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Fundamental Review of the Trading Book - What is FRTB and why start now?
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- 2. About Morten Weis © Morten Weis 2016 • Former Executive Director at Group Risk Management at Nordea Bank AB (1998 - 2016) •18 years experience in financial risk management and valuation of financial instruments • 11 years in various leadership roles within Nordea’s Group Market and Counterparty Credit Risk division, including: • Head of Group Market Risk at Nordea Bank AB (2012-2015) • Lead Business Owner for Nordea’s FRTB & Risk Platform project (2015-2016) • In these roles, I was responsible for Nordea’s FRTB preparations since 2012 and for participation in several Basel Committee coordinated Quantitative Impact Studies (QIS’s) • Active member of international FRTB working group arranged by ISDA and participated in preparing industry input to the Basel Committee on FRTB (2014-2016) • Ph.D. in theoretical physics from the Niels Bohr Institute, University of Copenhagen Foto• Former Executive Director at Group Risk Management at Nordea Bank AB (1998 - 2016) • 18 years experience in financial risk management and valuation of financial instruments • 11 years in various leadership roles within Nordea’s Group Market and Counterparty Credit Risk division, including: • Head of Group Market Risk at Nordea Bank AB (2012-2015) • Lead Business Owner for Nordea’s FRTB & Risk Platform project (2015-2016) • In these roles, I was responsible for Nordea’s FRTB preparations since 2012 and for participation in several Basel Committee coordinated Quantitative Impact Studies (QIS’s) • Active member of international FRTB working group arranged by ISDA and participated in preparing industry input to the Basel Committee on FRTB (2014-2016) • Ph.D. in theoretical physics from the Niels Bohr Institute, University of Copenhagen
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- 4. FRTB - A new “standard for minimum capital for market risk” issues by the Basel Committee for Banking Supervision in January 2016 © Morten Weis 2016 • The Financial Crisis (2007-2008) led the Basel Committee to launch an “emergency fix” to market risk capital rules in 2009 •Know as “Basel 2.5”, Value-at-Risk models was targeted and capital charges increased several fold for banks applying internal models for capital adequacy reporting, but standard rules were kept unchanged from Basel I/II • Intense lobbying saved internal models for correlation trading • Adopted by EU in CRD III and effective January 2011 • The Basel Committee knew rules was a mess and promised to make a “fundamental review"
- 5. FRTB – The path to a new capital standard © Morten Weis 2016 • Next step from the Basel Committee was to target counterparty credit risk, including negative Credit Valuation Adjustments (CVA) that was responsible for major losses in international banks during 2007-2008 •“Basel III” included among several elements a new CVA Risk capital charge for the embedded market risk in banks CVA adjustments: • Adopted with adjustments by EU in 2013 in CRD IV/CRR • Allowed for both standard approach and internal models • A ”hybrid” between counterparty credit risk and market risk, CVA Risk Charge was not integrated with the general market risk capital charge • CVA Risk Charge only address credit spread risk in CVA
- 6. FRTB - the path to a new capital standard © Morten Weis 2016 Basel Committee:Analysisof RWA for market risk - January 2013 • Benchmarking of banks internal market risk models for identical portfolios revealed massive differences • Widespread lack of confidence in banks objectivity in calculation of own RWA/REA figures emerged among politicians and regulators
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- 8. The key components of FRTB © Morten Weis 2016 Trading Book definition • Purpose of position decisive • Presumptive list of instruments •Internal Risk Transfers under tight rules Standardised Approach • “Mandatory” • Sensitivity Based Approach + • Default Risk Charge + • Residual Risk + • Securitisations Internal Models Approach • "Optional" • Stressed “Expected Shortfall” replaces VaR & sVaR + • Default Risk Charge + • Non-Modellable Risks
