Closer scrutiny of trading and more stringent capital requirements call for sophisticated data management and tighter integration.
Financial institutions are about to find their trading activities scrutinized under a more powerful microscope. The latest amendments published in December 2017 on minimum capital requirements for market risk, also known as fundamental review of the trading book (FRTB), proposed by the BCBS will require banks to estimate myriad market-related risks in far more detail than they are used to.
More important from the standpoints of risk management and data management, and compliance, the assignment of risk weightings to portfolio holdings will no longer suffice. Sensitivities to various risk factors, and the patterns that drive their evolution, will have to be discerned. Risks will have to be forecast and accounted for into a future that is inherently unknowable, except that it is certain to keep changing and, if history is an accurate guide, become quite dangerous at some point.
Among its main provisions, FRTB calls for banks to assess their market risk institution-wide and at the individual desk or portfolio level, too. Particular attention must be paid to classifying each position based on such criteria as its broad asset class – equity, bond, commodity etc. – its sector, industry, market capitalization, value or growth and so on. Firms also will have to gauge the impact of connections among holdings via hedges and diversification.
The risks can involve market-related factors, including changes in interest rates, and corporate and macroeconomic conditions. However, the committee is especially concerned with risks accruing from second-order effects, for example reduced trading liquidity or the default of a counterparty. It was a sudden deterioration in aspects such as these that instigated the global financial crisis and threatened the banking system’s survival. Firms also will be asked to factor in recovery estimates in the event of default, among other elements.
Achieving such a fine level of detail across so many criteria is a daunting enough challenge, but it is not the only one banks will face as they try to get to grips with FRTB. Accumulating all that information is merely the first step.
They then must calculate losses under extreme market conditions, or what the Basel committee calls expected shortfall, from the various sources of risk, and from that they must derive the capital charges to set against their holdings. Accomplishing these steps, and assessing the more complex relationships among assets under varying market conditions and how these risks and links are likely to change during periods of stress, requires sophisticated modeling and forecasting tools.
Developing and using them demands the right kind of financial analysis, and that can only be accomplished with the right data management system. Without strong data management to act as a microscope of their own that they can peer into, institutions will not be able to bring all that information into sharp enough focus. Without reliable and consistent financial analysis, they will not know precisely what they are looking at or what it means.
Equally important, if not more so, they will not be able to develop the most appropriate response – for regulatory compliance, and for financial and risk management – to the data and the calculations, as well as classification rules applied to them. Weak analytics could lead a firm to budget too much or too little capital, exposing it to more risk than it should be assuming or to less profit than it should be earning.
A high priority of financial supervision since the crisis has been encouraging forward-looking analysis and the integration of critical functions at banks. The Basel committee, through FRTB, accomplishes these aims in several ways. These include an emphasis on the sensitivity analysis and expected shortfall; and by establishing onerous capital charges for excessive exposures to specific risks, the committee is drawing risk and finance together and compelling each department to add its perspective to the analysis and modeling.
Trading desks and treasury officers will be contributing calculations, too, regarding existing and future financial and macroeconomic conditions. These can be done relatively quickly.
The more sophisticated analysis, involving the finance and risk departments, is likely to be devoted to simulations for assessing a variety of factors under a multitude of conditions, especially with respect to future lines of business. Indeed, simulations form a big part of FRTB analysis, far more than in the Value at Risk (VaR) calculations that have been in common use.
Is there a way around the analytical complexity built into FRTB? Yes and no. Institutions of all sizes will come under its provisions. The framework sets out a standardized approach for firms to use in their models and calculations. Simplified versions can be used, but at a price: The capital charges are higher, greatly lessening their appeal.
The standardized approach carries a price of its own, however, in the form of greater intricacy and complication, and the price just went up. The Basel committee recently published provisional revisions to the minimum capital requirements for market risk.
They include new ranges of lower weights
for general interest rate risk, equity and foreign-exchange risk classes. Also
among the amendments are the addition of liquid FX pairs and a limited reduction
in the capital requirement under the low-correlation scenario for empirically
observable risk factors that are consistently highly correlated with all market
In the estimation of capital requirements for non-linear instruments used in hedging, the committee is exploring an alternative approach that would define a sector as a subset of each asset class bucket and apply consistent upward and downward shocks to underlying risk factors.
To avoid cliff effects, the committee proposed applying a small correction in the formula used to calculate aggregate capital requirements. A move to address potential double-counting issues involving FX options is also being considered.
Several of the changes proposed concern the profit-and-loss attribution test applied under the internal model approach (IMA). These include setting limits on any possible inconsistency among hypothetical and risk-theoretical P&Ls; requiring testing of the relative input data; and revising the frequency and design of the P&L test metrics. For non-modelable risk factors, the committee provided clarifications about the risk factor eligibility test (RFET), as well as principles regarding the quality of data that banks use to calibrate their internal models.
Both standardized and advanced approaches require more complex data management, in particular a system that echoes the integrated organizational structure that is consistent with effective FRTB analysis. The hallmarks of such a system are a centralized warehouse that reconciles and integrates data from all sources and tight data lineage capabilities that track all calculations and the rules underpinning them at every step in each process.
Sound and sophisticated data management is required for more than FRTB and related regulations like Interest Rate Risk in the Banking Book (IRRBB). A similar analysis, modeling and forecasting are demanded in such frameworks as IFRS 9 Financial Instruments, Current Expected Credit Loss (CECL) and AnaCredit, among many others.
Advanced data management capabilities are valuable for business analytics, too, not just regulatory compliance and reporting. This always has been the case. What has changed is that the same data is used for financial analysis, risk management and regulatory reporting. In fact, these endeavors will no longer exist as separate duties and will merely form part of everyday business activities.
So while it may seem as though institutions are being asked to do a lot to comply with FRTB, their efforts will prove fruitful beyond that single framework, and indeed beyond regulatory compliance in general. Firms no doubt feel they are being gazed upon through many different microscopes, but all of those eyes want to see them take the same salutary steps.