Most firms with a Trading Book are now pressing ahead with implementing the new Basel Market Risk Rules – still widely known as the Fundamental Review of the Trading Book (FRTB) – and the documentation that goes with it.
But some smaller or medium-sized firms might not have really started yet. Nor might overseas subsidiaries. Or other firms who’ve been outside the scope of Basel’s intensive – and challenging – Quantitative Impact Studies (QIS) in the last three years.
Such firms will soon be planning their implementation. Or need to be. This blog looks to help, by focusing on the references to documentation in the new rules.
At Prism-Clarity we believe in the power of good documentation to highlight wider issues. We don’t believe in doing the documentation piece of a programme as an afterthought, a side-project or an inconvenience. It is and should be central.
By focusing early on the documentary outputs needed under the new rules, you can identify issues, ask good questions about your business, risk, other controls and technology, avoid false paths and potentially save costs.
Work backwards from the documentation to help shape your wider FRTB programme, or verify that your programme is on the right track.
What Kinds of Documentation?
We’re talking about policies, procedures, process maps, data maps, manuals, analysis papers. Anything that a firm will need as a document, either up-front or along the way, once the new rules are up and running.
Firms already need many of these – or regulators already insist on them – in some form. But the FRTB gives us some new ones to focus on.
And gives us an opportunity to spruce up existing policies and manuals that might have got out of date.
Start at the end
The idea is to focus on the output – a set of documents – and work backwards from there to ensure your programme is capable of delivering them.
Even if the implementation is two or three years away, you know that sooner or later you’ll need a process to get the documents written to a high (regulatory) standard. So start with the output.
It might prompt bigger questions.
For example: a firm might be quite sure it doesn’t have a regulatory trading book under the current definitions. But then finds, when it starts documenting its business under FRTB definitions, that it will have one under the future rules – even with no changes in its product set. This could come as a shock, to governing bodies, management, traders, risk, finance and audit alike. Better to find out now.
Or another example: let’s say a firm is doing structured credit trades with long-term maturities. It probably should be thinking about the capital implications of doing those trades under the new rules. Or even considering whether it really wants to be in that business – at all – once the new rules kick in in 2019.
Establishing a programme now will prompt that kind of thinking. Thinking about the documentation now can help kickstart the programme.
Categories of document needed for the FRTB
The focus here is market risk regulatory capital, of course, and we show below whether we think the necessary documents are mainly relevant for the new standardised Sensitivity Based Approach (SBA), the Internal Models Approach (IMA) or both.
There are five main categories of document that need consideration:
- Trading Book Definition and Control – SBA and IMA
- Desk Structure, Strategy and Management – mainly IMA
- Risk Management Policies, Controls and Processes – SBA and IMA
- Validation and Modellability; including Backtesting, Risk Theoretical P&L Attribution, Risk Factor Identification and Mapping, Non Modellable Risk Factors – mainly IMA
- Valuation Processes – SBA and IMA
We are assuming that the kind of firms who might be interested in this blog – smaller or medium sized banks, or foreign subsidiaries, who might not have yet embarked on the FRTB journey – will be mainly interested in the SBA. But for completeness, and because some firms might still be considering an IMA application even if they haven’t yet started their programmes, we talk about both.
An ongoing commitment
Bear in mind the FRTB needs some documentation processes to be ongoing once the new rules framework is live, not just up-front. Especially if you are seeking IMA approval.
We try to distinguish the more ongoing forms of documentation from more traditional and familiar policy and procedures. These ongoing documents are often unfamiliar and hard to do well.
We mean things like backtesting exceptions, limit breaches and calibration tests. Any action, incidence, decision, or piece of evidence that a firm might need to bring in front of its governance body or regulator, or to justify a particular risk management or modelling choice under the IMA.
We also try to identify documents the FRTB mentions in passing rather than as express requirements.
Please note: this list isn’t exhaustive. The items listed here are necessary but not sufficient. Other policies, procedures and practice documents will always be required. Most will already exist. The documents here are just the ones mentioned in the FRTB. It’s somewhere to start.
But we don’t mean reporting. That’s a separate topic and one we will come on to in a future blog. But there is plenty of reporting needed under FRTB. Just look at para 25 on page 10 as a pointer.
References in [italics] below are to the final FRTB document. In sub-headings we use the notation X.Y where X signifies page and Y paragraph or section. We also sometimes refer to the banking book as ‘BB’ and the trading book as ‘TB’.
