Fundamental Review of Trading Book - market risk transformation

1. FRTB
Implementing the Revised Market Risk Framework
Nikat Malik
September 2015
All Rights Reserved

2. The revised FRTB seeks to address weaknesses in the current market risk framework and capital adequacy
requirements. It aims to distinguish the trading book and banking book holding in order to define capital adequacy
requirements, especially as trading book assets require higher capital. Liquidity and profitability is key here as firms
seek to move assets to bank book when position goes against them where capital requirements are lower. Pricing
is a factor here in determining capital requirement. As a result firms‘ need to distinguish between short term
market trading strategy and long term investment holding. Major impact areas are OTC derivatives and
securitization, and more complex instruments. Hence FRTB, considered either as a regulatory subject or risk issue,
definitely requires a new business operating model with technology as a critical delivery component.
Dynamic allocation of positions between
books throughout the trade life cycle
Firms’ Value
Objectives
Defined Trading
and Investment
Strategy
Select
Markets and
Instruments
Aligned
Profit and
Risk Model
Capital
Adequacy and
Cash Flow
Technology Infrastructure
FRTB Impact and Strategy

3. Boundary: Definition of trade book and bank book boundary and restrictions on migration across the boundary.
Sensitivity: A revised standardised approach for market risk based on price sensitivities, which is intended to be more risk
sensitive compared to the existing standard approach, and reduce the gap between internal models and standard rules.
Measure: The substitution of value at risk and stressed value at risk with an expected shortfall risk measure to capitalise
for loss events in the tail of the P&L distribution.
Liquidity: Incorporation of market liquidity risk into internal models. Application of liquidity horizons in the expected
shortfall calculation to reflect the period of time required to sell or hedge a given position during a period of stress.
Risk: Replacement of the incremental risk charge with an incremental default risk model, which is designed to capture
default risk in the market risk framework.
Data: Eligibility of market data sources, treatment of data gaps, and liquidity horizon relation.
Model: Desk level model approval and P/L attribution. Back-testing requirements of internal models at trading desk level.
Failure to meet the validation criteria would force a desk to revert to using the standardised approach.
Disclosure: Enhanced public disclosures on market risk capital charges, including regulatory capital charges calculated
using both standardised and internal models approaches.
Key FRTB Proposals

4. Process Architecture & Governance
Market
Data
Pricing
Portfolio
Position /
Valuation
Quote /
Analytics /
Deal
Models
SA & IM
Risk Capital,
Limits &
Allocation
Modelled
Risks
Capital
Calculation
Risk
Assessment
Non
Modelled
Risks Vs
Stressed
Scenarios
FRTB/CVA/EC
Alignment
Capital
Charge
Reporting
- Desk &
Regulatory
Modellability Boundary Capital

5. 1. Market Risk waiver to be determined at Desk Level.
2. Risk sensitive calculation for non-linear and linear risks.
3. Capital floor as percent of Standardized Approach even if Internal Model is applied
4. Internal Model can be switched off and on at Desk level, this increases capital volatility.
5. No diversification between asset classes (inter-asset). Diversification (intra-asset) allowed on correlation
matrices.
6. Liquidity horizon increased from 10 days to 1 year. High impact on fixed income, medium impact on equities,
and low impact on foreign exchange.
7. Measurement method switched to Expected Shortfall from VAR. Credit spread capital requirements increase
disproportionately to other asset classes.
8. Incremental Risk Charge requires Banks‘ to calculate capital using a constant level of risk over a one year
capital horizon is replaced by Incremental Default Risk.
9. Market data, pricing and valuation key to risk coverage and capital computation.
10. Higher capital charge for risks not modelled.
11. Audit trail required for market data.
12. Market discipline requiring qualitative and quantitative disclosures.
Major Impact Areas

6. Risk Factor Category Liquidity Horizon
Interest Rate 20
Interest Rate ATM Volatility 60
Interest Rate (Other) 60
Equity Price (Large Cap) 10
Equity Price (Small Cap) 20
Equity Price (Large Cap - Volatility) 20
Equity Price (Small Cap - Volatility) 120
Equity (Other) 120
FX Rate 20
FX Volatility 60
FX (Other) 60
Credit Spreads 20 – 250
Commodities 20 – 120
Energy Price 20
• A liquidity horizon is the time required
to exit or hedge a risk position without
materially affecting market prices in
stressed market conditions.
• Increase in liquidity horizon from 10
days to 250 days maximum.
• Expected Shortfall calculated using
instantaneous shocks equivalent to
movement of risk factors during time
span of associated liquidity horizon –
ignores dynamic rebalancing and trade
maturity, and ignores path dependency.
• Risk factor dependent, not product
dependent, and independent of position
size
Liquidity Horizon
VAR is applied to calculate potential loss based on price volatility, lack of liquidity can cause additional loss necessitating
additional capital to absorb losses. This is an important element in the revised proposal.

7. Model Determination
Assessment of Banks’ Firm
Wide Internal Risk Capital
Model
Bank nominates Trading
Desks in-scope amd out-f-
scope for model approval
Standardized
Approach for entire
Trading Book
Pass
Pass
Assessment of desk level
model against quantitative
criteria
Model Approval Criteria:
 P/L Attribution,
 Backtesting,
 Model-Independent risk assessment
Independent Risk Factor
Analysis – frequency of
update, available historical
data, etc
Pass
Standardized
Approach for specific
trading desks
Fail
Out of
Scope
Modellable:
Global Expected Shortfall
with diversification
constraints
Non-Modellable:
Capital Add-On based
on Stress Scenario per
Risk Factor
Modellable:
Capital Charge for
Default Risk
Standardized
Approach for specific
trading desks
Determination of Eligibility for Internal Model Based Approach
Attributes of a trading desk:
 It is an unambiguously defined group of traders or trading accounts
with a clear reporting line to senior management and a compensation
policy linked to its pre-established objectives;
 It has a well defined business strategy, including an annual budget and
regular management information reports;
 It has a clear and formal risk management structure, including trading
limits and regular risk management reporting processes.
Identification of modellable risk factors:
 For a risk factor to be classified as “modellable” there must be a
sufficient set of representative transactions to allow for an appropriate
historical data series and should have at least 24 observations per year,
with a maximum period of one month between two consecutive
transactions.
 A price is “real” if:
• It is a price at which the Firm has transacted on an arms-length basis
• The price is taken from a firm executeable quote
• It is a price for an actual transaction between two other independent
third parties
Fail

8. Boundary Management
Trading intent has proven to be difficult to
govern, a trading evidence based approach and
a valuation based approach are considered. Key
considerations - objectivity in the definition of
the boundary, degree to which capital arbitrage
opportunities can be mitigated, extent to which
the boundary can be made less permeable,
extent to which the definition of the boundary
aligns with banks’ risk management processes,
and effectiveness of application.
Portfolio
Objectives
Trading Strategy
Instrument
Selection
Valuation
Method
Risk Control
Process
Liquidity
Management
P/L Booking
Process
Capital
Requirement
Focus :
 Instrument and Trade Switching
 Inventory Ageing
 Daily and Intraday Limits
 Market Liquidity