CRISIL YOUNG THOUGHT LEADERS 2016

The Impact of Fundamental Review of the

Trading Book on risk management at
Investment banks
Author: Swastik Mohanty
Email: um16365@stu.xub.edu.in
Mobile: 9986574853

Xavier Institute of Management, Bhubaneswar

Course: MBA (BM)
Batch 2016-18
First Year

Executive Summary

Banking Industry is like the blood line of global economy. It can be categorized into
commercial banks, merchant banks, investment banks etc. Among these, Investment banks
acts as intermediaries in capital market. They make the market but at that same time greed of
few investment bankers fuelled by short sightedness has brought wrath of global crisis at
various points. Post 2008 crisis several measures has been taken to stop any such future
global turbulence in economy. Fundamental Review of Trading Book (FRTB) is one such
measure that aims at setting up a stricter standard on trading activities that exposes bank to
market risk and can jeopardize global economy. This report talks about various flaws in risk
modelling and management that is not addressed by current framework and introduces the
idea and key points of FRTB. It has touched upon various qualitative and quantitative aspect
of FRTB, major criticism and its impact on Investment banking industry. It is evident from
report that Investment banking industry is going to have a tough time complying these norms
and its profitability in near future will decline.

Table of Contents

Executive Summary
Introduction
Problems in Existing Framework
Changes in Quantitative aspect of Risk Modelling
I.
II.
III.
IV.
V.

Redefined Regulatory Boundary:

Change in treatment of Credit
Change in Market Risk metrics and Stress Testing
P&L Attribution
Backtesting Assessment

Changes in Qualitative aspect of Risk Modelling

Criticism of FRTB
Impact of FRTB on Investment Banking Industry

Main Content:2220 words

Executive summary: 182 words

Introduction
The 2008 Financial Crisis, one of the worst since 1929 Great Depression raised questions
about how our financial institution works, why nobody could see it coming, what went
horribly wrong and many such questions. One of the major reason was the greed of
investment banks to earn more at the expense of high leverage ratio undermining the risk
associated. Post 2008 regulatory agencies all over the world started working on a stricter
regulatory framework to avoid any such incidence in future. Hence Basel 2.5 norm was rolled
out but now after scrutiny Basel Committee on Banking Supervision (BCBS) found out some
loopholes in it and has planned a new regulation known as the Fundamental Review of the
Trading Book (FRTB) which seeks to address the shortcomings of risk measurement under
internal model based approach and standardized approach. It is expected to be implemented
on January 2019 and banks need to start comply with it by December 2019. The major reason
behind FRTB is to create a framework that could address Market Risk resulting due to trading
activities of banks in a more comprehensive manner
Problems in Existing Framework

The definition and implementation of trading book/banking book boundary is very

subjective and depends on banks intent to trade and it is something very difficult to
regulate. There is no description about the type of instruments that should be held in
trading book and or about capital arbitrage mitigation
Historical price data might not efficiently reflect market risk e.g. before 2008 crisis,
highly illiquid structured credit products with low variation in price were perceived to
be safe which turned out to be horrendously wrong. So there has to be provision for
additional capital requirement for jumps in liquidity condition.
Current framework is relied on VaR (Value at Risk) as a quantitative risk metric which
is incapable of capture the tail risk of the loss distribution.

Changes in Quantitative aspect of Risk Modelling

I.

Redefined Regulatory Boundary:

First of all, BCBS defined the regulatory boundary in comprehensive manner and put forward
two definitions i.e. A trading-evidence approach and A Valuation-based approach. Under
trading-evidence approach boundary would be defined not only by banks intent but also by
evidence of their ability to trade and manage risk on a trading desk. Whereas valuation-based
approach moves away from concept of trading intent and constructs a boundary that seeks to
align the design and structure of regulatory capital requirements with the risk posed to a
banks regulatory resources.
The new objective rules determine whether instruments should be assigned to trading book or
banking book e.g. any instrument leading to a net short risk position in an equity in the
banking book must be assigned to trading book.

Instruments resulting from market making activities, underwriting activities and any unlisted
equity or equity investment in fund will be in trading book. Instruments like unlisted equity,
real estate holding, equity investment in hedge fund and other such instruments that don not
meet the description of trading book will be assigned to banking book.
All trading book instruments will be fair-valued daily and any valuation changes must be
recognized in the Bankss profit and loss account. With respect to securitisations, default and
credit spread risk (including migration risk) will be captured in the trading book capital
charges. The default risk component will be calibrated with reference to the capital charges in
the banking book. A similar approach will also be taken on default risk for nonsecuritisations.
II.

