Abstract
This chapter contextualizes the Fundamental Review of the Trading Book (FRTB) in the vast movement that has reinforced regulatory and prudential requirements. The author emphasizes the uncertainties linked to the final calibration of the new framework and the implications for economic banking models and market intermediation. Lastly, the chapter stresses operational issues linked to piloting this transformation process for regulated banks, which are facing a lot of uncertainty.
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Notes
- 1.
See in particular Minimum capital requirements for market risk, http://www.bis.org/bcbs/publ/d352.pdf. For a brief introduction see also the Basel Committee document, again published in January 2016, entitled Explanatory note on the revised minimum capital requirements for market risk, http://www.bis.org/bcbs/publ/d352_note.pdf.
- 2.
- 3.
The new regulations relating to OTC derivative products will have major consequences for end users, especially companies. The latter may be led to changing the risk profile of rates on their debts, via profiled asset swaps according to the bonds issued. These non-standard products are not cleared centrally. The cost of managing financial risks to companies is thus increased, either directly through a rise in intermediation margins on asset swaps, or indirectly through an increase in “basis risks,” if companies decide to take out insurance cover using standardized products. Culp and Miller (1995) illustrate the importance of basis risks in the case of Metallgesellschaft.
- 4.
See for example, The financial crisis and information gaps, published October 2009 https://www.imf.org/external/np/g20/pdf/102909.pdf.
- 5.
A Coordination Framework for Monitoring the Implementation of Agreed G20/FSB Financial Reforms, October 2011, http://www.financialstabilityboard.org/wp-content/uploads/r_111017.pdf.
- 6.
This includes:
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1)
The obligation for transactions in the simplest derivative products to be booked through clearing houses, with the aim of reducing the counterparty risks on these products. The clearing houses have been placed at the heart of the new market architecture for derivative products. For more detail on this matter. <AU Last sentence of Footnote 6 point 1 is incomplete: please correct>
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2)
The introduction of bilateral initial margins (guarantee deposits) for derivative products that are not centrally cleared, again in view of reducing counterparty risks and contagion via derivative products.
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3)
The improvement of pre- and post-trade transparency.
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4)
The use of trading platforms (Swaps Execution Facilities, SEFs).
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1)
- 7.
See “A brief history of the Basel Committee”, October 2014, http://www.bis.org/bcbs/history.pdf and Blundell-Wignall and Atkinson (2010) for a first assessment of Basel III.
- 8.
See https://www.bis.org/bcbs/gsib/ for the criteria classifying systemically important banks.
- 9.
Apart from the capacity to absorb losses, the Basel Committee has set out precise criteria for defining Core Equity Tier 1 capital, as a function of its capacity to absorb losses, its permanency and flexibility for payments. These latter two points have led to the exclusion of certain hybrid securities from CET1.
- 10.
In December 2009, the Basel Committee (http://www.bis.org/publ/bcbs164.pdf) proposed deducting minority shareholdings in subsidiaries from equity capital because they cannot cover losses at consolidated group level. The handling of minority interests has subsequently evolved. The reader may refer to the following documents by the Basel Committee concerning the definition of equity capital:
-
1)
Basel III: A global regulatory framework for more resilient banks and banking systems, June 2011, http://www.bis.org/publ/bcbs189.pdf (the first version was published in December 2010, the June 2011 version introduced an equity capital charge for variations in Credit Valuation Adjustment (CVA);
-
2)
The press release in January 2011, http://www.bis.org/press/p110113.pdf.
The FAQ available on the Basel Committee website (last update October 2011): http://www.bis.org/publ/bcbs211.htm.
-
1)
- 11.
Capital Requirements Regulation (CRR) and the technical document of the EBA on prudent valuation https://www.eba.europa.eu/documents/10180/642449/EBA-RTS-2014-06+RTS+on+Prudent+Valuation.pdf.
- 12.
- 13.
See the Basel Committee documents Review of the Credit Valuation Adjustment Risk Framework issued in July 2015, http://www.bis.org/bcbs/publ/d325.pdf, Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches, issued in March 2016, http://www.bis.org/bcbs/publ/d362.pdf, Capital requirements for bank exposures to central counterparties - final standard, April 2014, http://www.bis.org/publ/bcbs282.pdf.
- 14.
- 15.
US accounting standards are different from IFRS standards in terms of netting repo activities and security financing transactions (SFTs). Deutsche Bank showed that the size of its balance sheet according to US GAAP was twice as weak when compared to calculation based on international accounting standards, this being essentially because of the way repos are processed. The Basel ratio is the result of a compromise between international and US practices. It should be noted that the denominator of the leverage ratio (the exposure measure) includes off-balance sheet items, especially credit derivatives, as well as the exposure to risk on derivative products.