- 9. The Trading Book - Banking Book boundary © Morten Weis 2016 The purpose of the position decides the placement: short-term resale, profiting from short-time price moves, locking in arbitrage profits →Trading Book A presumptive list of Trading Book instruments: listed equity, bonds, derivatives, options including embedded derivatives in instruments issued from the Banking Book with equity or credit underlying, FX exposures, correlation trading, commodities Non-listed equities, funds without look-through or daily price, real-estate, retail and SME credits, are Banking Book per definition Banks can deviate from the presumptive list only if explicit FSA approval is granted
- 10. The Trading Book - Banking Book boundary – Can you pass? © Morten Weis 2016 FX risk in the Banking Book must be capitalised in the Trading Book as a separate Trading Desk –FSA may grant approval to exclude hedges of capital adequacy ratio under certain conditions Internal Risk Transfer from Trading Book to the Banking Book gives no capital recognition in the Trading Book Internal Risk Transfers from Banking Book to Trading Book must be identically match with external trades for equity and credit risk to give capital benefit Internal Risk Transfers of interest rate risk may be managed in separate Trading Book portfolio, capitalised on stand-alone basis in the Trading Book, and included in IRRBB exposure calculation
- 11. The Border Challenge relates to ALL banks © Morten Weis 2016 Every position must be supported by documentation for capital treatment Key concern could be liquidity buffers, often placed in Banking Book, but on the presumptive list of Trading Book instrument Riskmanagement of market risk of structured bond issuances may become more expensive due to demand for identical external hedge in Trading Book Management of IRRBB with derivatives traded with Trading Book may become more expensive due to stand-alone treatment All banks will have to spend more resources on documentation and control IT systems for capital calculation must be able to handle Internal Risk Transfers correctly in both Market Risk and IRRBB regulatorycapital
- 12. The Standard Approach capital is the absolute sum of 3 elements © Morten Weis 2016 Sensitivity Based Approach (SBA) Default Risk Charge (DRC) Residual Risk add-on (RRAO) Risk Factor Sensitivities • Delta + Vega • Curvature of options Credit Risk in Trading Book •Bonds, • Equities Notional Based Charge • Complex Instruments • Complex underlying • Includes pre-payment risk (e.g. DMB)
- 13. FRTB SBA delta risk in one page © Morten Weis 2016 For each broad risk class: General Interest Rate Risk (GIIR), Equity, Credit Spreads, FX, and commodities: assign sensitivities to different “buckets” Calculate a risk weighted sensitivity by bumping each sensitivity with a designated risk weight Within and across buckets, the weighted sensitivities are aggregatedaccording to specified formulae very similar to a parametric VaR model Correlations within buckets and across are given by the Basel Committee
- 14. FRTB SBA – examples of risk weights © Morten Weis 2016 • GIIR risk weights increased by 50% following the last consultation paper •The concept of “Domestic Currency” will be of importance for DKK banks Interest Rates* 1Y 5Y 10Y 30Y Risk Weight 2.25% 1.5% 1.5% 1.5% * EUR, USD, GBP, JPY, AUD, CAD, SEK + “Domestic Currency” may divide risk weight with √2 Credit Spreads Risk Weight Investment Grade Sovereigns, Central Banks,.. 0.5% Investment Grade Financials, also government-backed 5.0% Investment Grade Covered Bonds 4.0% Investment Grade Technology & Telecom 2.0% High-Yield or Not-Rated Sovereigns 3.0% High-Yield or Not-Rated Financials, also gov-backed 12.0% • Credit Spread charge applies for all bonds – also AAA-rated Sovereigns • Covered Bonds are very expensive compared to more corporate debt
- 15. FRTB SBA – examples of risk weights © Morten Weis 2016 • FX risk becomes more expensive •Scandinavian banks are likely to be hit by liquidity classification Risk Weight FX: RISK – divided on currency crosses 21% USD/EUR, USD/JPY, USD/GBP, USD/AUD, USD/CAR, USD/CHF, USD/MXN, USD/CNY, USD/RUB, USD/HKD, USD/SGD, USD/TRY, USD/KRW, USD/SEK, USD/ZAR, USD/IND, USD/NOK, USD/BRL, EUR/JPY, EUR/GBP, EUR/CHF, JPY/AUD 30% Rest of the world…... Including EUR/DKK, EUR/SEK, DKK/SEK, SEK/NOK etc...)
