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Options for entry-level compliance with the FRTB capital requirement

A photographic portrait of Jean-Noël Ardouin
Jean-Noël Ardouin

Partner, Consulting, Risk & Actuarial in Financial Services | EY Switzerland

5 minute read 15 Jun 2023
Related topics
Banking and capital markets
Financial services
Consulting
Risk

We share benefits, challenges and considerations related to the FRTB standardized approach and simplified standardized approach.

In brief

  • The FRTB is a regulatory framework to address market risk capital framework shortcomings and promote consistency in risk assessment and capital requirements.
  • Banks can choose between the Internal Model Approach and Standardized Approach. A simplified alternative to the SA can be granted in some cases.
  • While the simplified alternative might lower compliance cost, it is not a zero-effort approach as it needs to be properly justified and documented.

The Fundamental Review of the Trading Book (FRTB) is a regulatory framework introduced by the Basel Committee on Banking Supervision (BCBS) to overhaul the market risk capital framework developed by Basel 2.5, and to address the shortcomings of the current market risk capital framework and variability of risk-weighted assets (RWAs) across banks and jurisdictions.

Compared to Basel 2.5, the FRTB regulation provides:

  • More granular and prescriptive standards designed to limit divergence in interpretation and promote consistency in risk and corresponding capital outcomes
  • A revised trading / banking book boundary with more explicit requirements to reduce the scope for regulatory arbitrage
  • An overhaul of the capital requirement approaches and higher capital requirements across the industry
  • A stringent and prescriptive trading desk-level approval process for the internal model approach (IMA) including new P&L attribution tests

From an implementation perspective, banks have the option to select between two approaches for measuring and managing market risk: Internal Model Approach (IMA) and Standardized Approach (SA).

Aggregated capital charge image

How EY can help

The IMA allows banks to utilize their own proprietary models to estimate risk and calculate capital requirements based on their specific trading activities, subject to regulatory approval. This approach acknowledges the unique characteristics and complexities of individual portfolios, potentially resulting in more precise risk assessments.

Under the current system, IMA is approved at the bank level, encompassing all activities and levels. However, under FRTB the validation process will be conducted independently for each desk.

On the other hand, the SA advocates the use of a standardized formula – provided by regulators – to assess market risk. This approach offers simplicity and uniformity across banks and financial institutions, but it may not fully capture the nuances of various trading portfolios.

Choosing whether to apply the IMA or SA is not a decision to be taken lightly as it has significant implications for financial institutions. Even though the IMA offers the potential for more accurate risk measurement, it requires significant resources, modeling capabilities and risk management frameworks. Conversely, the SA provides a simpler and less advanced alternative, making it more accessible for smaller institutions or those with less sophisticated risk management capabilities.

The IMA/SA dilemma highlights the need for banks to find a balance between accuracy and simplicity in their market risk management practices. Financial institutions must carefully evaluate their capabilities, resources and risk profiles to determine the most suitable approach.

With regards to the SA, local regulators can allow individual banks to use a simplified standardized approach (equivalent to the current Basel 2.5 standardized approach) if they meet certain criteria. In this article, we leave aside the IMA and focus on comparing the path to the compliance based on whether a standardized approach or simplified standardized approach is applied.

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1

Chapter 1

Uniform method toward capital requirement compliance

Standardized formulas and rules

The primary goal of the standardized approach is to establish uniformity to risk measurement, enabling easier comparison between different financial institutions. Adopting common formulas, risk factors and parameters for various asset classes facilitates a consistent approach to measuring and managing market risk.

One of the key advantages of the SA is its clarity and simplicity. Banks can employ standardized formulas and predefined risk factors to calculate their capital requirements. This straightforward methodology is particularly advantageous for smaller banks with limited resources available for risk management as it offers an easier and more accessible way to measure market risk.

