FRTB: One Piece of the Capital Puzzle

With any jigsaw puzzle, it takes time before the full picture starts to become visible. Look at any single piece in isolation, and the picture is unrecognizable. Slot several of the pieces into place, and the image slowly starts to take shape.

A comparison of sorts can be made with the package of capital, leverage and liquidity reforms being introduced by the Basel Committee on Banking Supervision. The Group of 20 (G-20) has set out the picture it wants to end up with: a Basel III framework with an increase in the level and quality of capital banks must hold compared with the pre-crisis Basel II.

But the G-20 has also decreed that any work to refine and calibrate elements of the Basel III rules prior to their finalization and implementation should be made without further significantly increasing overall capital requirements across the banking sector. This is where it’s hard to see how the pieces come together.

The latest segment of the capital jigsaw to be slotted into place is the Fundamental Review of the Trading Book (FRTB), an initiative to overhaul market risk requirements. In its January publication of the final FRTB framework, the Basel Committee estimated the revised standard would result in a weighted mean increase of approximately 40% in total market risk capital requirements. That estimate, though, was based on a recalibration of quantitative-impact-study data from an earlier version of the rules.

As a result, ISDA decided to lead an additional industry study based on data from 21 banks to determine the impact of the final requirements – and the results were unveiled at ISDA’s 31st annual general meeting in Tokyo last week.

The study shows an overall increase in market risk capital of between 1.5 and 2.4 times compared to current market risk capital. The lowest estimate of 1.5 times assumes all banks will receive internal model approval for all desks. If all banks fail the internal model tests for all trading desks, market risk capital would increase by 2.4 times. ISDA believes the end result will be somewhere in between, but this will depend on two key variables: interpretation of rules on a so-called P&L attribution test and whether the calibration of capital floors applies to market risk.

The former is particularly important – and currently problematic. Under the FRTB, banks have to apply for regulatory approval to use internal models for each trading desk, with approval dependent on passing a P&L attribution test (essentially comparing internal capital systems with front-office models). But there is currently a lack of clarity over how this test will work in practice, while banks have not had time to develop the infrastructure that would enable them to produce the data required for the test.

Without more certainty on the methodology, and without knowing whether or at what level capital floors will be set, it is difficult to accurately estimate the ultimate impact. But it is unlikely all banks will receive internal model approval for all desks, meaning the end result may be closer to 2.4 times than 1.5 times.

Crucially, the study shows the final FRTB framework hasn’t eliminated a cliff effect between standardized and internal models. If a particular desk loses model approval, capital requirements could immediately increase by multiple times. This had been something the Basel Committee had wanted to eliminate.

The FX and equity markets are most affected. Losing internal model approval under the new rules would result in a 6.2 times increase in capital for FX desks and a 4.1 times increase for equity desks[1].

These are big increases, and come on top of the jump in capital requirements already envisaged in Basel III. The question is whether this single piece of the jigsaw suggests the final picture will be out of line with what the G-20 expects. To put it more simply, will this piece, when combined with other changes in the capital framework, ultimately result in further significant increases in capital across the banking sector? The honest answer is that no one knows.

We do, however, know that large increases in capital could mean certain business lines end up becoming uneconomic. This could severely affect the ability of banks to provide risk management services and reduce the availability of financing for borrowers. At a time when some jurisdictions are increasingly focused on initiatives to generate and sustain economic growth, that’s a concern.

[1] These numbers exclude the so-called residual risk add-on, non-modellable risk factors and diversification across risk classes under internal models

Leverage Ratio: Time for a Spring Clean

For most of us in the northern hemisphere, April denotes the real start of spring, and with it, the opportunity for a little spring cleaning. The Basel Committee on Banking Supervision has marked the season with some spring cleaning of its own, reopening its leverage ratio for consultation this month.

ISDA welcomes this development – and it’s something we’ve been calling on for some time. The leverage ratio has been a cause for concern for derivatives market participants since its finalization in early 2014, in large part because of how it would affect client clearing. That’s because the leverage ratio, as currently formulated, doesn’t recognize that properly segregated client collateral reduces exposure for firms that provide clearing services. This means the amount of capital required to support client clearing services is not appropriately calibrated with the risks of that business. The end result: the economics of client clearing becomes extremely difficult for clearing members that provide this service, which runs counter to the objective set by the Group-of-20 nations to encourage central clearing.

The latest paper proposes a number of changes to the leverage-ratio calculation. It suggests replacing the current exposure method (CEM) with the standardized approach for counterparty credit risk (SA-CCR). On the face of it, this is a helpful change: the CEM is a fairly blunt methodology that doesn’t differentiate between margined and non-margin trades, and doesn’t recognize netting in any meaningful way. In comparison, SA-CCR is more risk-sensitive.

It’s disappointing, though, that the Basel Committee chose not include the issue of whether to recognize collateral posted by counterparties within the spring clean. The consultation offered a good opportunity to obtain evidence and consider the impact of recognizing segregated client margin as an offset to potential future exposure (PFE, one of the key components of the leverage-ratio calculation) under SA-CCR. ISDA maintains that properly segregated initial margin posted by a counterparty is not a source of leverage and risk exposure for a bank. On the contrary, it reduces exposure by covering losses that may be left by a defaulting counterparty.