1. Trading Book Definition and Control
[P9 paras 20-21; P10 paras 29-30; P12 para 36; P83-85 App.E sections 1-3]
Having good control and transparency over what is in the trading book is almost axiomatic for these rules. It’s a basic need, which firms should already be fulfilling. There aren’t any major changes of the boundary itself, but there are more explicit presumptions, and an express need for tighter procedures about transitioning things in or out.
– General policies & procedures on TB instruments
[9.21 and 83.2]
Firms had better have a comprehensive set of documents about how they delineate their TB, down to book and instrument level, but also including things like trading strategies, holding horizons, marking approach and risk management approach. It is extremely prescriptive, well beyond the level of documentation regulators expected before in this area, even for the Volcker Rules which themselves were a step up.
– Instrument designation: in or out of TB
[9.20 and 83.1]
There are new standards (paras 10-14) and a ‘presumptive list’ (para 16) which give pretty explicit guidance on the regulators’ expectations on what can or should be ‘in’ the Trading Book. In practice a firm’s documentation here could take the form of an ‘instrument map’ with granular instruments on one axis and the attributes listed in FRTB paras 9 to 17 on the other axis. The ‘instrument’ axis of this map will need to include internal system codes for instrument types and sub-types, i.e. an actual system-based instrument mapping, that can be used with control functions and audit to demonstrate compliance.
– Re-designation between BB and TB
The standards for this have been ramped up significantly. The suggestion is that, up to now, firms might have been able to ‘game’ the rules and arbitrage between TB and BB. I know people who think some firms did this during the financial crisis, to get themselves out of a sticky mess. No longer. Not only do firms need prior supervisory approval, on top of the usual internal approvals, but they also need to publicly disclose such changes. This kind of re-designation will only be accepted in ‘extraordinary circumstances’ (para 27) which firms will have to document within an inch of their life.
– Internal risk transfers
[12.36a and 84.3]
This is to do with hedging: transferring risk from BB to TB via internal hedges. The rules expressly disallow risk transfers out of the trading book, which makes sense. The other way round is traditionally valid, and remains allowed under the FRTB subject to the constraints on pages 11-12 and 84. So if a firm hedges interest rate risk in its loan book using a swap, and wants to transfer the swap to its trading book to manage alongside the rest of its traded risk, it can. As long as the banking book source of risk is well-documented, alongside other conditions set out in para 36. For equities it is not so straightforward and extra conditions apply. But in general this activity is OK under the FRTB and not too burdensome.
2. Desk Structure, Strategy and Management
[P9 paras 21,24; P68-69 App.A]
The concept of desk is critical under the FRTB for many reasons. Under the IMA the desk becomes a mini standalone business in its own right. The regulators can approve or disapprove individual desks for IMA treatment and a desk has to pass validation tests in its own right. And each desk needs a SBA capital calculation as a standalone entity, regardless. Each desk has to be run as a coherent single entity with reports, limits and self-standing management. Accordingly it needs a lot more documentation as a standalone unit than before.
– Desk policy document
[9.21 and 69 #4, which refers back to 68-69 #1-3]
This is the main element of desk documentation. It includes the definitions and breakout of trading desks, a coherent description of long term or structural strategy and the desk’s approach to on-desk risk management: including funding, hedging, intra-day and trader level risk-taking, stop loss definitions, limits and escalation.
This kind of document has been needed for a while in some form, but with more emphasis since the Volcker Rules came in, requiring measurement against a new set of metrics known as RENTD (Reasonably Expected Near Term Demand from customers). Business managers have always baulked at documenting ‘strategy’ on grounds they don’t want to be constrained in pursuit of micro level trading ‘strategies’. That micro-strategy isn’t what the FRTB is looking for. It should just be a high level – but still meaningful – account of what the desk does, structurally. Its mandate, in a meaningful way. The markets it is in, the products it trades and doesn’t trade, not at a granular level but at least meaningful. The extent to which the desk is facilitating customer business, market making, trading on its own account, or acting purely as a customer sales channel.
Other more structural aspects should be more straightforward to document and update. Appendix A on FRTB pages 68 and 69 gives a granular breakdown of the kind of things that need to feature. A governance framework is a sometimes overlooked aspect of this. Ideally quarterly meetings and sign-off involving relevant business, risk, capital, finance and regulatory experts, to go over any changes in the document and ensure complete buy-in across the parties who have an interest in it.