Change in Treatment of Credit:

FRTB intends to bring trading book requirements closer to those of banking book and has a
differential approach to securitisation and non-securitisation exposures.
under both the models-based and the standardised approach, the total capital charge for credit
risk will have two separate components; an integrated credit spread risk capital charge, which
will also cover migration risk, and an Incremental Default Risk (IDR) capital charge.
An incremental capital charge for default risk mandated based on a VaR calculation using a
one-year time horizon and calibrated to a 99.9th percentile confidence level (consistent with
the holding period and confidence level in the banking book). This charge would apply to all
instruments that are subject to issuer default risk including equities. Inclusion of Default
Risk Charge (DRC) good for industry but due to large number of issuer and low correlation
between equities it will create challenge
Banks using the internal model approach to calculate a DRC must use a two-factor default
simulation model, which will reduce variation in market risk-weighted assets but be
sufficiently risk sensitive as compared to multifactor models. Default correlations must be
based on listed equity prices and must be estimated over a one-year time horizon (based on a
period of stress) using a 250-day liquidity horizon.
Capital charges for all types of securitisation positions (including any positions previously
classified as correlation trading positions) must be calculated according to the standardised
charges. As with other instruments, the capital charge for credit risk in securitisations will
comprise both a credit spread risk component and a default risk component.
A new set of capital charges will be implemented to capture the risk of changes to credit
valuation adjustments (CVA). Under these rules, banks must capitalise the impact of
changes in their counterparties credit spreads on the CVAs for all OTC derivatives, net of
allowable hedges. This must be done using either the standardised or advanced CVA
approaches.
III.

Change in Market Risk metrics and Stress Testing

The current frameworks reliance on VaR as a quantitative risk metric has one measure issue
i.e. the inability of the measure to capture the tail risk of the loss distribution. After the
implantation of FRTB banks have to use an expected shortfall (ES) measure for the internal
models-based approach and will use pre-determined risk weights for calculations under ES
methodology. ES will give comprehensive accounts for the tail risk, considering both the size
and likelihood of losses above a certain threshold.
Based on the more complete capture of tail risks using an ES model moving to a confidence
level of 97.5% (relative to the 99th percentile confidence level for the current VaR measure)
will be done. This confidence level will provide a broadly similar level of risk capture as the
existing 99th percentile VaR threshold, while providing a more stable model output and often
less sensitivity to extreme outlier observations.
There will be use of an indirect method of calculating the maximum stress over the
observational period. In this method, banks specify a reduced set of risk factors that are
relevant for their portfolios and for which there is a sufficiently long history of observations
so that no approximations are required.
The expected shortfall for the banks portfolio using this reduced set of risk factors is then
calibrated to the most severe 12-month period of stress available over the observation
horizon. The stressed period is to be based on the banks aggregated portfolio and not specific
individual risk factors. That value is then scaled up by the ratio of the current expected
shortfall using the full set of risk factors to the current expected shortfall measured using the
reduced set of risk factors.

IV.

P&L Attribution:

For the P&L attribution tests, all of the instruments held within a particular trading desk
would be identified and considered as a distinct portfolio. All of the risk factors for that
portfolio that enter into the desks risk management model would be used to calculate a risktheoretical P&L. For these purposes, the desks risk management model must include all the
relevant risk factors that the bank models, including any risk factors which the bank includes
in its internal firm-wide ES model.
The risk-theoretical P&L would be compared to the actual daily desk-level P&L (excluding
the impact of new transactions) to determine whether the risk factors included in the desks
risk management model capture the material drivers of the banks actual P&L.

V.

Backtesting Assessment:

In addition to P&L attribution, the performance of a trading desks risk management models
will be evaluated though daily backtesting. Backtesting requirements would be based on
comparing each desks 1-day static value-at-risk measure at both the 97.5th percentile and the
99th percentile to actual P&L outcomes, using at least one year of current observations of the

desks one-day actual and theoretical P&L. The backtesting assessment would be run at each
trading desk as well as for the bank-wide level.
Changes in Qualitative aspect of Risk Modelling

After the implementation of FRTB Investment Banks need to have an independent

risk control unit which will design and implement the banks risk management
system, produce and analyse the daily reports on the output of risk measurement and
report directly to senior management.
The unit must do regular back testing at firm wide internal model level for regulatory
capital determination level and P&L attribution programmes
The framework recommends Board of Directors and senior management to take Risk
Management on a serious note as it is crucial aspect of their business.
A routine stress testing programme will be conducted on the output of banks risk
management model and result needs to be reported to senior management.
The risk measurement system needs to be documented properly ensuring compliance
and any changes to an approved model must be approved by supervisor prior to
implementation.
FRTB has put huge emphasis on accuracy of completeness of position data, valuation
and risk transformation calculation and integrity of management information system.