- 16. FRTB SBA delta risk correlations are exposed to stress assumptions © Morten Weis 2016 For all SBA calculations, FRTB specifies three correlation scenarios The scenarios are denoted "low", "medium","high" Banks must select the one giving the highest capital charge Low: listed correlations ✕ 0.75 Medium: listed correlations ✕ 1.00 High: listed correlations ✕ 1.25
- 17. FRTB SBA – adding it all up © Morten Weis 2016 • All option products –including embedded options as in Danish Mortgage Bonds must be revalued in stressed up/down scenarios to form the “Curvature” risk charge • For GIIR this is a +/- 240 bp. shift* and you cannot floor at zero interest rate • The “Delta” risk charge for all 1.st order risk factors sensitivitets (delta + vega) are to be added up • For each risk factor within a broad risk factor class, such as GIIR, you must apply different correlations • E.g. swaps with different fixing rates, but same currency cannot be netted fully at the same maturity • The regulation is very prescriptive and detailed • Sensitivity calculations must follow specific technical definitions • The classification of risk factors is very detailed and residual buckets very punitive • Requires full-suite risk management IT tools
- 18. FRTB SA: Default Risk Charge – A 4 step process, (Non-Correlation Trading) © Morten Weis 2016 Identify Jump-to-Default (JTD) loss for each instrument Offset long and short JTD exposures to same obligor when permissible giving net long and shorts in distinct obligors Net short exposures are discounted by a hedge benefit ratio Default Risk Weights are applied to arrive at capital charge* Credit QualityDefault Risk Weight AAA 0.5% AA 2% A 3% BBB 6% BB 15% B 30% CCC 50% Unrated 15% Defaulted 100% *At national discretion claims on sovereigns, public sector, and multilateral development banks may be subject to a zero default risk weight
- 19. FRTB SA – fitting in the last pieces © Morten Weis 2016 • Summing up – we have • Higher Risk Weights • Larger coverage of risk factors • Much higher complexity • Expect higher capital & production cost • The Residual Risk Add-on (RRAO) is a simple capital charge on the gross-notional* of “complex products” with risks not captured well by the SBA • E.g. a digital option or bond with pre- payment risk • The Risk Weight is 0.1% for non-exotic underlying assets, otherwise 1.0% • The SA is designed to be a credible alternative to internal models, and to form basis for more objective comparison of banks risks • The SA will be central for utilisation of future capital floors • Disclosure requirements are still pending. BCBS 356 indicate only hypothetical portfolio figures to be published for pure IMA banks Example: • A DMB will give rise to GIIR delta + GIIR vega + GIIR Curvature + Credit Spread delta + Default Risk Charge + Residual Risk Charge * Pure back-to-back positions not included
- 20. The Internal Model capital charge is the absolute sum of 3 elements © Morten Weis 2016 Expected Shortfall (ES) Default Risk Charge (DRC) Non- Modellable Risk factors Historical Statistical Metric • Calibrated to stressed 1Y period during last 10 years •Liquidity scaling • High data requirements Credit Risk Monte Carlo model • Bonds, • Equities Stress Testing Charge • Lack of “real price data” • At least as conservative as the ES model
- 21. FRTB IMA – the new Expected Shortfall Model concept © Morten Weis 2016 • 97.5% ES for 1Y period of stress over the last 10 years replace VaR+ sVaR as price volatility risk metric Liquidity bucket examples: Risk factor category n IR: EUR, USD, GBP, AUD, JPY, SEK, CAD + “domestic" 10 IR: all other currencies 20 IR: volatility 60 FX: list of currency crosses 10 FX: residual currency crosses 20 Equity (large cap) 10 Credit Spreads: Corporate Investment Grade 40 • Contrary to CRD III, cross asset-class correlations are restricted to avoid to large diversification effects • Risk factors are classified in 5 liquidity buckets: 10d, 20d, 40d, 60d, 120d. All shocks are 10-day Example: a NOK swap for a DKK bank 𝐸𝑆&' = (𝐸𝑆+,). + (𝐸𝑆+,). • Exposure to several risk factors ⟹ the same trade is revalued multiple times in the calculation of ES
- 22. FRTB IMA – The main element to be aware off © Morten Weis 2016 • Full revaluation is not a formal requirement as in consultation version, but passing IMA tests without will be difficult •Differences between FO and Risk valuation methods will make IMA tests challenging to pass • Joint Equity and Bond defaults to be modelled in DRC • Significant increase in CPU & storage demands • The shift from VaR & Stressed VaR to ES is as such not difficult • The main problem is IMA approval will now be decided on Trading Desk Level • Hard quantitative and qualitative requirements are set: • P&L explain alignment FO – Risk • Back testing • “Real prices” must exist • The treatment of liquidity is simplistic and penalising for many exposures • The “domestic currency” will help DKK based banks • ”Broken hedges” will drive capital charges up • The minimum multiplier is reduced from 3.0 to 1.5