– Formal desk compensation policy
This is new and interesting. It reinforces the idea that the desk is now a standalone business and not just part of a larger organic whole. In practice numerous desks would be subject to a common compensation structure and policy. But each desk now has to be subject to one. It needs to be specific, deliberate and not incidental. Of course this information is proprietary and sensitive but that’s no excuse for not having the policy.
3. Risk Management Policies, Controls and Processes
[P51 para 180; P54 para 181; P58 para 183; P57 third para; P59-60; P60 and p62 para 186; P66 para 202; P67 App.D para 203]
Of all the documents required for FRTB, these are the ones that are most likely to exist already in some form, thus more likely to need just a spruce-up rather than starting from scratch. That said, the level of granularity and detail needed might go beyond the typical risk management policy in a typical small firm or subsidiary. It needs to be sufficiently detailed to explain to the informed outside reader – think the regulator as an example – what is really going on in terms of risk management tools, processes, methodologies, dataflows and mitigating controls.
– Comprehensive risk management manual
The FRTB states explicitly that the risk management manual needs to include key principles, a description of risk measurement systems, and details of empirical risk techniques the firm uses. In a sense it needs to go beyond policy but fall short of procedures. We prefer to think of it as a risk policy and practice manual. The ‘practice’ element of that label helps ensure it describes what is actually going on, with system diagrams, process maps, bookmaps, instrument maps and links to more dynamic documents such as limits and reports, all within a unified online framework.
– Dataflows and processes associated with risk measurement
The rules state that this document needs to include model specifications and parameters as well as dataflow diagrams. In the above example – the ‘risk policy and practice manual’ – this would all be available from the same comprehensive source. But it needn’t be, as long as it has all the elements somewhere. Because the new SBA rules are quite akin to a risk management model, this is probably the document that will need most new work in terms of documenting the quite complex SBA capital calculations: for example sources and definitions of sensitivities, or static or reference data such as bookmaps, correlations, buckets and other data needed for the SBA aggregation formulae.
– Model change procedures
[57, third para]
The FRTB refers to this in passing as ‘procedures for updating the model’. But we highlight it here as an increasingly important area of model control. Model technology is complex, and regulators, auditors and internal reviewers are increasingly focusing on how firms control changes. Given how important and sensitive the new SBA calculations are, we can infer that the regulators will expect them to be subject to excellent change management controls and documented accordingly.
– Empirical correlations used
Under the new IMA capital rules, risk model aggregation is an important element. No longer will historic correlations across asset classes automatically feed into the model without question, as they do currently in, say, a historic simulation or Monte Carlo VaR model. There will be more explicit scrutiny and questioning of the degree to which empirical correlations can offset a simple additive aggregation formula across asset classes. Ongoing documentation of analysis to support such assumptions will be needed if a firm wants them in the approved model.
– Liquidity horizon mapping and management: policies and current data/practice
This has elements of both up-front (policy and procedures) and ongoing documentation. Liquidity horizons are defined for particular risk categories under the IMA approach but a firm can refine that approach by choosing to deliberately use a higher (floored) horizon at the desk level if it has cross asset class hedges. This kind of decision will need to be carefully documented over time, to ensure it does not look like cherry-picking and remains under control.
– Proxy data usage
Missing data is a sensitive area under the IMA, because it can signify a problem with modellability. So, to the extent proxy data is used in an FRTB model, firms need to document that carefully, so it can be justified and approved. This will usually be in the context of stressed period calibration, where a risk factor is modellable but for good reasons data did not exist all the way back through the stressed period.
– Default risk calibration and validation procedures
[60.186b and 62.186p]
Firms have a choice, under the IMA approach, between using equity or credit spread data to calibrate default correlation, but – naturally – must document their choice. Similarly, in the absence of being able to directly backtest a modelled Default Risk calculation, due to the high confidence interval and long capital horizon, firms must carefully document their procedures for validating their IMA Default Risk Charge (DRC) models.
– Stress testing policies and data
Stress testing has always been an important area to document, and isn’t always one that firms do well. It is more of an art than a science, and the assumptions in that artful process need to be explicit. How exactly did you arrive at a particular set of shocks, or particular components of a stress scenario? And results from stress testing ‘need to be reflected in policies and limits approved by senior management’. Now it’s not very clear what that last sentence really means, but we can infer in general: good documentation of stress testing continues to be needed.