Criticism of FRTB:

As a result of implementation of FRTB, banks will potentially further reduce

allocation of capital to certain business lines already hit by the FRTB proposals. It
will decrease market liquidity and issuer will face higher financing cost.

The lack of granularity of the risk weight buckets leads to many asset classes being
classified into the residual bucket, and no distinction between AAA- and BBB-rated
assets.

The current proposal still does not address trades with residual maturities shorter than
their liquidity horizons, or positions that knock-out far before the end of the Liquidity
Horizon. For example, credit index options trade primarily at 3 months and 6 months
maturities but all would be assigned a 250-day Liquidity Horizon.

Impact of FRTB on Investment Banking Industry

The increased pressure of regulation to keep quality Tier 1 capital has forced
Investment banks to reduce their risk exposure, refocus on key product and service
lines while downsizing low return ventures.
Investment Banks are reducing their Proprietary trading where they wager their own
money in capital market and many of their dedicated desks are facing closure. The job
of all these traders are now getting reshaped to engage in serving clients near term

need and reduce risk. e.g. Goldman Sachs shut down its Proprietary trading and
Morgan Stanley spin them off as independent firms.
The impact of regulatory burden has forced banks to think about repricing their
products to stay profitable. Revenue is expected to decline and break-even rate would
go up. The below graph shows requirement of repricing across various product
categories.

Source: McKinsey report ROE: Return on Equity EQD: Equity Derivative

Reduction of RWA and Total asset is one of the major outcome of FRTB. Many IB has
created non-core divisions to divest or manage separately their business units that are
high risk and high maintenance type or fall under poorly performing asset category.
Many of these divisions are systematically getting rid of these assets strengthening
their balance sheet. Banks have used various tools like share issues, subsidiary
floatation, dividend reduction and issuance of contingent capital to increase capital.
IBs are either shifting from non-core product line like commodities or downsizing
their operation in that. Saturated commodity market, lower profit margin, high
operational capital requirement and tougher regulation is main cause behind this. This
trend is not only present in peripheral activity like commodities but also in businesses
where IBs play market maker role like in Fixed Income products due to low
profitability and high capital intensive nature on top of that the burden of capital
requirement mandated by FRTB. Many IBs have downscaled their private equity and
hedge funds especially American IBs. Structured products will be the worst hit after
this implementation. The below graph shows decline in ROE post implementation for

various business lines of Investment Banks. Source: McKinsey Report.

IBs have decreased their global footprint across various geographies due to uncertain
market, unstable government or high competition from local players so that they
could invest those funds in their core profitable business line. E.g. HSBC disposed of
74 businesses globally since 2011, Santander sold Columbian business in 2011, Latin
American insurance business
IBs have left their goal of becoming universal bank and focusing more on their sectors
where they have competitive advantage and also redefining their target customer. The
focus is now on institutional clients who could be source of regular revenue without
much adverse impact on their balance sheet. They are giving more emphasis on
financial advisory to clients rather than core investment banking.
Several steps have been taken by IBs to cut sot like streamlining processes, cutting
jobs, reducing bonus payment, restructuring of business units, divesting low profit
units etc.
The large amount of data processing due to large volume of P&L attribution
programme and back testing and corresponding requirement for better IT
infrastructure will push IBs to invest more to have proper infrastructure in place to
address these issues.

References
1. Fundamental review of trading book: A revised market risk by Banking Committee on
Banking Supervision, January 2014
2. Minimum capital requirements for market risk by Banking Committee on Banking
Supervision, January 2016
3. Global Corporate and Investment banking: An Agenda for Change by McKinsey and
Company
4. Ten key points from Basels Fundamental Review of the Trading Book-First take, A
Publication of PwCs Financial services regulatory practice
5. Impact of Bank structural reforms in Europe - Report for AFME by PwC

6. Structural reform study: Supplementary report 2, Inventory of bank responses to

regulatory change by PwC
7. Wholesale & Investment Banking outlook, Liquidity Conundrum: Shifting risks, what
it means by Morgan Stanley & Oliver Wyman
8. Basel: The Next Generation, what is the future for internal regulatory capital models?
By Deloitte
9. Fundamental review of the trading Book, The revised market risk capital framework
and its implications, February 2016 by EY
10. The way forward on FRTB implementation by CRISIL Global Research & Analytics,
July 2016