Comparison of the new BCBS Standard with existing and proposed EU Regulations
One of the principal goals of the FRTB is to remove the ability for banks to play with the trading book, banking book boundary to gain a regulatory capital advantage.1 The following table describes how the new rules will change the regime for the EU, comparing the new 2016 BCBS standard with the existing CRR (2013/575) regime and the EC’s proposed amendments to CRR published in November 2016. Obviously the EC proposal is not final but it shows high alignment with the BCBS.
It’s hard to argue against the governance requirements including senior management approval. Having supervisors also approve every desk structure their operation and any modifications may prove burdensome to firms and supervisors. Defining the frequency and content of internal reporting seems like overkill, other approaches can be as effective.2 The problem is that many firms that cannot produce say, desk level RWAs just accept the fact rather than take steps to fix the gap and often the business takes no responsibility for the change. By making it a condition for the desk’s approval the business will want to assist in the prioritisation and completion of the work. Banks already disclose vast amounts of information and I very much doubt that disclosure of any BB<=>TB transfers will make much difference particularly as there will be no capital saving. The new internal hedging criteria will add extra rigor for Equity and Interest Rate risk but Credit, Commodities and FX will effectively be unchanged.
Comparison of current EU Regulation with EU Proposals and BCBS FRTB Standard.
| Current EU CRR Rules (2014/575) | EC November 2016 CRR Proposed Amendment | BCBS 2016 FRTB Standard | |
|---|---|---|---|
| Governance, Structure, Management, policies and procedures | Trading strategies should be clearly documented and approved by senior management, including expected holding period. Policies and procedures should clearly identify permitted instruments, limits, approved strategies, management reporting, marketability or hedge-ability of the position or its component risks, active anti-fraud procedures and controls. Policies and procedures should extend to identifying where positions can be marked to market daily via an active liquid two way market and where positions will be marked to model and the extent to which the risks can be identified, hedged and the key assumptions and parameters used in the model. Compliance should be the subject of periodic internal audit. | Trading desks must have clear business strategies. Trading books must be attributed to a trading desk. Each desk must have a clear organisational structure and have position limits. Dealers should be assigned to a single desk with clear functions. Each desk must have one dealer designated as its head. Each desk’s business plan must include its remuneration policy. Reporting of activity, profitability, risk management and regulatory requirements must be reported for each desk at least weekly. The proposed desk structures must be presented to and approved by regulators. All trading book positions must be marked to market daily. Compliance should be subject to annual internal audit | Trading desk objectives, business strategy (budget, revenue, costs, RWAs), reporting lines, compensation, risk management structure must all be documented and clear and unambiguous. Supervisors’ approval for trading desk structure (but not sub-desks) is required. Traders can be only be assigned to a single desk and each desk must have a head trader who can only be the head of a single desk. Minimum weekly reporting of P&L, Internal and Regulatory risk reporting. Daily reporting of risk limit utilisation, breaches, follow up. Intraday risk limits measurement and utilisation reporting. Inventory aging and market liquidity reporting are all required. |
| Trading Book and Banking Book Inclusion/ exclusion | The current rules have no instrument or specific trading book/banking book direction provisions. There is a requirement that there must policies and procedures to define the activities considered as part of the trading book. The trading book should hold all positions held with "trading intent". Trading intent includes; 1) Proprietary positions and positions arising from client servicing and market making. 2) Positions intended to be resold short term. 3) Positions intended to take advantage of short term price movements. | The EU is following the BCBS standard very closely with only minor deviations; 1) Unlisted equities are not specifically mentioned whereas BCBS directs them to the Banking Book. 2) The EU includes instruments valued at fair value in the trading book, whereas the BCBS requires trading book positions to be fair-valued. | See this diagram The BCBS is very prescriptive on products and activities that are trading book and also instruments that it regards as banking book. |
| Transfers between the Trading Book and Banking Book | Policies and procedures are required to address when positions may be transferred and the criteria for such transfers. | EBA will be asked develop guidelines for such transfers. Institutions need policies to identify the “exceptional circumstances”. Such policies must be reviewed annually. Any transfer will require management body approval followed by regulatory approval. Transfers must be permanent. Any capital improvement to be added back as a permanent own funds adjustment until the position matures, to prevent any capital benefit. Public disclosure of the transfer is required. | Market events, liquidity changes, change in trading intent alone are NOT valid reasons for a transfer. Any transfers must be approved by senior management in line with policies, documented and then also approved by supervisors. No capital benefit permitted, with an own funds add back. Transfers must be permanent. Public disclosure of the transfer is required. |
| Risk transfers and hedging of the Banking Book by the Trading Book | Internal hedges should be documented and compliant with internal policies and dealt at market levels and dynamically managed within the trading book and compliant with the book’s limit structure. The primary objective should not be to reduce or avoid the own funds capital requirement. There is a stricter requirement for internal credit risk hedges for the banking book which will only be recognised in capital calculations where there is a corresponding external credit derivative matching the credit exposure in the trading book. | The EC is again following the BCBS closely. Internal hedges should be documented and compliant with internal policies and dealt at market levels and dynamically managed within the trading book and compliant with the book’s limit structure. The primary objective should not be to reduce or avoid the own funds capital requirement. Internal hedges for banking book credit or equity exposures require an external trade which perfectly offsets the market risk of the internal hedge. Interest rate hedges for banking book exposures may be traded through a dedicated book within an internal risk management desk. Trades with other trading books from this desk need to have exactly matching external trades. The internal risk management desk's market risk capital requirement is additive to that of the other trading desks. FX and commodity risk can be managed by transfers to the ordinary trading books. | Banking book risk hedges have three levels of rigor; 1) Equity and credit must have an exactly offsetting third party trade in the trading book. 2) Interest rate risk must go through a separate trading desk which exists solely for this purpose, but its third party hedges do not need to match exactly. 3) FX and commodity risk can be transferred the general trading desks for these risks. Internal risk transfers (trading book providing a hedge for a banking book exposure) for equity and credit risks are ignored for capital calculations unless there is an exact match third party trade in the trading book. Interest rate hedges must come from a designated trading book which only exists to execute hedges for the banking book and is part of an internal risk management desk (i.e. separate from the other trading desks). Where the book trades with another trading book there must be an exactly matching external trade, but the internal risk management desk can hedge its net risk externally with trades that do not exactly match the risk transferred from the banking book. FX and commodity risk can be managed by transfers to the ordinary trading books. |
Overall I think these requirements can be met by any bank that is well organised and committed to effective MIS and management. FRTB is likely to be most challenging in the need to keep both the internal model and sensitivities based method market risk requirements running in parallel in case the internal model P&L tests are failed where a bank has internal model approval. Where it does not the sensitivities based method will be more complex than the standard rules they replace.
1 Abuses of the regime included banks running trading books that never traded and banking books where position inception and close outs were segregated into hold to maturity treatment portfolios for short term positions.
2 Hong Kong has a better solution where the SFC publishes a non binding code of conduct which will be used when determining if a firm has followed best practice. It gets updated usually annually and acts as very strong guidance (treated by most firms as the standard they will meet).