The long-awaited Q1 FRTB Consultation Paper: Is change the only constant?
As the fog lifts on the FRTB framework following the publication of the BCBS' consultation paper and firms buckle down to meet the June 2018 response deadline, opportunities remain to influence the final outcome. These opportunities can however only be seized if banks have sufficient interactive capital assessment and risk factor management capabilities to provide supporting evidence, in particular for IMA. They say humour supports problem solving, so I thought I would add an offbeat twist to what can be quite an idiosyncratic topic. #HumourInAdversity
After some prolonged heartfelt advocacy around the impracticality of the PLA test, the industry got its way; not only on redefining the test but also on the consequences of failing it. The previous test has been replaced by two comparisons of the Hypothetical P&L (HPL) and the Risk Theoretical P&L (RTPL) distributions, first with a correlation (Spearman) test and second with a Kolmogrov Smirnov or a Chi-Squared Test. #FromRussiaWithLove
On the consequences of failing the PLA test and the resulting transition from IMA to SA, BIS' response is to introduce an 'amber' status for desks that do not pass both PLA criteria, but that do not fail them below a certain threshold. This aims to avoid capital cliff-effects and to smooth the transition.
However, the celebrations can only last so long as firms still have to grapple with the Risk Factor Eligibility Test (RFET) - formerly known as modellability criteria - with the BCBS still sanguine about the impact of seasonality despite the widespread advocacy. You can read our contribution in this festive blog post. #HappyHolidays
Our teams here at IHS Markit have worked with many banks as they design their FRTB frameworks. Based on that experience, we also welcome the BCBS' intention to address the challenges of maintaining the confidentiality of Real Price Observation (RPO) pooling schemes both "nascent" and "adolescent". The capital impact studies we have run, leveraging our own pooling activities, have shown that the success of pooling will have a dramatic impact on capital intensity for banks with a knock-on impact on liquidity and ultimately funding cost for end users.
Capping RPO contributions to each Risk Factor to one a day also doesn't come as a surprise as we have been using such a "binary" approach for some time. It simplifies deduplication and leverages the fact that the binding constraint in RFET is the gap, not the count, and therefore typically has no impact on NMRF results unless the gap criteria changes. #MindTheGap
But this certainly doesn't warrant complacency: what the BCBS concedes with pooling and PLA, they have offset with demanding new requirements around validation. Indeed, the seven principles laid out significantly raise the bar in two areas:
- Validating scenario data sources with RPO data sources, and
- Governance of risk factor derivation, gap filling, proxying, and data quality.
Having built a production Risk Factor Utility from the ground up - with the objective of meeting best practice governance standards since inception - we recognize that the implementation of such principles, as well-intentioned as they are, does not come without significant cost.
Navigating Annex D and its possible interpretations for model approval won't be trivial; however, arguably the prize for the most important and yet most subjective text goes to: "A "real" price is representative for a risk factor of a bank where the bank is able to extract the value of the risk factor from the value of the real price". Does an inflation swap observe an interest rate zero curve for example? Does a 6m LIBOR swap observe a 3m vs 6m basis? Does the firm have to mark-to-model every RPO? #GetRealPO
On the topic of defending Risk Factor definitions, we gave a presentation entitled "Is Risk Factor management the new risk management?" at the London InfoLine FRTB Conference in March 2017. The theme was developed on the basis that banks would have five taxonomies to contend with: ISDA SIMM, SBA, RFET, IMA(RTPL) and HPL - all of which interact and potentially create conflicts.
If alternative 2 for RFET bucketing is adopted, it potentially introduces yet another taxonomy which extends the SBA taxonomy to incorporate relative strike for modellability buckets. Let's call it SBA++.
We've already established that the prescribed strike buckets still need a reality check based on the liquidity we see in our data (covering 80% of Rates OTC) and using our flexible modellability API. For instance, the central strike buckets of low rate currencies would be very tight: just north of 3bp wide for JPY when considering a 5Y-5Y forward at 35bps. #UnbuckleTheBuckets
As Heraclitus once said, "The only constant is change itself", which is why firms will need genuinely interactive, accurate analytics to drive not only decision-making, but also advocacy in the critical months to come.
I used to think the required level of agility was utterly alien to most banks. However, I was in a workshop with a bank just last week where a participant introducing himself as the "product owner" commented that a particular use case would take "two sprints" for their scrum team to deliver. I look forward to being disproven more and more.
We believe that agile methods and cloud-based analytics will transition from being the outlier, to being the norm, thus enabling banks to improve efficiency ratios and develop an agile view of risk. Welcome to financial services 2.0: demanded by big regulation, powered by big data and ruled by data scientists - it's a brave new world indeed.
For further information, please visit https://ihsmarkit.com/solutions/frtb-solutions.html
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