The Fundamental Review of the Trading Book (FRTB) has been a long time coming. However, it is thought that the European Commission will introduce legislation to trigger a three-year implementation period starting in 2021. With the FRTB finally approaching, now is a good time to review attitudes towards FRTB, and how organisations are preparing.
What is FRTB?
After the 2008 credit crisis, the Basel Committee on Banking Supervision (BCBS) extended and refined banking standards by creating the Basel III regulation, which includes the FRTB. The FRTB’s primary purpose is to better prepare financial institutions for periods of uncertainty by improving the calculations used to estimate the capital required to cope with losses from market risk.
One of the key changes is to create a more objective boundary between the banking book and trading book — intending to reduce the incentive to arbitrage between them. Other changes include a revised standardised approach that encourages greater reliance on risk sensitivities as inputs into capital charge calculations, and a revised internal model approach that replaces value-at-risk with expected shortfall.
Challenges and opportunities?
The number one complaint about FRTB is the cost. Banks have expressed concern about the amount of capital they will be required to hold, the complexity of the regulations, and the additional staff needed to ensure compliance. The Basel Committee has made several amendments to FRTB since its initial proposal in order to reduce the financial pressure on organisations. However, the financial and logistical challenges of implementing FRTB should not be understated.
Despite this, it is also important to recognise the opportunities FRTB offers. Banks that fully embrace FRTB have the chance to rebuild modelling approaches using tools such as big data, analytics, cloud technology and data science. This could provide a competitive edge and offset increased costs of compliance. For example, the FRTB requires enormous amounts of data, which could also be used to improve fraud detection and trend spotting.
How are banks preparing?
While there are a few banks whose existing infrastructure (i.e. those with bespoke and integrated trading and risk platforms built with advanced technology) facilitates the move to FRTB, for most organisations preparations are extensive. However, despite the pandemic, preparations for FRTB are still going strong. According to Risk.net’s conversation with Bloomberg’s Essan Soobratty, ‘banks have mostly continued along their established pre-Covid trajectories.’ And while there have been some inevitable delays, some banks are even viewing the current situation as an ‘opportunity to continue at a pace that allows for a more strategic implementation.’
These more strategic banks are viewing FRTB as an opportunity to improve their entire risk platform. For example, a key priority includes assessing and upgrading computing and operational systems to support the tasks that will be necessary to comply with FRTB (e.g. P&L testing, expected shortfall and sensitivity analysis). In addition, FRTB requires an unprecedented level of integration across departments. This means that banks are having to re-align roles and responsibilities across Risk, Finance and Trading, and co-ordinate FRTB implementation with other programs (such as BCBS 239) to achieve holistic transformation. This approach is likely to provide long term-gains and avoid the situation of the new system, which has been built on different data and models, conflicting with the existing one.
Alternatively, many banks are considering third party platform and data vendors. With the number of infrastructure solutions on offer and the FRTB move towards increased standardisation, McKinsey & Co have suggested that it makes sense for banks to buy in certain solutions while building only the aspects of their infrastructure that provides a competitive advantage.
Clearly, a bank’s approach to FRTB preparations will depend on existing infrastructure, size and culture. However, more and more banks are using the delay caused by Covid-19 to implement deeper structural change. While it may make sense to outsource certain processes, investing in new technology and committing to the integrated culture required by FRTB establishes an organisation as a bank of the future.