[About the author: Satinder (Sid) Jandu is an industry expert/public speaker on risk. He was a student on the City, University of London Writing for Business short course in January-March 2019. Sid wrote this blog as part of a homework/in-class exercise on that course.]
The power struggle of regulators vs banks as god and man
Bang! The financial crisis of 2008 sent atomic shock waves across every corner of the world. Established pillars of finance which stood like Solomon’s temple, too big to fail, were rocked to the core. The relationship of god and man, regulator and bank, had changed forever.
The authority of god/regulator was reasserted through Basel III:
“…an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09. The measures aim to strengthen the regulation, supervision and risk management of banks.” https://www.bis.org/bcbs/basel3.htm
After initially focusing on credit risk, the primary driver of the financial crisis, regulators turned to the final piece of the jigsaw, market risk. They set about conducting a Fundamental Review of the Trading Book, known as FRTB.
FRTB, or its real name “Minimum Capital Requirements for Market Risk”, is a global financial regulation that affects every bank in the world. https://www.bis.org/bcbs/publ/d457.pdf
This short blog examines whether regulators have gone too far and the struggle of banks to meet shareholder demands versus regulator demands.
Nuclear bombs and trading desks
The famous American physicist Julius Robert Oppenheimer became known as the “father of the atomic bomb” due to his role in the Manhattan Project at the Los Alamos Laboratory in the US where nuclear bombs were developed.
On seeing the first nuclear explosion on July 16th, 1945, Oppenheimer noted the reactions of those around him: a few laughed, a few cried but most were silent.
Likewise, on reading the FRTB regulations for the first time: a few laughed, a few cried but most were not silent.
Oppenheimer was fluent in Sanskrit and the sacred Hindu scriptures the Bhagavad Gita. And the brightness and power of the explosion reminded him of the words of Lord Krishna’s (Vishnu) call to arms to his warrior prince, Arjuna.
Krishna revealed his true form and power before battle:
“Now, I am become death, destroyer of worlds.”
Reflecting on Oppenheimer and the effect of FRTB on the industry, I came to a realisation:
“FRTB: Now, I am become death, destroyer of desks.”
The spirit of the regulation
It is important to understand the framework of the regulation through the spirit in which the regulators created it.
Any financial regulation has two components, the letter of the regulation and the spirit of the regulation.
- Regulators are principle-based and the letter of the regulation is its actual physical text.
- The spirit of the regulation is what the regulator is hoping to achieve.
Regulators were growing increasingly unhappy with the existing measures in place to capture risk in trading instruments. Changes to capture the risk adequately under the previous Basel 2.5 reforms – whilst providing good structural reform – did not go far enough.
The complete rationale for, and changes under, FRTB are well captured in the following BCBS draft: https://www.bis.org/bcbs/publ/d352_note.pdf.
Banks had too much flexibility in the way they could book trades in the banking book and trading book. This is a key input to their risk calculations which determines the level of capital they have to hold. Regulators wanted to stop banks from “gaming the system”, and to provide a framework which would be consistently applied across all banks.
It was never the regulators’ intention to increase the capital requirements deliberately. Instead they wanted to ensure banks were correctly capturing the risk in the right place – and that they were capturing all the risks.
If the capital requirement rises under FRTB then, quite simply, that is a more accurate reflection of the bank’s risk profile.
This is a very important point and encapsulates well the spirit of the FRTB regulation. By viewing risk through the inclusion of all the factors that drive risk, the rules compel banks to report their risk completely.
The FRTB framework
Key improvements in the FRTB framework are:
- Clear definition of the trading book with list of allowable instruments.
- Strict boundary between banking book and trading book with no ability to arbitrage risk by booking trades incorrectly. All changes will require regulatory approval; so they will be well policed.
- Internal model approval (using the bank’s own models for calculating the market risk capital charge) has moved from bank wide to desk level. Greater accountability for tail risk; market illiquidity risk; constraints on the capital-reducing effects of hedging and portfolio diversification.
- Revised standard approach. This is part of a wider industry standardisation across other regulations, with similar standard rules formulas for SIMM and FRTB SA-CVA as well as FRTB market risk.
Every trading desk will have to calculate a sensitivity based standard charge which acts as a credible fallback for internal model approval. The implication by regulators is the need to use a common infrastructure across both internal models and standard approach.
The essence of the regulation is the alignment of the traders in the front office with the risk managers in the middle office. Both will need to be using the same tools for pricing and risk respectively.
The spirit of the regulation is:
- Standardisation: across regulations, banks and models. The alignment of front office with middle office risk functions.
- Robustness: through a sensitivity approach that even banks with limited trading can handle.
- Completeness: inclusion of all risk factors – no “sweeping under the carpet” outside the VaR calculations as in Basel 2.5.
From the time my daughter was at junior school to the time she reached the first year of university – a decade – is the length of time that the FRTB regulations have taken to be finalised.
FRTB 2.0, as it’s now referred to, was released in January 2019 and is, from the BCBS point of view, the final text. It is now up to local regulators to implement the regulation across the banks through laws.
The controversy arises from the eligibility criteria for using the more efficient capital calculation known as internal model approval.
- Eligibility of internal models. The Profit and Loss attribution test (PLAT) as it was first drafted makes it difficult for a trading desk to pass eligibility criteria for internal model approval.
- Modellability of risk factors. Quantitative studies have shown that a significant proportion of the banks’ capital under FRTB consists of non-modellable risk factors.
[Modellability being a measure of the data quality of the time series: a modellable risk factor meets requirements for good data set by the regulator. Where data is poor, the risk factor is deemed un-modellable and banks take a greater charge in capital.]
The consequences of these two changes are:
- Banks face doing a cost benefit analysis on each trading desk as to its future viability (via the PLAT).
- A significant uplift in market risk capital due to punitive charges from the inclusion of risk factors that banks do not have adequate time series data for.
These two problems have left banks with the problem of protecting their franchise against regulatory compliance.
Banks have also been quick to point out conflicting requirements within the regulation itself. Increasing the granularity of time series for risk factors helps the P&L attribution tests. But this has a converse effect on the modellability of risk factors, resulting in higher capital charges.
The eternal struggle of banks
Banks face the eternal struggle of man: squaring the circle in meeting the demands of keeping their business alive and meeting shareholder expectations; against pleasing the regulatory requirements – god.
The Leonardo Da Vinci sketch sums up their problem perfectly. With straight arms and legs the bank is looking after itself; with arms raised and legs apart – the pentagram shape, symbolic of god – it is serving the regulator.
FRTB is a good regulation and designed to be the strategic driver for other regulatory initiatives. Treat it with respect and start implementing it now to hit the go-live date of 2022.
Market risk is the risk of losses arising from movements in market prices. https://www.bis.org/bcbs/publ/d352.pdf
Credit risk is simply the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.https://www.bis.org/publ/bcbs75.htm