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A Model Approach to FRTB

Steven Holland
By Steven Holland , Head of Regulatory Products Jan 9, 2024
A Model Approach to FRTB


Banks face stringent new rules on how they calculate capital requirements, yet until now have lacked sufficient data to underpin how they model this. Steven Holland reveals how a new solution is about to make life easier. The Global Financial Crisis marked a turning point for banking regulation. As financial watchdogs across the world sought to eliminate a repeat of the 2008 crash, a range of new regulations were imposed which were designed to shore up institutions’ capital reserves and provide greater financial security.

Among those was the Fundamental Review of the Trading Book (FRTB), designed by the Basel Committee on Banking Supervision (BCBS) as an international standard laying out the rules governing the amount of capital banks must hold against market risk.

Included in the Basel III regulations, and subject to reforms due to come into force in 2024 /2025 depending on the financial jurisdiction, FTRB imposes more stringent rules for banks that use proprietary models for calculating capital and ensures they capture tail risk. It also reinforces the boundary between trading and banking books. This will make it easier to compare risk-based capital ratios across banks, and is intended to restore confidence in those ratios and the soundness of the sector overall.

Banks using the internal model approach (IMA) must employ the expected shortfall measure to calculate capital, as well as applying capital add-ons for risk factors that lack sufficient data for modelling. These are known as non-modellable risk factors (NMRF). Increasingly banks, especially large institutions, are looking to use IMA rather than relying on the solvency assessment imposed by regulators, since these may mean they can hold lower capital reserves.Yet the move to IMA is far from straightforward and, so far, we have seen a relatively low take up.

Data challenges

The introduction of FRTB will be a game changer for capital market trading businesses and has reinforced the need for banks to have access to high quality real observable trade and order data to accurately mark their OTC positions. Yet there are several challenges banks must overcome if they are to comply with the new regulations: Firstly, it can be problematic for banks to gather the requisite data to assess whether a Standardized Approach (SA) or IMA would be better for their institution. Secondly, banks often struggle to harmonise and align data across different sources and, in some areas, this may necessitate a complete reengineering of their data processes. There are also challenges in finding the relevant data for the risk factor eligibility test (RFET) due to the quality and quantity of data required across all asset classes and types, including linear and non-linear products. The combination of these factors makes it difficult for banks to justify investing in a new data infrastructure to support IMA if they cannot be sure it leads to lower capital requirements.

A new solution

However, breakthroughs in the market are making life easier for banks to move to proprietary approaches to capital modelling. As an operator of multiple venues across many regions and asset classes, TPICAP and Parameta solutions offer clients a golden source of observational data to help them run their RFET and the expected shortfall tests that are necessary to assess how to model their risk factors. This data sits mainly in the OTC and non-linear sphere, where market data is scarce. The solution consists of a daily/monthly set of files containing price observations covering both trade data and ’committed quote’ data. This approach brings together observational data from all our venues across the globe, covering EMEA, APAC, and the Americas. Comprehensive asset class coverage includes credit, equities, FX, fixed income, commodities, and derivatives thereof.

Time to review

FRTB presents an updated Standardized Approach while also revising the framework for the Internal Model Approach. Both methods present their own challenges, and to effectively implement FRTB, banks must examine and enhance their risk architecture and governance processes. They will also need to think about the way in which they obtain and use their reference and market data, if they are to satisfy some of the more data-intense elements of FRTB. The UK has pushed back its deadline for implementing Basel III, giving banks more time to consider the benefits of moving to IMA. The US is likely to follow suit and the EU may also align, which would provide a consistent approach across the world. Banks can use this extra time to look into ways to enhance their data gathering and analysis, enabling them to better understand the possibilities of moving to IMA. Parameta Solutions has exclusive access to trade and order data on a wide range of OTC products, making us ideally placed to provide the requisite market data for clients on their compliance journeys.

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