Implementing the Fundamental Review of the Trading book: state of play and key challenges ahead

At a glance

The capital framework for banks’ trading activities has faced significant regulatory change for more than a decade. More change lies ahead as regulators take key decisions this year on finalising market risk rules, but the path to the finish line remains uncertain and increasingly complex for banks that operate cross-border business models. There is, however, an urgent need for banks to make use of delays in the regulatory timetable to ensure they are ready for implementation when it comes. This blog examines the current state of play of FRTB implementation in the EU and UK (as well as other key jurisdictions) and discusses “no regret” actions – such as those on desk structure strategy, automation, and data enhancements – that banks can take now before jurisdictional rules are finalised.

Intended audience: Chairs of board risk committees, CROs, treasurers, heads of markets, heads of regulatory affairs in IMA banks with significant trading activity

Background to the FRTB

In 2012, the Basel Committee on Banking Supervision (BCBS) consulted on its Fundamental Review of the Trading Book (FRTB), which proposed to reform the market risk rules in the Basel bank capital framework by introducing a new Standardised Approach (SA) and Internal Models Approach (IMA), a revised boundary between the trading and banking books, and a series of new supervisory tests for IMA approval.

The FRTB was finalised by the BCBS in 2016 and revised again in 2019, since wen it has been treated by most jurisdictions as part of the broader Basel 3.1 package. The BCBS deadline for implementing the FRTB package is 1 January 2023, but most key financial services jurisdictions have not yet finalised their adoption of FRTB rules or confirmed the timing of its implementation, making significant delays either certain (in some countries) or inevitable in others.

Part I: Why the FRTB matters for banks

The BCBS intended the FRTB to tackle design flaws in the existing market risk framework in two principal ways: by better capturing the risks that banks face in their trading activities; and by reducing the variability between IMA outcomes through limiting banks’ flexibility to use their own modelling assumptions. This is meant to ensure that banks are sufficiently capitalised to absorb the trading losses they could face, including under stressed situations.

The forecast impact of these revisions is substantial, but highly variable from bank to bank. The size of market risk RWAs relative to total RWAs on the balance sheets of global banks varies significantly (see Figure A) and the nature of their trading activities and use of internal models will drive further differences.¹

The European Banking Authority (EBA), which has conducted the most extensive public impact assessments of any major regulator, has estimated that the impact of FRTB implementation in the EU will result in a 32.5% [2] average increase in minimum capital requirements for market risk, with inter-quartile impact ranging from –12.9% to +82.8%. The EBA found that, among internationally active banks, 63% of the average capital requirement increase will be driven by the implementation of the revised IMA requirements. 

These impact figures are debated, however. Industry bodies have claimed that they underestimate the likely increase in capital requirements that will be driven by the FRTB if a greater proportion of trading desks shift from IMA to SA (either through management decisions or desks failing IMA eligibility tests) [3].

Such significant increases in the capital intensity of trading could have important knock-on effects on the ability of banks to maintain their trading activities. This could increase prices or decrease trading volumes for certain products, reduce banks’ willingness to participate in market making, and limit the availability of risk management solutions banks can offer to their clients. An inconsistent global implementation of the FRTB could also create level-playing-field challenges for banks that compete more directly in global capital markets than for other banking services.

Part II: FRTB implementation – the state of play

Since the BCBS finalised the FRTB in 2019, some of its members have begun to transpose the rules into their domestic laws and requirements. Jurisdictions are progressing with this work according to different schedules and this has made tracking the implementation of the FRTB much more complex. From our point of view, we are looking at developments in the four areas set out in the table below.

 1. EU FRTB Implementation – Reporting requirements

• 2019 – Capital Requirements Regulation (CRR2) implemented the FRTB as a reporting requirement rather than a binding capital requirement.
• 2021 – EU banks began reporting using the FRTB SA in September 2021.
• June 2022 – Adoption of technical standards on IMA by the European Commission as Delegated Acts. Following parliamentary scrutiny, this will begin the three-year implementation period for IMA reporting under CRR2.
• Q3 2025 – FRTB IMA reporting under CRR2 rules can begin.

