe’s revised capital requirement rules (CRR II) were published in the Official European Journal on June 7.

In Germany, banks remain focused on ensuring they comply with CRR II – which is compulsory - rather than FRTB – a recommendation - according to Frederick Winter, a financial regulation partner at LinkLaters LLP.

For Winters a number of Basel IV recommendations remain unclear, particularly around daily price quotes for equity investments in a fund.

“Are we talking about real prices in the sense of prices based on actually transactions on a trading venue or are we talking here about daily prices that are available from the investment company but for which there is no daily pricing based on trading?” says Winters.

But there are a number of Basel IV rules yet to be adopted into CRR II which is becoming “critical” he says.  

“There is still room for change here and additional regulatory technical standards will be enacted in due course and all this contributes to a situation where the industry is to an extent a bit overwhelmed by the sheer magnitude and speed of regulatory change,” says Winters.


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