Research Post

Fundamental review of the FRTB comments

Fundamental review of the FRTB comments

12 November 2018

Ahead of the anticipated release of the final FRTB standards expected by the end of this year, we take a review industry feedback from the 42 respondents to this year’s consultation by BCBS. Unsurprisingly, the views expressed by respondents strongly reflected both the nature of the business and geographical location as well as the size of the market in which they operate. Looking at these responses by respondent type, theme and preferences, we identify the key areas of concern and provide commentary on the most popular choices among the changes suggested. This should enable quick analysis of how well key areas have been addressed, once the final standard is published.

On the 22nd of March 2018, the Basel Committee on Banking Supervision (BCBS) published its consultative document (CD) on the proposed revisions to the new market risk framework, Fundamental Review of the Trading Book (FRTB). The BCBS invited interested parties to provide comments on the suggested proposals in the CD by 20th June 2018. As published on the BIS website, 42 parties (comprising organisations and individuals) responded to the BCBS’ invitation for comments. As the anticipated release of the final FRTB standard is fast approaching, this paper reviews the comments submitted by these parties with the view to highlight the key areas of concern raised by the industry participants on the revisions proposed by the committee. This review should enable quick analysis of whether these key areas have been addressed in the final standard once it is published.

Summary of proposals in CD

According to the BCBS, the revisions detailed in the CD are designed to address issues identified as part of the ongoing monitoring of the January 2016 FRTB standards . The impact of these revisions is varied – whereas the proposed changes to RWAs used in the Standardised Approach (SA) will lead to a reduction in capital allocation, the introduction of strict market data principles to determine modellability of a risk factor will inevitably lead to more capital add-ons under the Internal Models Approach (IMA) as more risk factors are deemed to be non-modellable. The impact of the proposed revisions across the key areas of the standards are discussed below.

A.  Standardised Approach: The highlights of the proposed revisions to the Standardised Approach include the following:

i.  The recognition of a currency pair as liquid if it can be formed from the combination of any two currency pairs which are in the current list of liquid currency pairs as defined in the FRTB standards. This new currency pair can thus be allocated lower risk weights.

ii.  Modifications to the curvature risk measurement to ensure a) application of consistent shock scenarios to risk factors within the same bucket and b) application of a floor to the formulae used to calculate the aggregate curvature risk capital.

iii.  Reduction of risk weights for the following risk classes: Interest rate, Equity and FX.

B.  Internal Models Approach: Proposed revisions under the IMA address key elements of the Profit and Loss Attribution (PLA) test and provide a set of principles to determine whether a risk factor can be included in the Expected Shortfall (ES) model or should be subject to Non-Modellable Risk Factor (NMRF) charge. With regards to the PLA test, the committee proposes the following:

i.  Alignment of the market data input used to calculate the Hypothetical P&L (HPL) and Risk-theoretical P&L (RTPL).

ii.  PLA test frequency to be updated to quarterly and will use the preceding 12-months data sample.

iii.  The introduction of two new metrics: Spearman Rank correlation coefficient, to measure the correlation between the HPL and RTPL; and a choice of either Kolmogorov-Smirnov (KS) or Chi-squared test, to assess the similarity between the distribution of the HPL and RTPL data.

iv.  The introduction of the “modified traffic light” approach to smoothen the transition of a trading desk from using IMA to SA to calculate its capital requirement. This minimises the volatility in capital allocation.

In addition to revisions made to the PLA test, the committee also outlined a set of principles to govern the selection of market data used to calibrate internal models and forms part of the NMRF framework. The committee also welcomed comments on the effect of seasonality on the NMRF framework as well as comments on whether the current treatment of idiosyncratic equity risk results in high capital charges for equity risk NMRF. Furthermore, a choice of alternative bucketing options is proposed for risk factors that represent a point on a curve or surface to meet the Risk Factor Eligibility test (RFET) requirement. Alternative 1 provides banks with the flexibility to define the buckets for risk factors with the condition that buckets must not overlap while alternative 2 stipulates the use of standard buckets defined by the committee...


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