The way forward onFRTB implementation Minimum capital requirements for market risk July 2016 Risk & Analytics Director.com www.com [email protected]@crisil.com Santhosh Kumar Associate Director.com/gra .crisil.kumar@crisil. Risk & Analytics santhosh. Risk & Analytics nageswara. Contact us: Nageswara Sastry Ganduri Kshitij Bhatia Director. ................................... 5 Questions confounding practitioners .................................................................................................................................................................. 8 The way forward on FRTB implementation .......................................... 6 FRTB implementation charter ..... 9 CRISIL GR&A is a preferred partner in FRTB implementation .......................................................................................................................................Table of contents FRTB – The New Minimum Capital Requirements for Market Risk .. 10 3 ............................... 4 . Residual risk add-on uses a simple notional-basis calculation. 2. which desks have to pass. While linear charge includes delta and vega risks. where banks will be compelled to think about re- optimizing their businesses to minimize capital requirements. and 3. Value at Risk-based Default Risk Charge. acknowledges the severity of tail events. The Internal Models Approach The IMA has three components of capital charges that are aggregated – 1. All desks have to calculate capital charges based on the Standardised Approach (SA). FRTB marks the emergence of a new regime. the non-linear one is the curvature risk. The approval process includes back-testing. IMA is also subjected to stringent regulatory approval process failing which desks will have to fall back on SA. irrespective of whether they are eligible for Internal Model Approach (IMA) or not. and non-correlation trading portfolio. and. 5 . it is VaR- based. Expected Shortfall (ES)-based Market Risk Charge. However. ES affords elbow room to handle illiquidity by incorporating varying liquidity horizons. IMA desks also need to identify modellable (MRF) and non-modellable (NMRF) risk factors because additional stressed capital add- on charges apply to the latter. The Standardised Approach The SA has three components of capital charges that are aggregated – 1. As for Default Risk Charge in IMA.FRTB – The New Minimum Capital Requirements for Market Risk The new minimum capital requirements for market risk is commonly referred to as Fundamental Review of Trading Book (FRTB). Sensitivity-Based Charges 2. DRC is calculated separately for securitization (for correlation trading portfolio. The new framework makes capital charge calculations a function of market moves. implementing IMA is more challenging because of the stringent approval process involved. The granular model approval process requires monthly back-testing and daily P&L attribution. DRC measures the rise in default risk. Desks where IMA is rejected or approval is withdrawn have to fall back on SA for capital calculations. along with stringent qualitative standards and internal and external validation. In SA. ES aims to capture tail risk. The revised components Under the FRTB. Sensitivity-Based Charges cover both linear and non-linear risks across asset classes. along with Stressed ES. or Sec CTP. or Sec Non-CTP) and non- securitization. stress testing and P&L attribution tests. Residual Risk Add-on. Stressed ES-based Stressed Capital Add-On. Default Risk Charge (DRC) and 3. replaces VaR and Stressed VaR in IMA. banks have to move away from reporting at the legal entity level to the desk level. it is calibrated to the credit risk treatment for the banking book. As per the latest quantitative impact study (QIS). and ensures banking and trading book boundaries are impermeable. the Standardised Approach is expected to be more punitive on capital charges than IMA. this will throw up new challenges. 6 . NMRF treated differently IMA is applicable not at a Desk Level Model approval subject to passing of Perimeter desk level but at overall PL attribution & Desk back-testing tests on regular trading book level basis Questions confounding practitioners Industry experts are facing many unanswered questions and there is no clarity on the best way forward.5% (MRF) Stressed VaR at 99% Metric Stressed ES at 97.5% Default.SA and IMA: Key changes owing to Minimum Capital Risk standards Approach Components Previous framework Minimum capital requirements framework Sensitivity-based approach Metric Risk-weighted exposure Default Risk Charge Residual Risk Add-On Risk-weighted sensitivities summed per asset Standardised Linear summation of RWA per class Approach Calculation asset class Worst of the calculations based on three levels of correlations to be chosen Trading book not considered Trading book under IMA to be considered as a Perimeter for IMA fallback and a benchmark VaR at 99% Expected Shortfall at 97. back testing and stress testing tests need to be passed at the desk level to continue to enjoy the benefits of IMA. From the perspective of managing the internal structure of a bank. Overall cost of model maintenance Stringent regulatory restrictions and desk level monitoring of models for internal model approach poses new