2. EU FRTB Implementation – Capital requirements

• 2021 – The Commission proposed the “Banking Package” (CRD6/CRR3) to implement the Basel 3.1 framework, including converting the FRTB into a binding capital requirement.
• 2025 – The proposed implementation date is 1 January 2025 for the entire framework including market risk, two years after the BCBS deadline. A January 2025 FRTB implementation as a capital requirement would come before the introduction of CRR2’s IMA reporting requirement – an overlap EU regulators have not yet addressed.
• Up to 2027 – CRR3 includes a provision that would allow the EU to extend the implementation of the FRTB by up to two additional years, or to re-calibrate its impact, based on level-playing-field concerns if other jurisdictions do not implement the FRTB on time or faithfully.
   

• 2022 – In January, Canada published the Capital Adequacy Requirements (CAR) for the implementation of the Basel 3.1 standards. Regulators in Japan and Canada have finalised their domestic rules for the FRTB.
• 2023 – Switzerland is expected to publish its Capital Adequacy Ordinance (CAO) in June/July 2023. The Ordinance is set to encompass credit and market risk, CVA and leverage ratio.
• 2024 – By mid-2024, Canada, Japan, and Switzerland are expected to bring their domestic FRTB rules into force.
• 2025 – After several revisions due to COVID-19, Australia plans to implement its prudential Capital Adequacy Standards on market risk (APS 116) by January 2025.

United States – US regulators have not yet consulted on their implementation of the FRTB and the broader Basel 3.1 package. An Advanced Notice of Potential Rulemaking (ANPR) (a precursor to a formal consultation) led by the US Federal Reserve is expected later this year. US regulators have not yet provided a date by which they expect the FRTB to be implemented.

Part III: Timing considerations for implementation work

Although substantial regulatory uncertainty remains in the FRTB implementation process, it now appears likely that no major financial services jurisdiction will implement the FRTB on 1 January 2023. The EU and UK have clarified that their earliest implementation date will be 1 January 2025, and it appears unlikely that US implementation will come before this.

By the end of 2022, however, proposed or consultative rules for the FRTB should be published in the UK and the EU’s CRR3 text will be at a more advanced stage in negotiations. While this will not eliminate the policy uncertainty, it will narrow it and allow banks to make better informed decisions about how to proceed with implementation work, and model design and application decisions for IMA banks.

Internationally active banks may, nevertheless, have trading activities in jurisdictions that currently look set to implement the FRTB before 2025 and will need to account for that in their overall approach. So far, Canada, Switzerland, Hong Kong and Japan have all proposed or finalised rules that will bring the FRTB into force before January 2025.

Part IV: Implementation challenges and actions in the banking sector

For several years, most banks made little progress preparing for the FRTB as its implementation deadline was pushed back by the BCBS, leaving several complex implementation challenges largely unresolved. We have, more recently, seen a step change in the sector’s activity as implementation has come into sight. Much of the recent preparatory work has been focused on putting in place the necessary risk infrastructure and improving data quality and capture. Among IMA banks, the biggest challenges of the new framework continue to be passing the P&L attribution (PLA) test and the capital charges that would arise if exposures are caught by the non-modellable risk factor (NMRF). These have remained decisive issues in banks’ cost-benefit analysis around desk structure decisions.

Some banks have already had initial discussions with their regulators about applying for permission to use IMA models, particularly in the EU where the CRR2 reporting framework provides a basis to do so. More generally, we are seeing a hesitancy to proceed with some FRTB work due to ongoing regulatory uncertainty, including in the EU (where the CRR3 negotiation process could still make critical changes to the EU approach). In a letter to banks, the UK PRA has recently put parameters around this timing uncertainty by clarifying that firms are expected to submit pre-application materials by 1 January 2024. This will apply to firms opting for new IMA models and for some elements of the new SA requirements.

