WhatisFRTBandwhystartnow?

KPMGseminarontheFundamentalReviewoftheTradingBookCopenhagen- 9June2016

MortenWeis,Ph.D.Independentriskmanagementexpert

AboutMortenWeis

©MortenWeis2016

• FormerExecutiveDirectoratGroupRiskManagementatNordeaBankAB(1998- 2016)

• 18yearsexperienceinfinancialriskmanagementandvaluationoffinancialinstruments• 11yearsinvariousleadershiproleswithinNordea’sGroupMarketandCounterparty

CreditRiskdivision, including:

• HeadofGroupMarketRiskatNordeaBankAB(2012-2015)• LeadBusinessOwnerforNordea’sFRTB&RiskPlatformproject(2015-2016)

• Intheseroles,Iwasresponsible forNordea’sFRTBpreparationssince2012andforparticipationinseveralBaselCommitteecoordinatedQuantitativeImpactStudies(QIS’s)

• ActivememberofinternationalFRTBworkinggrouparrangedbyISDAandparticipatedinpreparing industry input totheBaselCommitteeonFRTB(2014-2016)

• Ph.D.intheoreticalphysicsfromtheNielsBohrInstitute,UniversityofCopenhagen

Foto• FormerExecutiveDirectoratGroupRiskManagementatNordeaBankAB(1998- 2016)

• 18yearsexperienceinfinancialriskmanagementandvaluationoffinancialinstruments• 11yearsinvariousleadershiproleswithinNordea’sGroupMarketandCounterparty

CreditRiskdivision, including:

• HeadofGroupMarketRiskatNordeaBankAB(2012-2015)• LeadBusinessOwnerforNordea’sFRTB&RiskPlatformproject(2015-2016)

• Intheseroles,Iwasresponsible forNordea’sFRTBpreparationssince2012andforparticipationinseveralBaselCommitteecoordinatedQuantitativeImpactStudies(QIS’s)

• ActivememberofinternationalFRTBworkinggrouparrangedbyISDAandparticipatedinpreparing industry input totheBaselCommitteeonFRTB(2014-2016)

• Ph.D.intheoreticalphysicsfromtheNielsBohrInstitute,UniversityofCopenhagen

Questionsweseektoanswer:

©MortenWeis2016

WhyisFRTBhere?

WhatisFRTB?

Whyarelargebanksconcerned?

Whystartpreparingnow?

FRTB- Anew“standardforminimumcapitalformarketrisk”issuesbytheBaselCommitteeforBankingSupervisioninJanuary2016

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• TheFinancialCrisis(2007-2008) ledtheBaselCommitteetolaunchan“emergencyfix”tomarketriskcapitalrulesin2009

• Knowas“Basel2.5”,Value-at-Riskmodelswastargetedandcapitalchargesincreasedseveralfoldforbanksapplyinginternalmodelsforcapitaladequacyreporting,butstandardruleswerekeptunchangedfromBaselI/II

• Intenselobbyingsavedinternalmodelsforcorrelationtrading• AdoptedbyEUinCRDIIIandeffectiveJanuary2011• TheBaselCommitteeknewruleswasamessandpromisedto

makea“fundamentalreview"

FRTB– Thepathtoanewcapitalstandard

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• NextstepfromtheBaselCommitteewastotargetcounterpartycreditrisk,includingnegativeCreditValuationAdjustments(CVA)thatwasresponsibleformajorlossesininternationalbanksduring2007-2008

• “BaselIII”includedamongseveralelementsanewCVARiskcapitalchargefortheembeddedmarketriskinbanksCVAadjustments:

• AdoptedwithadjustmentsbyEUin2013inCRDIV/CRR• Allowedforbothstandardapproachandinternalmodels• A”hybrid”betweencounterpartycreditriskandmarketrisk,CVA

RiskChargewasnotintegratedwiththegeneralmarketriskcapitalcharge

• CVARiskChargeonlyaddresscreditspreadriskinCVA

FRTB- thepathtoanewcapitalstandard

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Basel Committee: Analysis of RWA for market risk - January 2013

• Benchmarkingofbanksinternalmarketriskmodelsforidenticalportfoliosrevealedmassivedifferences