Even though the SA offers consistency and comparability in calculating capital requirements for market risk, it comes with challenges in terms of fully capturing the true risk profile of certain assets or portfolios. The use of standardized formulas and risk factors may overlook unique risk characteristics specific to particular assets, leading to potential gaps in risk assessment. Therefore, banks implementing the SA need to carefully consider whether it adequately captures their portfolio’s specific risk attributes.

Certain banks may also be eligible for the  simplified version of the SA, known as the simplified standardized approach. This approach is suitable for banks with smaller trading portfolios, providing a more straightforward method to compute capital requirements. Given that the method can have an impact on the capital requirements, it is important to understand the advantages and limitations to enable better efficiency in market risk calculations.

In terms of methodology, the capital requirement under the SA is the aggregation of three components:

Composition of standardized approach under FRTB
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2

Chapter 2

An even simpler alternative for eligible banks

SSA lowers compliance costs by reducing complexity and documentation requirements

The simplified standardized approach (SSA) provides an alternative to the SA for measuring market risk in financial institutions. It offers simplicity and ease of implementation thanks to the use of predefined rules and parameters for risk measurement and capital requirements.

As far as implementation is concerned, the primary advantage of the SSA is its straightforward and transparent nature. By using standardized formulas and predefined risk factors, financial institutions can easily calculate their capital requirements without the need for complex modeling or customization.

The SSA has some key differences compared to the SA, including:

  • Reduced complexity, due to a focus on the most relevant risk factors and the use of simplified calculations
  • A simplification of the risk factor categories, allowing banks to focus on the key risk factors that are most applicable to their portfolio
  • More straightforward sensitivity computation based on more generic parameters and assumptions, which ultimately reduces the data requirements and computational burden
  • Lighter documentation requirements and validation processes

On the flip side, it is important to note that the SSA may not capture the specific risk profile of certain assets or portfolios as comprehensively as it relies on predefined rules, meaning that unique risk characteristics of certain assets could be overlooked. This limitation could potentially result in gaps in the risk assessment. In other words, the SSA may not reflect a financial institution’s true risk exposure as accurately as the SA.

To be eligible for this approach, a bank typically needs to meet the following criteria:

  • Not to be a global systemically important bank
  • Not use IMA for any trading desk
  • Not have correlation trading positions are held
  • Not engage in complex trading activities

While there is no clear definition of the term “complex trading activities”, the activities involving the structured products and non-linear derivatives are generally deemed as “complex”.

EY encourages financial institutions to arrange a dedicated analysis of their trading activities in order to verify that they meet the requirements of not engaging in “complex trading activities”. Moreover, according to the “Final Basel III standards – Swiss Financial Market Supervisory Authority explanatory report”: “FINMA is likely to use its authority to issue orders if trading activities are complex in the sense that the simple market risk standardized approach generates a lower capital requirement compared to the market risk standardized approach”. “In other words, the bank needs to be able to demonstrate that using the SSA does not allow for capital requirement arbitrage compared to the SA”. In terms of methodology, the SSA considers four risk classes:

Composition of simplified approach under FRTB

Therefore, the capital requirement from the SSA is the simple sum of the recalibrated capital requirements arising from each of the four risk classes multiplied by scalars to ensure a sufficiently conservative calibration of capital requirements.

Summary

Banks have to make an informed choice in whether to apply the internal model approach, standardized approach or simplified standardized approach (SSA). Although it offers simplifications, the SSA is not hassle-free for banks. SSA candidates still need to perform a dedicated analysis of their trading activities in order to conclude that there is not enough evidence to be deemed to operate “complex trading activities”. FINMA then has to assess whether it supports the eligibility assumption of the bank.

Acknowledgement

We kindly thank Vadym Sheiko and Constantin Bosc for their valuable contribution to this article.

About this article

A photographic portrait of Jean-Noël Ardouin
Jean-Noël Ardouin
Partner, Consulting, Risk & Actuarial in Financial Services | EY Switzerland
Committed to delivering exceptional client service. Passionate about teaming and coaching. Husband, father and avid trail runner.
Related topics
Banking and capital markets
Financial services
Consulting
Risk

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