- 16.
See for example http://www.usbasel3.com/docs/Final%20SLR%20Visual%20Memo.pdf.
- 17.
The Market Risk Amendment of 1996 (http://www.bis.org/publ/bcbs24.pdf), see also the Basel Committee’s document entitled International Convergence of Capital Measurement and Capital Standards (http://www.bis.org/publ/bcbs128.pdf), published in June 2006 as a consolidated version.
- 18.
http://www.bis.org/publ/bcbs158.pdf, see also Analysis of the trading book quantitative impact study (http://www.bis.org/publ/bcbs163.pdf), published in October 2009.
- 19.
The regulatory framework: balancing risk sensitivity, simplicity and comparability, http://www.bis.org/publ/bcbs258.pdf. Other references include the speech by the Secretary General of the Basel Committee in February 2013 (http://www.bis.org/speeches/sp130226.pdf) and a document by the Fed and the OCC relating to risk models, which has become the reference text for US supervisors: Supervisory Guidance on Model Risk Management (https://www.federalreserve.gov/bankinforeg/srletters/sr1107a1.pdf). We also refer to Aikman et al. (2014).
- 20.
This approach and terminology were initially described in a Basel Committee document entitled Supervisory framework for the use of ‘backtesting’, published in January 1996 http://www.bis.org/publ/bcbs22.pdf.
- 21.
Documents in 2013: http://www.bis.org/publ/bcbs240.pdf and http://www.bis.org/publ/bcbs267.pdf, document submitted to the G20 in 2014: http://www.bis.org/bcbs/publ/d298.pdf.
- 22.
- 23.
See for example the summary of the report by Fed’s Office of Inspector General (http://oig.federalreserve.gov/reports/board-supervisory-processes-jpmorgan-chase-oct2014.pdf), the Senate report (http://www.hsgac.senate.gov/download/report-jpmorgan-chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses-march-15-2013) and numerous other commentaries in the press.
- 24.
Fundamental review of the trading book: A revised market risk framework, Basel Committee on Banking Supervision http://www.bis.org/publ/bcbs265.pdf.
- 25.
Fundamental review of the trading book - second consultative document, Basel Committee on Banking Supervision http://www.bis.org/publ/bcbs265.htm, “Fundamental review of the trading book: outstanding issues”, Basel Committee on Banking Supervision
- 26.
The Basel Committee has published its responses: see for example, http://www.bis.org/bcbs/publ/comments/d305/overview.htm for the third consultative document.
- 27.
- 28.
“Minimum capital requirements for market risk”, http://www.bis.org/bcbs/publ/d352.pdf. See also Explanatory note on the revised minimum capital requirements for market risk (http://www.bis.org/bcbs/publ/d352_note.pdf) published in January 2016 by the Basel Committee, which provides some information on the origin of rules published the same month, and on the impact of new measures.
- 29.
The level of granularity of internal models by banks is more detailed (typically including several tens of thousands of risk factors).
- 30.
More specifically, the risk factors are the finite differences from which it is possible to quantify the scale of directional positions (the “deltas”) and negative convexity (negative Gamma or “curvature risk” in Basel terminology).
- 31.
The valuation models used for interest rate options differ from one bank to another, particularly as regards the sensitivity to interest rates. This raises the question of whether to harmonize models, albeit at the expense of innovation. It is also possible that the reconciliation exercises, which should be conducted with the establishment of bilateral initial margins for derivatives that are not centrally cleared, lead spontaneously to such convergence.
- 32.
It has also been suggested that higher fixed costs owing to compliance could constitute an entry barrier.
- 33.
See for example the presentation by Anat Admati, https://www.gsb.stanford.edu/sites/default/files/research/documents/Slides.pdf.
- 34.
Expected Shortfall is a subadditive measure in contrast to VaR. This makes it possible to remedy the fact that the benefits of diversification are not taken into account. This new risk indicator, however, is not unanimously supported. It is criticized for being overly dependent on a few extreme events (a lack of statistical robustness), the theoretical problems of carrying out backtesting. Eventually, the measured risks are proportional to positions, without taking into account the negative impact of concentrated positions.
- 35.
On the issue of securitization, see Daphné Héant et al., Chap. 16, this volume.
- 36.
This is not, however, the case for sovereign risks, given the exemption margins from which they benefit.
- 37.
- 38.
Fundamental Review of the Trading Book – interim impact analysis http://www.bis.org/bcbs/publ/d346.pdf.
