Importance of banking regulations
Regulatory framework is one of the most important pillars that support an economy. Banking & Finance regulations outline a framework for smooth functioning of the industry and market. The banking industry is a very important part of any economy. The reason being, banking activities are in-grained in almost every action that happens in the economy. It is vital to have a stable banking system to support the needs of the economy and the broader market. Stability of the banking system implies that banks are well capitalized and are robust enough to tide over any stress scenarios as and when they show up. The thing about market stress is that it can manifest at any point in time and this can happen very fast, thereby, giving very little time for banks to respond to such scenarios. It is therefore necessary that banks follow a stringent regulatory framework that will make them ready to tackle difficult times without having to ask for a rescue package to the regulator or the government.
Basel III guideline has been around for a long time now, and globally banks have been calculating their regulatory capital based on this guideline. However, to strengthen the existing regulatory framework of the banking system, the new guideline — Fundamental Review of the Trading Book (FRTB) has been introduced and is being rolled out in a step-by-step manner for banks globally.
I am a planning to describe the foundations of FRTB guideline in an article series. This is the Part I of the series of articles on FRTB, we will discuss key foundational concepts and discuss the Standardized Approach (SA) for calculation of market risk capital charge under the FRTB guideline. Further, we will write a Part II of this article series in the coming days where we will discuss the fundamentals of capital charge under the Internal Models Approach (IMA) of the guideline.
Why do we need another banking guideline?
While there already are existing set of regulatory guidelines for banks, the FRTB guideline attempts to address the below key points which were not fully addressed by existing regulations:
a. Defining the “revised” boundary between the Banking Book and the Trading Book. For readers who aren’t familiar with these two terms, do check out my short video explaining Banking Book Vs Trading Book on my Institute’s YouTube channel here: https://youtu.be/hiKn8TJHhY8
b. Giving the details of which products to be included / excluded from the Trading Book
c. Giving supervisor the authority to ask banks to re-classify products if they are not grouped correctly between these two books
d. This guideline attempts to prevent the regulatory arbitrage which can be generated by switching positions between the two books
e. Banks are dis-incentivized by penalizing their requirements on Tier I capital if it attempts to benefit from regulatory arbitrage between the two books
Introduction to the FRTB guideline
FRTB classifies products into three categories namely:
a. Financial Instruments
b. Foreign Exchange
It clearly spells out the conditions when a particular instrument needs to be designated as a Trading Book instrument, if the bank holds the same for any of the following purposes:
Plans to re-sale the instrument
To generate P&L from short term price fluctuations
To engage in arbitrage trades
To hedge risk arising from instruments meeting any of the above criteria
Further it gives conditions for treating instruments either as mandatorily assigned or presumed to be assigned to the Trading book.
The Basel Committee of Banking Supervision (BCBS) enlists comprehensive documentation requirement that banks need to maintain under FRTB. This may require banks to either:
a. Create of new firm-wide policy Or
b. Enhancements to be applied to the existing firm-wide policies
Documentation requirements includes inter-alia the following:
o Trading strategies
o Hedging strategies
o Daily valuation of the items on trading book
o Daily Profit & Loss attribution etc.
Standardized Approach (SA)
Every bank is expected to calculate the capital charge under the Standardized Approach (SA). Supervisory approval is not required for usage of this approach.
Under SA there are 5 risk classes that are defined and every instrument will be grouped into one risk class or a combination of more than one risk classes namely:
o General Interest Rate Risk (GIRR)
o Credit Spread Risk (CSR)
o Foreign Exchange (FX)
Further, the FRTB guideline explains in detail the risk factors to be used under each of the risk classes. Further, the guideline also specifies three correlation scenarios. These are required because correlations between risk factors can fluctuate drastically as the market conditions change.
SA capital charge is composed of three components as below:
Capital Charge under Standardized approach = Sensitivities Based Method (SBM) capital charge + Default Risk Charge (DRC) + Residual Risk Add-on (RRAO)
A brief description of each of the above three components is explained below:
a. Sensitivities Based Method capital charge (SBM)
This component takes into consideration the linear risk component (i.e. delta and vega risk charge) and non-linear risk component (i.e. curvature risk charge).
Delta risk charge accounts for the change in the value of the instrument for a small change in the underlying. This is the risk measure that is based on the sensitivity of the trading book to the regulatory delta risk factors.
Vega risk charge accounts for the change in volatility of the underlying risk factors. This is the risk measure that is based on the sensitivity of the trading book to the regulatory vega risk factors
Curvature risk charge accounts for the incremental risk not measured by the delta risk. This involves usage of two shock scenarios an upward and a downward shock to the risk factors
The vega and curvature risk charge is applicable only to options and option-like products.
To arrive at the capital charge for SBM for each of the above three components, the guideline requires the following steps to be done in the calculation. For example, for every instrument on the trading book:
1. Assign Risk position to risk classes
2. Risk factor identification under risk classes
3. Identify risk buckets to find out the risk weights
4. Calculating delta and vega sensitivities
5. Calculate weighted sensitivities at bucket level
6. Aggregating weighted sensitivities at bucket level
7. Weighted sensitivities in one particular bucket is aggregated using the prescribed correlation within the bucket
8. Aggregate risk charge is then calculated across all relevant risk classes for that instrument
b. Default Risk capital charge (DRC)
The reason why we require the DRC is because we have to factor in the risk of sudden default by an obligor/issuer. We may think of this as an idea of Jump to Default (JTD) to factor in the risk of counterparty defaulting. To calculate the DRC, we follow the following steps:
1. Calculate the Gross Jump to Default (JTD) positions
2. Calculate the Net Jump to Default (JTD) positions
3. Assign default risk weights to net JTD positions as per credit quality
4. Allocate buckets for weighted net JTD positions
5. Recognizing hedge benefit for each bucket
6. Aggregate the bucket level capital charge
c. Residual Risk Add-On capital charge (RRAO)
The RRAO capital charge factors in the risk component that is not captured by the SBM and the DRC. This is typically required for more complex instruments wherein we are unable to capture the full risk using the SBM and DRC only. Complex instruments generally include exotic derivatives and any other complex structure whose payoff cannot be replicated in a linear fashion by using a set of vanilla products. There are however, certain products which get excluded from the RRAO too — including the ones cleared by a CCP Or transactions that are matched exactly by third party transactions
This article covers the important aspects of the Standardized Approach for capital charge calculation for market risk. There is a lot of work going on around FRTB globally since the last couple of years. These guidelines will be rolled out across various banking jurisdictions in the coming years. Therefore, having a knowledge of FRTB guidelines is helpful from job market point of view too, because banks and consulting firms are looking to hire talent in this space.
In the next part of this article series we will discuss the main aspects of the Internal Models Approach (IMA) for FRTB.