The good news is that the Basel Committee has said it will specifically look at this issue with regards to client clearing. Over the coming months, it will collect data via an additional quantitative impact study to help determine the impact of the leverage ratio on client clearing. Depending on the result, it may consider allowing a clearing member’s PFE to be offset by initial margin posted by a client for cleared trades.

Among the other notable features of the proposal is a decision to maintain the margin period of risk (MPOR) in line with the SA-CCR, where the level depends on whether the transaction is cleared and collateralised, among other things. Under this approach, a cleared transaction subject to daily margining would attract an MPOR of five days – a reduction in the time horizon that should decrease clearing-member PFE compared to the CEM.

It’s too early to provide detailed feedback at this stage, but ISDA welcomes the opportunity to respond on this, and we will work with our members over the weeks and months to provide facts on the cost of not recognizing the risk-reducing impact of margin.

Clearing has become an extremely important feature of the derivatives market. As such, it’s vitally important we get this measure right.

Far from the Modelling Crowd

It’s been clear for some time that the enthusiasm for internal bank capital models has been waning within certain parts of the regulatory community. The latest signal of that decline is a recent Basel Committee on Banking Supervision proposal to restrict the use of models for the calculation of credit risk-weighted assets. Within that proposal is a very clear decree: the use of the internal model approach (IMA) for the calculation of credit valuation adjustment (CVA) capital is no longer allowed.

The timing of that announcement came as a surprise. One reason given for the decision is that the Basel Committee has doubts CVA can be effectively captured by an internal model. However, only one quantitative impact study (QIS) has so far been completed on proposed revisions to the CVA capital framework, and that was hindered by lack of completeness, an absence of clarity (particularly over the treatment of portfolio hedges) and time constraints (the QIS was run in conjunction with a QIS on the Fundamental Review of the Trading Book (FRTB), but with less preparation time to make the necessary changes to bank systems).

As a result, the Basel Committee launched a second, comprehensive QIS earlier this year. But the decision to eliminate internal models for CVA has been taken while that second QIS is still in progress, before the Basel Committee has even seen the data submissions from banks.

Regulators further justified their decision to eliminate IMA-CVA by noting that CVA capital will be significantly reduced anyway due to greater use of central clearing and the introduction of margining rules for non-cleared derivatives. That’s true, but certain counterparties – non-financial corporates and sovereigns, for instance – are exempt from mandatory clearing and margining. As a result, trades with these end users will be subject to a CVA charge calculated using a standardized or basic approach. An overly conservative methodology will therefore particularly affect those counterparties.

The decision to eliminate the IMA-CVA follows other, similar developments elsewhere: a requirement for all banks to model market risk capital using a standardized approach, and for those outputs to potentially act as a floor for internal models; a proposal to introduce capital floors more broadly; the emergence of non-risk-based backstops such as the leverage ratio; and the ditching of the advanced measurement approach for operational risk.

Some regulators have highlighted complexity and variation in risk-weighted assets (RWAs) as a rationale for wanting to restrict the use of internal models. ISDA understands these concerns, but believes there are ways to address trepidation about RWA variability without eliminating internal models – through greater consistency of model inputs or through ongoing testing procedures, for instance. Opting instead for a broad restriction in the use of internal models, or disallowing their use entirely, has several important implications.

For one thing, internal models are much more sensitive to risk and better align with how banks actually manage their business. In comparison, standardized models are relatively blunt, meaning the required capital charge for holding a particular asset might not adequately reflect its risk. This can lead to poor decision-making: a bank might choose to pull back from low-risk assets, counterparties or businesses where capital costs are relatively high. Conversely, they might opt to invest in higher-risk assets that appear attractive from a capital standpoint. These issues were what prompted the Basel Committee to create incentives for the use of risk-sensitive internal models in the first place via Basel II.

We believe, as a general point, that capital levels should reflect risk as closely as possible. A less risk-sensitive capital framework leads to the possibility of a misallocation of capital and an increase in systemic risk. Making decisions in a business that is intrinsically about taking and managing risk, based on a capital framework that is being made purposely less risk sensitive, creates its own hazards – as described in this recent article from Risk.

Another likely impact of this shift away from models is an increase in capital. That’s because standardized approaches tend to be more conservative. For example, an industry study on a draft of the FRTB rules, conducted by ISDA and other trade associations last year, revealed a move from internal models to the standardized approach would result in a jump in capital of between 2.1 and 4.6 times, depending on the trading desk. The Basel Committee has since published its final FRTB framework, and ISDA is involved in another study to determine whether these cliff effects still exist.

The Group-of-20 nations and the Basel Committee have both stated that further refinements to the capital framework should not result in significant increases in overall capital levels. We believe that is the right approach given the significant increases in capital that have occurred already as a result of Basel III. The challenge is that each individual measure tends to be considered in isolation. So while a single refinement might not meaningfully increase overall capital levels by itself, it might, when combined with all the other little tweaks, end up leading to higher capital levels in total.

Only a comprehensive impact study to determine the overall effect of all the changes together, including the changes to models, will provide the answer to this. And that should occur sooner rather than later.