UK: Fundamental Review Of The Trading Book - A New Round Of Upheaval And Change For Trading Operations

Last Updated: 9 February 2016
Article by Ian Kelly

The Basel Committee on Banking Supervision published its finalised framework for assessment of market risk, a major part of the Fundamental Review of the Trading Book (FRTB), on 14 January 2016. This follows a lengthy period of consultation with the industry. National regulators must implement the new rules by 2019.

While some of the more controversial aspects of the earlier proposals - such as desk-by-desk disclosures - have disappeared, many far-reaching changes remain.

  • Trading Book / Banking Book boundary: There will be more strict rules on whether items can be designated as being in the trading book or the banking book. The Basel text now includes 'presumptive lists' of items that it would expect to fall into each book. Most listed equities, for example, will need to be held in the trading book. Switching instruments between the books will be much trickier and require prior supervisory approval. Crucially, any capital benefit derived from switching instruments between the books will be offset by a Pillar 2 add-on. This will leave banks wondering if switching between books is really worth the trouble.
  • Revised Standardised Approach: The new standardized rules will be more complex and risk-sensitive than the current rules. For debt instruments and commodities, the capital charges will be determined by more granular risk-weight tables. Equity risk-weights will be driven by the issuer's geographic location and financial soundness. Positions will be subject to an additional 'Default Risk Charge' and a 'Residual risk add-on'.  Capital charges for foreign currency exposures will see a sharp jump from the current 8% risk-weight to a 30% risk-weight. A small number of 'approved' currency pairs will attract a risk-weight of 21.21%.
  • Internal Model Approach (IMA): VaR will be replaced by an Expected Shortfall (ES) measure. Model applications and approvals will be determined on a desk-by-desk basis rather than portfolio wide, with 'backtesting' and P&L Attribution assessments of the model applying at the level of each desk. This will effectively require each desk to be viable on a standalone basis. Desks that breach certain quantitative backtesting or P&L Attribution thresholds will be forced back on to the Standardised Approach for a minimum of 12 months. In a worst case scenario this could lead to a situation where multiple desks could be moving in or out of scope of IMA simultaneously. Furthermore, this contradicts the EBA's recent draft RTS on market risk, which proposed that market risk internal models would need to cover 90-95% of positions.  Perhaps most strikingly, desk structures must be 'approved by supervisors'. Supervisors will have to consider whether the proposed desk structures are sufficiently granular and meet all the governance conditions.
  • Securitisation: All securitisation positions must now be assessed under the Standardised Approach rather than under IMA. In most cases this will significantly increase capital charges for securitisation positions.
  • Capital floor: Similar to the credit risk framework, Basel is planning to introduce a new 'capital floor' which will operate as a minimum capital requirement for banks that use internal models. The floor is expected to be calibrated as a percentage of the capital charges that would apply under the standardised approach, e.g. 50-80%. This will require banks to assess all of their positions under the new standardised rules even if they have IMA approval for certain desks.

The impact of these changes will be profound. All eyes will now turn to the European Commission and the EBA for an indication of how these standards will apply in Europe, and whether the European authorities will try to tweak or amend any final rules that are applied. For globally active banks this once again raises the familiar worry that FRTB may end up being implemented differently in different jurisidictions, e.g. between the United States and Europe. Obtaining supervisory approval for trading desk structures could be a difficult and time-consuming exercise for banks.

The Committee says it will consult on revisions to the market risk disclosure framework separately. It is also expected to consult on the level of the capital floor following a QIS exercise.

Whatever form FRTB will take in European legislation, it is clear that front-office engagement and a strong understanding of risk and capital allocation across front office desks will be crucial to ensuring its orderly implementation. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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