Implementing standardised approaches for market risk

Moving the dial article series

October 2022

As banks move towards implementing the fundamental review of the trading book (FRTB) for Basel 4, several common issues and challenges are emerging.

These are particularly apparent in Asia, with reporting dates coming near and expected short periods between reporting and capitalisation dates. Banks in mainland China, for example, must begin FRTB reporting and calculations from 1 January 2023 only a few months away. In Hong Kong (SAR) China, reporting and capital calculation requirements have been staggered, from 1 July 2023 and 1 January 2024, respectively. Europe started FRTB reporting earlier in September 2021; however, as the capitalisation date is likely to be set at January 2025 by the Capital Requirements Regulation III (CRR3), banks have time to iron out implementation issues. The UK is also expected to have later implementation dates and take a staggered approach. Final rules and adoption timelines are yet to be confirmed for the European Union (EU), UK and US, but are hoped for by the end of 2022. Since there is still a degree of uncertainty, many institutions have begun to work in advance to get ready for the new requirements.

KPMG firms have been supporting several institutions across these regions with their market risk projects. The main issues that we see arise from the adoption of the standardised approach (SA), rather than using internal models (IMA) although we note that some firms are selecting to also use IMA for specific parts of their portfolio.

• Staggered implementation dates may not actually help: Regulators such as the Hong Kong Monetary Authority (HKMA) and the European Banking Authority (EBA) have placed a gap between reporting and capital calculation dates as a concession to making the shift to the FRTB framework lighter and to delay any possible increase in capital requirements. But the experience in Asia is that this delay can create a different set of challenges due to the complexity, from a systems perspective, having to run two different calculations simultaneously (one under the old Basel 2.5 market risk regime, the other under the new FRTB regime) during the interim period. Banks in the EU, some of which are already under the reporting regime, will have a longer gap, and some are therefore looking at workarounds for the parallel reporting period. The main obstacle does not lie so much in the expectation of running two parallel prudential frameworks until Basel 4 enters into force, rather in properly complying with every aspect of the FRTB. 
• The boundaries between trading and banking books are not always clear: The FRTB introduces changes to trading book and banking book classifications, but the rules are not always crystal clear and there is some ambiguity in their interpretation and application across legal entities. This is especially the case for less common instruments. For example, how should a perpetual bond be treated as an equity or as a debt instrument? Some complex instruments like structured deposits may contain different elements that need to be split out between the two books. There are also organisational impacts, given that many banks have separate front office teams managing trading and banking book activities. New roles and responsibilities may be needed, in addition to new allocation of revenues between different desks. 
• Consistency between actual profit and loss measurement and FRTB systems is a challenge: Many banks are looking to buy and implement `off-the-shelf' vendor systems to manage the FRTB, to calculate sensitivities and capital charges under the FRTB Standardised Approach (SA), especially in Asia. Meanwhile, the bank's existing front office systems will continue to produce actual profits and losses for financial reporting purposes. However, data and configuration may be different across the two systems. While the Basel rules for FRTB SA do not require profit and loss (P&L) backtesting for FRTB capital charges, there is nonetheless an assumption under the SA that front office pricing models used in actual P&L reporting shall provide an appropriate basis for the determination of regulatory capital requirements for all market risks. It will be interesting to see how this area develops and whether the rules will be clarified or changed. Another issue that institutions are encountering is that some vendor systems struggle to measure risk for some more `exotic' products for the FRTB risk sensitivity and capital calculation banks are therefore having to create workarounds to obtain the calculations needed and it seems likely that more tailored solutions will be needed. 
• Redesigning of market risk limits is a work in progress: Current market risk limits are based on concepts of value at risk (VaR) and stressed value at risk (SVaR), but these are no longer directly related to the capital charge under the FRTB SA. Some banks are considering limits and risk appetite based on FRTB risk measures, like the Default Risk Charge (DRC), Sensitivities-Based Approach (SBA) and Residual Risk Add-On (RRAO), but there is no clear `winner' emerging as yet. Some banks are assessing whether it might be beneficial to switch to market risk monitoring based on the FRTB SA, instead of still relying on older internal measures. This switch would allow for the alignment between internal risk monitoring and the regulatory framework.
• Unclear structural foreign exchange (FX) definition and calculation: Another technical area that is causing uncertainty is the treatment of structured FX, which can be used to `neutralise' risks in FX positions. The definition of structured FX, and the methodology to be used to calculate it, is not clear under the new rules as they currently stand. More clarity and therefore consistency across the industry would be welcomed here moving forward.
• Strong governance is key: A clear lesson emerging through work to date is that it is essential to ensure activity is integrated into banks' governance frameworks, including established or new committees and forums, with clearly documented processes to identify the controls and oversight between teams and functions. Manual processes and controls should be consistent and in line with the bank's policies and standards, while all interpretations, judgements, assumptions and approvals should be documented and reviewed by an independent third party. End-to-end traceability should also be documented.

Although implementing the SA for market risk has generally been simpler than adopting internal models, many complexities are nevertheless arising. This makes it all the more critical that there is sound programme management across the project's workflow, processes and controls, and that governance is integrated with the bank's model risk governance framework for alignment and consistency.

Remember too that all of this is only for Pillar 1 banks have yet to move on to the Pillar 2 internal capital adequacy assessment process (ICAAP), which will enhance their financial stability through additional capital buffers.

It is therefore essential that institutions get started while there is still some time. Take it as a given that there will be a number of issues requiring discussion and approval from your regulator, who will have a long list of requests to work through and may not be able to consider them immediately. 

Those institutions that allow sufficient time and plan their projects carefully, supported by sound external advice, are making good headway as they move towards the new but complex market risk regime.