Discover CubeMatch UK Head of Risk Management, Francis Kiwanuka’s latest article on FRTB Internal Models.
Fewer trading desks will use their own models to calculate market risk capital requirements than originally predicted. Recent surveys have found that trading desks at most banks would switch to Standardised Approach (SA), despite higher capital requirements than Internal Model Approach (IMA).
Surveys also reveal that IMA coverage across all desks will be between 20% and 30%, lower than originally expected. Banks are trying to reduce the number of Non-Modellable Risk Factors (NMRF) used to accurately model capital requirements. NMRF are subject to a capital requirement calculation under Stressed Expected Shortfall (SES) measure, which is much more punitive. Banks are assessing the impact of non-modellable risk factors on capital charges for desks adopting IMA.
The proposal from the European Banking Authority, to remove non-modellable risk factors from the expected shortfall model has resulted in desks, trading equity and credit being taken off the IMA perimeter, due to the large number of underlying debt and stocks that could be potentially classed as NMRFs. Omitting these desks reduces the computational data required for calculating expected shortfall, a critical input to measure market RWAs (Risk-Weighted Assets).
Another reason why desks are excluded from the IMA is that they are unable to pass the tests measuring the difference between the Profit-and-Loss values produced by risk models versus those from front-office price models. The floor on internal model outputs, set at 72.5% of RWAs when calculated using SA, also discourages smaller banks from making a business case in applying for FRTB IMA because they see no capital benefit.
The CRR III reforms could alter rules
Fundamental changes were introduced to the FRTB internal models’ approach, which include model approval at the trading desk level, a new market risk metric and greater sensitivity to market illiquidity. These changes are quite significant that banks must apply for new approvals on their IMA. Banks planning to use their IMA must apply to regulators for model checking and approval. The current working assumption is that model approvals will take up to two years if applications are in place by the mid or end of 2023 and go-live is in 2025. In the UK, the Prudential Regulatory Authority (PRA) asked UK banks to submit applications before the end of 2023.
The CRR III reforms could significantly change the incentives for desk structures and their capitalisation. CRR III introduces the FRTB approaches for calculation of capital requirements. Thus, the criteria for allocating positions to the trading book or the banking book are revised. CRR III also introduces a waiver that allows a bank to allocate to the banking book, specific instruments that would otherwise be allocated to the trading book. This derogation is subject to very strict conditions and to an approval of the bank’s competent authority.
The new IMA significantly overhauls the current framework. Only some banks will choose to seek IMA approval under the new rules. However, all banks with a material exposure to market risk will need to implement the FRTB SA and report the outcomes to their supervisor. The new approach essentially overhauls the existing one to better reflect the level of market risk to which individual banks are exposed. It is much more detailed and sophisticated and requires banks to perform more calculations, resulting in increased data requirements.
The immediate priority for firms is to proactively action and track remedial work ahead of any planned IMA submission by January 1, 2024. A key success criterion is a robust data sourcing strategy across Front Office, Risk and Finance given the more stringent P&L tests.
EBA publishes final draft standards on key areas for the EU implementation of the FRTB
Letter to firms “Fundamental Review of the Trading Book (FRTB): Timetable for submission of internal model/standard approach pre-applications” h