difficulties for model maintenance. P&L attribution test. a reorganization of desks may be needed Transition to a new desk structure may not be smooth and straightforward in most cases FRTB might change the capital charge landscape within different desks of a banking entity. failing which banks need to switch to the punitive SBA approach. Migration based on Default Risk Charge Internal VaR Models Daily shocks multiplied by Liquidity Horizon (up to 120 days) Calculation Approach √10 MRF. Here are some of the vexing issues: Organisation of trading desks Currently most banks follow the Volcker Rule-based trading desk structures In order to optimize capital charges at the firm level. CRISIL GR&A is helping banks in gap studies. Then there is the risk of pushing existing investments to sunk costs. Moving from VaR to ES would mean that many internal and external stakeholders will have to grapple with painful teething issues. drawing up roadmaps. and ramping up teams with the required skillsets to handle increased operational challenges in an optimized manner All Aspects Of Industry Conduct May not be Cast in Stone During The Initial Years of FRTB It would be an understatement to say that FRTB has put pressure on an industry already struggling to save their top and bottom lines.Switching from VaR to ES Major stakeholders in the finance and risk functions are very familiar with VaR as a risk measure. banks also incur hidden costs (such as creating meta data infrastructure). Will this affect the price of products traded by the desk? Extrapolating this scenario might lead to a rosy picture for simpler products in the short run. Most banks may not find it economically feasible to maintain huge data infrastructure on their own. In addition to obvious costs such as rising capital requirements. The immediate focus for 2016 is largely to get the data foundation stronger. CRISIL GR&A feels that all aspects of industry conduct may not be cast in stone during the initial years of FRTB implementation. Explosion of data Increase in granularity and information intensity of capital calculation leads to an exponential increase in the amount of data to be processed. perform comprehensive impact study of various aspects of the regulation and draw up an implementation charter. It is going to be a long journey in a changing regulatory landscape . if IMA fails for some reason. The industry might keep looking for answers even after the 2019 kick-start. The impact of capital floors is also not well understood. a complete understanding of the differences in capital impact requirement between SA and IMA for each individual desk is lacking. And under the FRTB regime.and not about that one amber signal before a hairpin bend. but each and every item inside. For example. But as of today. Banks have been working out different tactical solutions to manoeuvre around. Imagine a hypothetical situation where you are preparing to board a flight and the security authorities insist that it is not enough to wrap whole suitcases. Desk-level approvals are akin to this. New businesses surrounding pooling of data and maintaining common platforms are the future. The industry is yet to understand the true price of data for modellable and non-modellable risk factors. Also. there is no silver bullet available. 7 . for safety. then the corresponding desk needs to fall back on SA with a bulked up capital charge. that’s a real situation and not a hypothetical one. FRTB implementation charter Based on our experience of working with large banks in FRTB programs. model and monitoring Infrastructure Definition and Planning data infrastructure.Definition and Planning. Assessment.A robust risk data infrastructure aligned with pricing framework. – Preparation of BRDs and FSDs alignment responsibilities and approach • Tactical initiatives towards are defined and sensitized exploring technological and • Prepare an agile based modular operational innovations approach 8 . scope. and Execution. intra-day • Organize workshops and trainings Impact analysis. design and Implementation Stage II • Data Models . Expectedly. with the exercise mostly concluding close to the final deadline. So it is quite likely that the first two stages could be repeated back-to-back in an iterative manner. expected shortfall Assessment implementation and risk factor • Iterative assessment and review modellability framework of MR components in light of • Desk level Model Risk Stage I FRTB guidelines Management and performance – Book boundaries. which amplifies the importance of getting all things right in the first two stages. P&L attribution. we have seen that change management can be categorized in three stages -. • Different analyses – Gap analysis. the scope to correct errors will be minimal by the end of the Execution stage. risk factor • P&L Attribution and Backtesting – • Identification of all stakeholders modellability. Deep dive desk level reporting for all involved parties/employees analysis • Desk re-organization or re- – Objectives. Execution is expected to be characterized by lengthy implementation of alternative designs and architectures. A Robust Change Management Plan and Implementation Stage III Execution • Target state definition. Desk level threshold monitoring who would be part of the backtesting and reporting implementation charter • Reporting – Model assumptions. involving huge investments in resources. threshold breaches. Reporting • Identification of risk factors for • Managing risk data aggregation risk classes • Increased computational SBA • Risk factor definition requirements • Maintaining consistency across desks and jurisdictions • Reporting framework for aggregated capital charge across all desks SA • Defining DRC sub-bucket criteria • Model development for SA .The way forward on FRTB implementation We have studied the operational and infrastructural challenges for FRTB across its components under three factors: 1. the extension of deadline for FRTB has given some breathing space. 