While some hesitancy is understandable, we believe that there are a number of urgent “no regret actions” that will help banks move more quickly and make better-informed decisions around model build and applications once the final rules are in place. These actions include:

Develop a desk structure and operating model strategy: FRTB implementation will have important implications for a bank’s capital markets operating model. The desk-level application of the framework [4] means that banks need to assess the regulatory feasibility of using IMA models for certain products as well as how product and client profitability may be affected by the capital costs of FRTB implementation. This assessment should encompass the impact of SA and IMA changes, as well as the impact of the standardised Output Floor when it is fully phased-in (in many banks, we have recently seen that the Output Floor can substantially limit the expected capital benefit of IMA models). If draft or final jurisdictional rules are not yet available, banks should base this analysis on the BCBS standards as a tentative reference.

We have observed that some regulators have recently put more pressure on banks to identify the desks for which they intend to make IMA model applications. Many banks may feel it is still too early to make these decisions, especially where ongoing upgrades to risk infrastructure are not yet complete. Where regulatory pressure exists, however, banks should identify and prioritise preparatory work for a sub-set of desks where their cost/benefit assessment is clearest, even where ongoing upgrades to their risk infrastructure are not yet complete.

Invest in automation: some of the most advanced IMA banks are developing automation capabilities that generate and update relevant model documentation that is consistent with the models they have built. Such a capability can reduce the cost and labour intensity associated with model management and reduce the likelihood of extensive remediation being required to address gaps and inconsistencies. This will also help banks move more quickly to the IMA application stage once the relevant jurisdictional rules are finalised and have more complete and consistent documentation supporting their application.

Focus on architectural and data enhancements: aligning Front Office pricing and Risk models is a key challenge in passing the PLA test and many banks still need to do significant work to put in place the needed architectural enhancements to support this. Banks should focus on promoting more comparable Hypothetical P&L and Risk-Theoretical P&L⁵by ensuring that both Front Office and Risk have access to consistent market data, as well as making sure the market data is appropriately “transformed” between Front Office and Risk definitions of risk factors. Adjustments made to P&L data remain a pain point for many banks, especially where their inclusion could jeopardize the PLA test. Conversely, their exclusion can affect success in backtesting. Whatever approach banks end up taking here, they will need to provide robust justifications, including quantitative analysis and explanation, to regulators.

Focus on risk factor modellability: in order to limit the potential for significant NMRF charges, IMA banks should use the extra time afforded by implementation delays to focus on their preparedness for the risk factor eligibility test as well as the Stressed Expected Shortfall (SES) calculations. Banks should consider where there are opportunities to re-factor the risk factors used in the market risk model (for example, decomposing them into general and idiosyncratic components) to maximise the proportion of risk that is explained by observable risk factors, therefore reducing the size of the SES charge.

Part V: Taking advantage of regulatory delays

Even though the finalisation of national/jurisdictional rules is critical for banks to proceed with their FRTB implementation programmes, most regulators will need several years to process an IMA model application. IMA banks that are not ready when the relevant rules are finalised, and are consequently behind in this process, will risk not having their models approved by the go-live date for FRTB capital requirements. This could leave banks exposed to calculating their market risk RWAs based on the more conservative SA for a period. The UK PRA has already confirmed that this would be the case for firms delaying their model materials submissions later than 1 January 2024.

Our view is that banks should take advantage of the extra time that regulatory adoption delays will buy them to ensure that they are in a good position this year and that they can confidently navigate the complexity of regulatory finalisation and adoption when those milestones are finally reached.
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References

1. Among 22 of the 25 banks included in Figure A, an average of 60.1% of market risk RWAs were based on IMA models and 39.9% based on the SA in 2021. Three US banks do not report the split between SA and IMA.
2. EBA, Basel III monitoring exercise, September 2021 (note: the 32.5% figure is from a “reduced estimation bias” calculation presented by the EBA that excludes the submissions from three G-SIBs that the EBA judged to be too conservative in their assumptions.
3. International Swaps and Derivatives Association, ISDA, AFME Position Papers on CRR III, FRTB Position Paper, 2022.
4. This is different to the current “all or nothing” approach and it will represent a significant change (i.e., in the supervisor’s ability to turn model approval on and off at desk level, leading to potentially significant market risk RWA volatility).
5. These are the measures used by the regulators during the P&L attribution test – a test that the trading desk must pass to use the IMA for market risk purposes. The Hypothetical P&L is generated by the desk’s front-office pricing models; the Risk-Theoretical P&L is generated by the bank’s own risk models.