- 39.
http://www.bis.org/bcbs/publ/d352_note.pdf on the database, June 2015.
- 40.
Industry FRTB QIS Analysis, 22 October 2015, https://www2.isda.org/functional-areas/risk-management/
ISDA/GFMA/IIF published the industry FRTB QIS analysis, 18 April 2016, https://www2.isda.org/attachment/ODM0OA==/QIS4%202015%20%20FRTB%20Refresh%20Report_Spotlight__FINAL.pdf.
- 41.
A study entitled Has corporate bond market liquidity fallen?
https://bankunderground.co.uk/2015/08/27/has-corporate-bond-market-liquidity-fallen/ published on the blog of the Bank of England by Yuliya Baranova, Lousia Chen & Nicholas Vause concludes that, “These findings support the claim that the market-making capacity of dealers has fallen in recent years, reducing secondary market liquidity.” It may be hoped that funds develop contrarian strategies and/or develop market-making activities to provide the market with liquidity. De Long et al. (1990) instead emphasize the dangers of procyclical and destabilizing investment strategies. To get an idea of inventory costs under the new framework, in a letter sent in October 2015 to Mario Draghi (in his capacity as Chairman, GHOS), and to Stefan Ingves (as Chairman, BCBS), the financial services industry indicates that about €1 of capital is needed (using the standard approach) for every €1 invested in 30-year German government bonds (the letter is available on the ISDA site). The total lack of any leverage effectively means that banks in practice have become investment funds. This situation far exceeds the 20 % to 30 % equity capital ratios put forward by Anat Admati https://www.gsb.stanford.edu/sites/default/files/research/documents/Slides.pdf. Alex Brazier, Executive Director for Financial Stability Strategy at the Bank of England indicated in March 2016 that “after a point, another unit of capital buys a much smaller fall in the probability of bank failure. There may be seriously diminishing returns. And at the same time, it’s possible that ever more bank capital may not best serve the real economy” (speech entitled “A macroprudential approach to bank capital: Serving the real economy in good times and bad.”
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech887.pdf.
- 42.
On this subject, see the study published by PWC in August 2015, Global financial markets liquidity study, https://www.pwc.se/sv/financial-services/assets/global-financial-markets-liquidity-study.pdf.
- 43.
Jacques-Joseph Duguet (1649–1733), Institution d’un prince, ou traité des qualitez, des vertus et des devoirs d’un souverain, published posthumously in 1739.
- 44.
For example, BlackRock Solutions https://www.blackrock.com/aladdin/blackrock-solutions or the Multi Asset Client Solutions services provide by Axa IM Corporate.
- 45.
- 46.
See the FSB reports, Shadow Banking: Strengthening Oversight and Regulation (2011), http://www.fsb.org/wp-content/uploads/r_111027a.pdf and Strengthening Oversight and Regulation of Shadow Banking (2013), http://www.fsb.org/wp-content/uploads/r_130829a.pdf.
- 47.
As mentioned in the study reported on the blog of the Bank of England (cited above), this reduction in market depth, which is specific to OTC markets, is hardly measured by the usual liquidity metrics. In a document published by Blackrock, The liquidity challenge, in June 2014, (http://www.blackrock.com/corporate/en-mx/literature/whitepaper/bii-the-liquidity-challenge-us-version.pdf), Peter Fisher (Senior Director of the BlackRock Investment Institute) states that, “The whole system relies on liquidity illusion”. The International Monetary Fund in its Global Financial Stability Report of April 2015 (http://www.imf.org/external/pubs/ft/gfsr/2015/01/pdf/text.pdf) provides the same analysis. The reader may refer to Elliott 2014 or Fender and Lewrick 2015, or more generally to the lively debate on the evolution of liquidity in the bond markets.
- 48.
See for example the summary presentation by Krugman (2010), http://krugman.blogs.nytimes.com/2010/04/18/six-doctrines-in-search-of-a-policy-regime/.
- 49.
See the revealing article by Calomiris and Nissim (2014), the analyses by Keeley (1990), Allen and Gale (2000), Hellmann, Murdock and Stiglitz (2000), Repullo (2004) about bank franchises and that by Gorton (2012) on “quiet banking.” Unfortunately, the regulators only look at tangible equity, and not the market value of shares, for the reason that intangible assets cannot be ceded easily in case of liquidation. However, such arguments cannot be applied to incentives or moral hazard.
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Laurent, JP. (2017). The Knowns and the Known Unknowns of Capital Requirements for Market Risks. In: Douady, R., Goulet, C., Pradier, PC. (eds) Financial Regulation in the EU. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-44287-7_11
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