4. Validation and Modellability
- Risk Theoretical P&L Attribution
- Risk Factor Identification and Mapping
- Non Modellable Risk Factors
[P55-56, P56-58, P70-79 App.B]
This is an extensive set of topics which we cannot do justice to in this short blog. We will return to it more fully in a future dedicated blog. Suffice to say the whole environment described under these four headings is a documentation programme in its own right. Needing full up-front documentation of models, independent validation reports, policies and practical approaches, PLUS an ongoing explanation of data structure, incidences (breaches) and governance processes and decisions.
We recommend that readers with a particular interest in documenting these modelling topics go back to the final FRTB document, and make a point of going through pages 55-58 and Appendix B in particular. These topics are right at the heart of the FRTB IMA and should be treated extremely seriously from a documentation standpoint.
For the purposes of this blog we simply highlight some features which a typical regulator will need to see in the documents under this heading.
Hypothetical P&L methodology and sources; risk factors in and out of the calculation; books included and excluded; exceptions (overshootings) on both the upside and downside of the P&L distribution at different levels of granularity; exception count at different confidence intervals.
– Risk Theoretical P&L Attribution
P&L methodology and sources; risk factors in and out of the calculation; comparisons with Hypothetical P&L; statistical evidence of the two tests as defined in the FRTB.
– Risk Factor Identification and Mapping
A full inventory of risk factors across all products and systems with evidence of modellability according to the defined criteria.
– Non Modellable Risk Factors
An inventory of risk factors deemed not modellable and the consequent capital calculation, including details of eligibility for a non-additive aggregation approach, if appropriate.
We emphasise this is the single most important area of documentation for a successful IMA approach to be maintained – both in terms of up-front processes and ongoing results, supported by a sound governance and sign-off framework.
You can contact Prism-Clarity separately for more advice in this area.
5. Valuation Processes
[P80-82 and 84 App D]
These include documented procedures underlying the valuation process [80.718c and cii], material on valuation adjustments [81.718cviii and ix], and material on liquidity adjustments for capital purposes [82, 84]. Please refer to the highlighted pages in the final FRTB document for more details, but these sections are reasonably self-explanatory and intuitive. It is true, though, that valuation processes and their supporting documentation become more important from a regulatory standpoint every year. Valuation is complex. Markets are complex, and dynamic factors such as market liquidity, concentration risk and one-way markets as well as technical aspects of modelling all come into play.
In general though – especially given the prominence of valuation issues that emerged from the financial crisis – this is an area that firms now document more effectively than they used to, for internal governance purposes as well as for the regulators. So the new FRTB standards under this heading may not challenge firms’ documentation processes as much as the earlier headings. Though, once again, smaller firms and subsidiaries may find these areas more challenging. For them, again, it is worth a good look at Appendix D of the final rules.
Why It Matters
There is a lot here but it can be distilled into some big themes which reflect the wider aims and philosophy of the FRTB. The requirements on documentation give us clues as to what the regulators care about. Because often the documentation is their front line view into a firm. It’s the first thing they ask for and the first thing they see.
If the documentation is clear to them, it just might be clear to the firm itself. It might signify that, yes, there is good governance and management going on here.
Or the converse.
A firm’s documentation is like a brand statement. It gives off lots of conscious and unconscious messages about what the firm is like. What it does well, and doesn’t do well. And how much the firm cares about the information it makes available to its regulators. That can matter a lot, especially if things turn difficult for reasons outside the firm’s control.
In terms of FRTB documentation we can identify the big themes as follows.
- Front Office engagement critically matters. The ‘F’ in FRTB does not stand for Front Office but it might have done.
- Map the firm’s business directly to the rules, to a high level of granularity, using system-driven bookmaps, instrument maps and risk factor mappings.
- Document internal events with depth and clarity, as if they were being disclosed to an external analyst.
- No more excuses. Management standards over trading books needed to improve: things were not being done well enough before. If that seems to mean a lot of work, so be it: firms only have themselves to blame for that and had better just take it on the chin.
Finally we reiterate our main message: that focusing on documentation at an early stage in your planning will help both to determine the shape of your FRTB programme and to prompt management and governance bodies to be asking the right fundamental questions – whether about the business, risk, other controls or technology – in advance of the implementation date in 2019.