2. NMRFs) • Enhancing VaR and SVaR models ES • Liquidity horizons mapping to generate ES and Scaled ES • Sourcing and validation of • Model enhancement to account for • Exception monitoring framework historical market data revised/scaled liquidity horizons • Fall back process for IMA desks. Firms are increasingly seeing this as an opportunity to repurpose their infrastructure end to end. and 3. To be sure. Listed below are some of the key components that banks need to incorporate in its implementation roadmap to ensure that challenges are addressed in a systematic and strategic manner: Key aspects in strategic FRTB implementation program Data Models and calculations Reporting Totally integrated data architecture Calculation intensive Infrastructure to report Centralized infrastructure -. traceability and integrity Development of P&L Precise classification of risk factors for attribution and back-testing modellability infrastructure Fall back process to SA 9 .for massive Implementation and real time at desk level storage. retrieval and audit of data calibration of ES and DRC Robust governance Sort data into risk buckets and classes models structure and processes Maintain accuracy. breaching prescribed limit • DRC data integrity to account • Model development for IMA – DRC • Reporting framework for disclosure IMA for stressed data period calculations to regulators DRC • DRC validation using stress tests. etc. Data. uncleared margin requirement (UMR) rules.DRC (irrespective of IMA use) DRC calculations • Governance structure • Model validation and frequency • Identification of instruments • Incorporation of additional charge Add with exotics and other residual for exotics and non-exotic On risks instruments Market Data Model & Calculations Reporting Risk • Risk factor classification (MRFs • Historical simulations Vs. Risk-based database We have observed that firms are studying and taking a combined approach for key regulations such as FRTB. Model & Calculation. • Governance and monitoring sensitivity and scenario analysis • Hypothetical PL – Full revaluation • Historical simulation based on full Add • Risk-based PL revaluation method On • Hypothetical Vs. We support implementation and setting up of FRTB infrastructure. and regulatory reporting. have helped leading banks and financial institutions meet their regulatory objectives within prescribed timelines As a part of our change-management offering.CRISIL GR&A is a preferred partner in FRTB implementation CRISIL GR&A is working with multiple firms and is a preferred partner for end-to-end FRTB implementation support. data management and change management. As a part of this. finance and other key teams at banks. In risk and analytics. Our team of experts. Firms are clearly seeing this as an opportunity to repurpose their overall risk and reporting infrastructure. we are engaging with firms in revamping P&L attribution and independent price verification processes. with rich experience across model development and validation. supporting them in risk management including model development and validation. and are engaging with firms to revamp their risk-management infrastructure to support SA. we have helped firms conduct quantitative impact studies and benchmark analysis in the early days of FRTB. Our vast experience right from the inception of FRTB -. 10 . we are helping firms in drawing up a comprehensive implementation charter across various regulations including FRTB. including centralized risk database and enhancement of market risk-related models.has made us an industry leader. IMA and DRC model development. We are also working on developing SA templates for various asset classes and for Default Risk Charge.including support to banks in their quantitative impact studies -. and developing ‘functional prototypes’ for overall strategic implementation programs. data management. CRISIL GR&A works with 17 of the top 20 global banks and several mid-sized/regional banks. Our proven strategic partnerships with banks in designing and implementation of regulatory reform projects have given us opportunities to engage early with them on FRTB implementation. Our expertise and experience across banks have helped us execute industry best practices across projects for risk. . We offer corporate strategy.spglobal. We are proud to be an organization that has the vision to proactively invest in its people and get them future-ready. or to let us know your preferences with respect to receiving marketing materials.com . research. 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