At the end of this year, the Basel Committee on Banking Supervision plans to finalize its Fundamental Review of the Trading Book (FRTB). And the impact – based on recent analysis led by ISDA, GFMA and IIF – looks like it will be significant, with banks having to hold multiples more capital than they do today.
According to an analysis of data submitted by 28 banks, and based on current calibrations, the standardized approach will result in 4.2 times the total market risk capital that firms hold under the existing methodology. That’s a big increase. And it matters for a number of reasons.
For one thing, trading book capital requirement increased substantially in the immediate aftermath of the crisis through Basel 2.5. Raising capital levels further was not a stated objective of the review. Instead, the FRTB was intended to overhaul trading book capital rules, replacing the mix of measures introduced through Basel 2.5 with a more coherent set of requirements. The changes are primarily targeted at addressing structural shortcomings in the market risk framework by including a risk-sensitive standardized approach, as well as reducing the variability in capital levels between banks.
The results suggest these objectives aren’t being met. For example, 47% of the total market risk figure comes from a new notional-based add-on to capture residual risks under the standardized approach. As a notional-based measure, it’s not risk sensitive: it depends on the size of positions, rather than the risk they pose. The analysis also shows large differences between capital numbers generated under the internal model and standardized approaches. This is important, because the Basel Committee intends the standardized approach to act as a credible fallback to internal models, making it easier for regulators to withdraw internal model approval. However, the analysis suggests a change from internal models to the standardized approach would require between 2.1 and 4.6 times more capital, depending on the risk-factor class.
The 4.2 times increase in market risk capital under the standardized approach isn’t just an issue for smaller, less sophisticated banks or those that lose regulatory approval to use internal models. Last December, the Basel Committee proposed introducing capital floors as a backstop to internal models. Any floor would likely be set at a percentage of the standardized model output – so, the higher the capital requirements under the standardized approach, the higher the floor.
Engagement between the regulators and the industry on the FRTB has been extremely constructive so far – illustrated by the Basel Committee’s decision in June to run an additional QIS. That came in response to concerns expressed by the industry about the quality of the data submitted for the first two firm-wide studies.
These results, however, pose some fundamental issues. An increase in capital of this magnitude could result in certain markets and businesses becoming uneconomic. This includes the securitization market, where the results show a 2.2 increase in capital requirements, as well as credit to the SME sector and small-cap equities. This reduces the availability of financing for borrowers at a time when some jurisdictions are increasingly focused on initiatives to generate and sustain economic growth. Additional increases in capital could also further reduce dealer capacity and affect market liquidity.
ISDA is pleased to be able to contribute to this important discussion to help quantify the impact of this capital rule. We hope the Basel Committee will continue with its constructive engagement and consider modifications suggested by market participants that will meet the objectives of the trading book reforms, while keeping capital at a level that is proportionate to the risk.