Basle 4 and the Minimum Capital Requirements for Market Risk (FRTB)

Peter WalshFRTB, Market RiskLeave a Comment

The BIS published their reforms to Basle III on the 7th of December 2017 with a raft of measures to improve the measurement of risk and calculation of capital. The reforms also have an impact on the arrival of the Minimum Capital Requirements for Market Risk, commonly known as FRTB.

The reforms focus on the following areas:

  • Improvements to credit risk and CVA including removal of the option to calculate these using an internal model
  • A new leverage ratio buffer for globally systemically important banks (G-SIBs)
  • Changing the Basle II output floor for a more risk-aligned approach

Credit Risk

Changes include:

  • Using the loan-to-value ratio of residential mortgages to assign a risk weight
  • Reducing reliance on credit ratings
  • An improved approach to unrated exposures to banks and corporates
  • A more granular approach to bank exposures, corporate exposures, retail exposures and off-balance-sheet items

Internal Ratings Based Approach to Credit Risk

The BIS notes that there have been shortcomings to the IRB approach with excessive complexity, a lack of comparability across banks and a lack of robustness for certain asset classes. As a result, the BIS recommend the removal of the advanced-IRB approach, and include some minimum values for key inputs such as probability at default (PD) and loss-given-default (LGD). A general theme has been to reduce the variability of Risk Weighted Assets by being more prescriptive on how banks implement their models for credit risk.

CVA

The reforms enhance CVA by improving its sensitivity to exposure and hedges in a portfolio. The reforms also reduce the options for modelling CVA to a Standardised Approach (SA) and a basic approach. A firm with less than €100bn of uncleared notional may simplify CVA by using a multiplier of its credit risk charge. Finally CVA has been revised to be consistent with FRTB and the market risk framework.

Operational Risk

The BIS have realised that measuring risk for events such as misconduct or inadequate systems or controls is hard to do consistently. As a result, they will replace the calculation with a single standardised approach which uses bank income and historical losses as inputs. It assumes that losses increase with income and that the level of losses in the past is a guide to the future.

Leverage Ratio Buffer

To quote the BIS: “The leverage ratio complements the risk-weighted capital requirements by providing a safeguard against unsustainable levels of leverage and by mitigating gaming and model risk across both internal models and standardised risk measurement approaches. “ In this case a new buffer for G-SIBs is introduced which must be met with Tier 1 capital and has a sliding scale of multipliers for banks which don’t meet their CET1 risk weighted ratio or Tier 1 leverage ratio.

Output Floor

The output floor has been in place since Basle I and was updated with Basle II and Basle III. The new approach requires firms to calculate the higher of total RWAs calculated using each firms’ approved models, and 72.5% of total RWAs using only the standardised approach. The paper goes on to explain what the standardised approach means for credit risk, counterparty credit risk, CVA, securitisation, market risk and operational risk.

Timing

The introduction of these reforms is best explained using the table from the BIS:

The revised market risk framework is also known as FRTB, leading to a new timeline for FRTB below.

FRTB Timeline

Given these new reforms, FRTB is still some years away, but given the huge change this will cause within the front office, this gives 2018 as a year to consider your firms approach and not lose time in understanding how the economics of your business will change due to FRTB.

Anyone who has studied FRTB will know that it impacts firms by:

  • Requiring you to map your organisational structure into a hierarchy
  • Demonstrating effective valuation of trades and portfolios
  • Maintaining up to date models and data to carry out pricing
  • Allocate capital back to your business hierarchy giving new transparency on cost drivers

The sooner firms begin modelling the effects of FRTB on their business, the sooner they can begin to decide how to meet the regulation but also learn earlier where the costs are coming from in each business line. The Razor Risk platform can give you that early view now as we have been preparing for FRTB in advance. Visit our contact page and ask us how we can give you that early FRTB view.

Final Thoughts

Rami Cassis, CEO of Razor Risk Technologies said “The changes to the Minimum Capital Requirements for Market Risk (or FRTB) mean firms have time to gather metrics on the capital consumption of desks, counterparties and products to inform their organisational strategy. By knowing now how FRTB will align cost with todays trading decisions, firms can decide now whether to exit specific business lines, products or counterparties and better prepared for the market post-2022.
The Razor Risk platform has already been adapted to deliver the metrics firms need to prepare for FRTB, using todays trading data. Find out how you can get ahead of FRTB by contacting us. We also broadcast a webinar on FRTB for which you can request access to the recording using the form on this page.

More Information

As with all commentary on regulations, do not rely on this article for your compliance approach or plans, please refer to the original source texts.

Peter Walsh
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Peter Walsh

Global Head of Sales at Razor Risk
Peter is a banker by trade (ACIB) and a qualified practitioner in managing IT intensive programmes allied to a lifetime of City-based roles and experiences. His experience and knowledge of the risk management and management disciplines helps provide clarity – and, with his background in banking, regulatory compliance and risk systems he is uniquely placed to discuss and describe how technology enablers can be deployed to deliver effective and efficient solutions in the most demanding situations, including the bewildering array of regulations and changes that will be affecting collateral, margining and associated risk management.
Peter Walsh
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