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Podcast: Fundamental Review of the Trading Book - Part 1 - Overview and Challenges

Speaker: Dr Simon Acomb

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A course on this topic is available in London Time Zone, New York Time Zone and Singapore Time Zone

Podcast Overview

In this podcast, Dr Simon Acomb gives us an insight into the Fundamental Review of the Trading Book (FRTB) - the recent piece of regulation by the Basel Committee affecting capital standards for market risk. Simon addresses how these changes will impact institutions and regulators around the globe; as well as describing what the main priorities for the banking community should be in preparation for the upcoming deadlines.

Podcast Transcript

1. Just over a year ago, the Basel Committee published new capital standards for market risk as part of the Fundamental Review of the Trading Book (commonly known as FRTB). These new standards introduce significant changes, which will, of course, impact the banking community globally. FRTB is a very hot topic at the moment, so can I start by asking you to give us a bit more background about this new regulation, Simon?
A. Certainly. The FRTB is really part of the overhaul of the banking regulation that follows the financial crisis of 10 years ago. It was clear in 2008 that Basel II, the financial framework which was then in place, wasn't doing a very good job in representing the market risk run by many of the banks. And in response the regulators came up with something that became known as Basel 2.5 which was really just a patch on the existing market risk framework. Since then there has been a bit of a re-think of capital in general and that's resulted in the new framework we now know as Basel III. The thing about Basel III is that it does many things, but it doesn't address any shortcomings in market risk - it just leaves in place the patched rules from Basel 2.5. So, 18 months ago the Basel committee published the FRTB which aims to complete update market risk part of Basel III. It's not a small change, in fact it is really a complete re-think of the capital environment for trading activities. Practically this is going to mean a big change in how banks are going to calculate market risk capital.

2. So who exactly are the institutions that are going to be impacted by these changes?
A. Clearly the big banks with large trading books are going to be impacted by the rule changes. The impacts for them are going to be in new systems and new ways of working. They will need to completely overhaul their internal risk models. But the FRTB will also impact the way in which their trading businesses are structured and organized - introducing yet another layer of regulatory policy and procedures that has to be put in place and monitored.

Interestingly the mid-size and the smaller banks will also be impacted. The FRTB changes the long standing standard approach to capital calculations. In an effort to make capital more uniform and risk-based the FRTB really increases the complexity of these calculations. This is going to place a lot of strain on mid-size banks as they try and implement these new rules.

Finally, I think we should also spare a thought for the regulators themselves. The Basel Committee is dependent on the national regulators to interpret the standards and implement their own rules nationally. This is going to be a massive change for the regulators as well as the banks.

3. And in terms of timeline, how much time do banks have to get ready? What will happen once this regulation is in place? And what will be the consequence is banks are not ready by then?
A. The rules were published in January 2016, and the official timeline is that local regulators have until January 2019 to put in place FRTB based regulation. The standards document of the FRTB anticipates that banks will then have 2019 as a dry run ready for reporting capital to the new standard by Dec 2019. In reality this is looking increasingly optimistic. We have already seen the Australian regulator say that it will be looking for implementation in 2020, and I would expect many other regulators to announce a slip in the timeline.

4. FRTB will be applicable worldwide, so how are countries/local regulators reacting so far? There was a report recently of Malaysia setting to delay FRTB implementation for instance… are there any trends we can observe?
A. The delegation of powers plays a part here. The Basel Committee who came up with the FRTB is a supranational group, which proposes minimum standards for all national and regional regulators to follow. The implementation of the FRTB and the supervision of this is down to the local regulators (Malaysian Central Bank in this case). Not only does the FRTB place new requirements on banks, but it places new requirements on regulators as well. This requires development of new policies and procedures at the regulators, which at the moment they are struggling to implement. A consequence of this is push back from the local regulators as well as from the banking community.