- 23. FRTB: Why are the large banks very concerned? © Morten Weis 2016 • Capital planning hard to predict due to automated IMA admission tests • Large cliff effects between SA and IMA •Massive investments in people, data and IT for metrics hard to use internally for own risk management • Negative effects on liquidity expected • May significantly affect investment banks business composition • Industry associations have led voluntary survey across 21 leading banks on impact of final rules • While the final rules are less penalising than latest draft version, market risk capital will still increase 1.5 – 2.5 times on average compared to todays rules SA to IMA* Interest rate risk 3.0 Credit spread risk 2.0 Equity risk 4.1 Commodity risk 2.9 Foreign exchange risk 6.6 * SA excluding RRAO & IMA excluding NMRF, 18th April 2016
- 24. FRTB – What is the timeline? © Morten Weis 2016 Basel standard final January 2016 Further Basel rules: CVA, Capital Floors, IRRBB, … during 2016 EUprocess 2016 - 2018 BCBS: local regulation in force 01-01-19 BCBS: first reporting 31-12-19 Unknowns are plenty…. DG-FISMA (EU) have just launched consultation considering lesser SA demands on the smallest banks Unknowns are plenty.. CVA Risk Charge seems to become part of FRTB SA with no IMA option
- 25. FRTB – Why start preparing now? © Morten Weis 2016 • Large increase in data and calculations •SBA require full capital markets IT platform • High need for automation • IMA require full set of new market risk models • SA requires full- revaluation for options including DMB's • High resource demands • SA no longer a job for Finance • Hard to get specialist resources • Cross-firm collaboration takes time to establish • Market data • “real prices” • Trade classification • Static data data people ITmodels And do not forget time for model validation, audit and FSA dialogue and approval
- 26. FRTB – Why start preparing now? © Morten Weis 2016 data people ITmodels •Two main scenarios for Danish banks: 1) Own IT system development 2) Sector based shared IT provider • In both scenarios, planning, funding and execution will take considerable time and require full-time attention by own risk specialists as well as your IT provider Case A: • In both SA and IMA you need to have complete control of the classification of all positions in the Trading Book to know what calculations are required • High demand on data processing for high-volume products • Data models most likely need to be extended to support FRTB classification of trades Case C: • Risk factor sensitivity calculations are required for products where not commonly used – e.g. for credit spread sensitivity of government bonds • Configuration of risk calculations takes long time due to numerical complexity and need for new data loads Case B: • Clever risk data aggregation techniques may increase the capacity of your IT solution significantly • Many leading banks and vendors apply in-memory “cube” technology as it is well-suited for non-linear measures as in IMA • High dimensionality and large number of numerical computations
- 27. FRTB – Why start preparing now? © Morten Weis 2016 data people ITmodels •For both SA and IMA banks, data demands will be very high • Position data • Instrument data • Market data • Static Data • Reporting dimensions Market data: • SA and IMA banks will need the same level of detailed market data to calculate risk factor sensitivities • IMA banks will need to prove that historical prices are “real” to be in ES model • SA banks will need market data they previously may not have seen need for, e.g. credit spread curves for government bonds Static data: • SA and IMA both have high risk factor dimensionality that set high demands on static data • E.g. market cap of equities and sector classification fitting FRTB rules • E.g. issuer ratings on all bonds and equities and ability to link equity and bond issuers Reporting dimensions: • Disclosure requirements are still not final, but BCBS356 in hearing till 10th June set high demands • The FSA may set additional requirements • Expect: trading desk structure, trading desk strategies (detailed), granular risk factor contribution to final capital charge, hypothetical portfolio capital charges,….
- 28. Some personal experience to share from Nordea © Morten Weis 2016 Key to have senior Front Office management involvement in FRTB project - business models may change with FRTB. Trading involvement is key in most of the data work: market data –instrument data – static data Uncertainties in final rules favour agile model and IT development approach IMA require close integration of Front Office, Finance and Risk IT The large international banks are now running big FRTB projects, most with two-digit million EUR budgets You are not alone about this challenge - sector collaboration, external advise and benchmarking was very helpful for getting Nordea's project off on a good start
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