• Widespreadlackofconfidence inbanksobjectivity incalculationofownRWA/REAfiguresemergedamongpoliticiansandregulators

TheaimoftheFundamentalReviewoftheTradingBook

©MortenWeis2016

Ensuresufficientcapitalformarketriskin“TradingBook”

Avoiddoublecounting,butmeasurerisksrealistically,reflectingmarketliquidity

Ensureobjectiveandfirmdefinitionof“TradingBook”vs.“BankingBook”

Ensurecoherentcapitalisationformarketriskacrossbanks

Establishacrediblealternativetointernalmodelapprovalforlargebanks

ThekeycomponentsofFRTB

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TradingBookdefinition• Purposeofpositiondecisive

• Presumptivelistofinstruments

• InternalRiskTransfersundertightrules

StandardisedApproach• “Mandatory”• SensitivityBasedApproach+

• DefaultRiskCharge+

• ResidualRisk+• Securitisations

InternalModelsApproach• "Optional"• Stressed“ExpectedShortfall”replacesVaR &sVaR +

• DefaultRiskCharge+

• Non-ModellableRisks

TheTradingBook- BankingBookboundary

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Thepurposeofthepositiondecidestheplacement:short-term resale,profitingfromshort-timepricemoves,lockinginarbitrageprofits→ TradingBook

Apresumptive listofTradingBookinstruments:listedequity,bonds,derivatives,optionsincludingembeddedderivativesininstrumentsissuedfromtheBankingBookwithequityorcreditunderlying,FXexposures,correlationtrading,commodities

Non-listed equities,fundswithoutlook-throughordailyprice,real-estate,retailandSMEcredits,areBankingBookperdefinition

BankscandeviatefromthepresumptivelistonlyifexplicitFSAapprovalisgranted

TheTradingBook- BankingBookboundary– Canyoupass?

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FXriskintheBankingBookmustbecapitalisedintheTradingBookasaseparateTradingDesk– FSAmaygrantapprovaltoexclude hedgesofcapitaladequacyratioundercertainconditions

InternalRiskTransferfromTradingBooktotheBankingBookgives nocapitalrecognitionintheTradingBook

Internal RiskTransfersfromBankingBooktoTradingBookmustbeidenticallymatchwithexternaltradesforequityandcreditrisktogivecapitalbenefit

InternalRiskTransfersofinterestrateriskmaybemanagedinseparateTradingBookportfolio,capitalisedonstand-alonebasisintheTradingBook,andincludedinIRRBBexposurecalculation

TheBorderChallengerelatestoALLbanks

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Everypositionmustbesupportedbydocumentationforcapital treatment

Key concerncouldbeliquiditybuffers,oftenplacedinBankingBook,butonthepresumptivelistofTradingBookinstrument

Risk management ofmarketriskofstructuredbondissuancesmaybecomemoreexpensiveduetodemandforidenticalexternalhedgeinTradingBook

ManagementofIRRBBwithderivativestradedwithTradingBookmaybecomemoreexpensiveduetostand-alonetreatment

Allbankswillhavetospendmoreresourcesondocumentationandcontrol

ITsystemsforcapitalcalculationmustbeabletohandleInternalRiskTransferscorrectlyinbothMarketRiskandIRRBBregulatory capital

TheStandardApproachcapitalistheabsolutesumof3elements

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SensitivityBased

Approach(SBA)

DefaultRiskCharge(DRC)

ResidualRisk

add-on(RRAO)

RiskFactorSensitivities• Delta+Vega• Curvatureofoptions

CreditRiskinTradingBook• Bonds,• Equities

NotionalBasedCharge• ComplexInstruments• Complexunderlying• Includespre-payment

risk(e.g.DMB)

FRTBSBAdeltariskinonepage

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Foreachbroadriskclass:GeneralInterestRateRisk(GIIR),Equity,CreditSpreads,FX,andcommodities:assignsensitivitiestodifferent“buckets”

Calculateariskweightedsensitivitybybumping eachsensitivitywith adesignatedriskweight

Withinandacrossbuckets,theweightedsensitivitiesareaggregated accordingtospecifiedformulaeverysimilartoaparametricVaR model

CorrelationswithinbucketsandacrossaregivenbytheBaselCommittee

FRTBSBA– examplesofriskweights

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• GIIRriskweightsincreasedby50%following thelastconsultationpaper