The FRTB is a radical departure from previous regulations. As a consequence it is not surprising that there are contradictions, and points that need clarifying within the 92 pages of FRTB regulations. Unfortunately the Basel Committee seems to have run out of steam. Speaking to some of the people at Basel they seem completely worn out by the effort of getting to this point, and don’t seem to have the ability or will to resolve some of these issues. This means that many issues will be left to the local regulators to resolve. This gives local regulators such as the Malaysian Central Bank a definite reason to delay implementation. And they are not the only regulator with issues. As I mentioned previously the Australian regulator has signaled a delay in implementation. Similarly the Canadian regulator say that the rules won't be implemented for deposit taking institutions until 2021. Some experts are even saying that the EU won't be fully implemented until 2025. Although I expect the EU to announce a phased introduction of the new regulations. In the US there has been a push back from the Trump administration on global regulation, particularly if the regulation will have an impact on US businesses and US growth, so at this point I would expect delays to be inevitable.

One thing that I think is problematic is the growing number of unresolved issues, and contradictions within the current FRTB standards. For example there are contradictions within the standards on precisely how P&L attribution testing is to be performed for internal models. Either the Basel Committee has to resolve these anomalies, or they will be left to the national regulators to resolve which will result in different standards being applied in different jurisdictions.

5. So do you anticipate differences between the regulators?
A. Historically there have always been differences between the national regulators. For example within the Asia Pacific Region the Monetary Authority in Singapore is notoriously rigorous and strict. Under the previous Basel 2.5 rules the MAS has never approved an internal model for any of the local Singaporean Banks. (By the way I expect this to change with the introduction of FRTB, as business lines at some of the banks will become uneconomic unless they adopt internal models.) In comparison I recently noticed that the Reserve Bank of New Zealand prides itself on having a light touch with regard to regulation and several of the local banks in New Zealand use internal models.

As always national politics may be at play here, with different national governments showing various degrees of appetites for banking regulations. As we have seen in the US even national appetites for regulation can go in cycles. The US has gone from deregulation, to re-regulation and then back again in my working career.

What I think is important here are two things. Firstly the FRTB has vast scope and ambition, but it is dependent on the national and regional regulators for implementation. Given this vast scope there will be unavoidable delays in adoption by these local regulators who will pick and chose which parts of the FRTB they prioritize for implementation by the banks under their supervision. This prioritization will be based not only on the business mix of the banks they supervise, but political pressures from national governments.

Secondly, given the vast complexity of the FRTB rules there will be a requirement for national regulators to place their own interpretation on the calculations and how they want them to be implemented.

Together these two points will inevitably given rise to slightly different standards in different jurisdictions. As we have seen in the past this could give rise so called regulator arbitrage, where banks chose to carry out business in the more lightly regulated environments. To avoid this requires an acceptance by the regulators of what is feasible for the banking community to implement, and a speedy mechanism from the Basel Committee to clarify the regulations in areas where there are holes and contradiction.

6. Finally, we have just over two years until the December 2019 deadline; what should be the priorities for banks and regulators right now? What is your best advice?
A. At the moment the priority has to be staffing and training. Some banks are holding off on hiring staff, but I think this would be a mistake. The priority for banks has to be to work out the impact of the rules, and how it will change business practices. Now is the time to train staff and to plan for the coming changes. I would imagine that by the beginning of 2018 banks should have a route map in place from where they are now to where they want to be by the beginning of 2019.

It is well accepted that banks will receive the best capital treatment if they use internal models to calculate their risk, and without these models some business lines may become uneconomic. Unfortunately these models take a long time to design, and if a bank decides it need to develop or improve an internal model the earlier they start the better. The FRTB comes at a hefty price. A study earlier this year estimated that some of the world’s biggest banks are set to spend something like $200m each to implement the new regulation. I would suggest however that with some careful planning and training of its staff many banks will be able to deliver a limited internal model for far less than this.

The FRTB course goes through efficient ways to implement an internal model. In addition the course goes through the changes to the SA in some detail, and offers tips and information on how to implement this approach. I think that training can help in reducing the implementation cost for many of the banks face with the challenge of the FRTB.

LFS offers the 2-day 'Fundamental Review of the Trading Book' programme with Dr Simon Acomb in London, New York, Toronto, Sydney, Hong Kong and Singapore.

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