• Theconceptof“DomesticCurrency”willbeofimportance forDKKbanks

InterestRates* 1Y 5Y 10Y 30Y

Risk Weight 2.25% 1.5% 1.5% 1.5%

*EUR,USD,GBP,JPY,AUD,CAD,SEK+“DomesticCurrency”maydivideriskweightwith√2

CreditSpreads RiskWeightInvestmentGrade Sovereigns,CentralBanks,.. 0.5%InvestmentGradeFinancials,alsogovernment-backed 5.0%InvestmentGradeCoveredBonds 4.0%Investment GradeTechnology &Telecom 2.0%High-Yield orNot-RatedSovereigns 3.0%High-Yield orNot-RatedFinancials,alsogov-backed 12.0%

• CreditSpreadchargeappliesforallbonds– alsoAAA-ratedSovereigns

• CoveredBondsareveryexpensivecomparedtomorecorporatedebt

FRTBSBA– examplesofriskweights

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• FXriskbecomesmoreexpensive

• Scandinavianbanksarelikelytobehitbyliquidity classification

RiskWeight FX:RISK – dividedoncurrencycrosses21% USD/EUR,USD/JPY,USD/GBP,USD/AUD,USD/CAR,USD/CHF,USD/MXN,USD/CNY,

USD/RUB,USD/HKD,USD/SGD,USD/TRY,USD/KRW, USD/SEK,USD/ZAR,USD/IND,USD/NOK,USD/BRL,EUR/JPY,EUR/GBP,EUR/CHF,JPY/AUD

30% Restoftheworld…...Including EUR/DKK,EUR/SEK, DKK/SEK,SEK/NOKetc...)

FRTBSBAdeltariskcorrelationsareexposedtostressassumptions

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ForallSBAcalculations,FRTBspecifiesthree

correlationscenarios

Thescenariosaredenoted

"low","medium","high"

Banksmustselecttheonegiving thehighest

capitalcharge

Low: listedcorrelations✕ 0.75

Medium: listedcorrelations✕ 1.00

High: listedcorrelations✕ 1.25

FRTBSBA– addingitallup

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• Alloptionproducts– includingembeddedoptionsasinDanishMortgageBondsmustberevaluedinstressedup/downscenariostoformthe“Curvature”riskcharge

• ForGIIRthisisa+/- 240bp. shift*andyoucannotflooratzerointerestrate

• The“Delta”riskchargeforall1.storderriskfactors sensitivitets(delta+vega) aretobeaddedup

• Foreachriskfactorwithinabroadriskfactorclass,suchasGIIR,youmustapplydifferentcorrelations• E.g.swapswithdifferentfixing rates,

butsamecurrencycannotbenettedfullyatthesamematurity

• Theregulation isveryprescriptiveanddetailed

• Sensitivitycalculationsmustfollowspecifictechnicaldefinitions

• Theclassificationofriskfactorsisverydetailedandresidualbucketsverypunitive

• Requiresfull-suiteriskmanagementITtools

FRTBSA:DefaultRiskCharge– A4stepprocess,(Non-CorrelationTrading)

©MortenWeis2016

IdentifyJump-to-Default(JTD)lossforeachinstrument

Offset longandshortJTDexposurestosameobligorwhenpermissiblegivingnetlongandshorts indistinctobligors

Netshortexposuresarediscountedbyahedgebenefitratio

DefaultRiskWeightsareappliedtoarriveatcapitalcharge*

CreditQuality DefaultRiskWeightAAA 0.5%

AA 2%

A 3%

BBB 6%

BB 15%

B 30%

CCC 50%

Unrated 15%

Defaulted 100%

*Atnationaldiscretionclaimsonsovereigns, publicsector,andmultilateraldevelopment banksmaybesubjecttoazerodefaultriskweight

FRTBSA– fittinginthelastpieces

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• Summing up– wehave• HigherRiskWeights• Largercoverageofriskfactors• Muchhighercomplexity• Expecthighercapital&production

cost

• TheResidualRiskAdd-on (RRAO)isasimplecapitalchargeonthegross-notional* of“complexproducts”withrisksnotcapturedwellbytheSBA• E.g.adigitaloptionorbondwithpre-

paymentrisk• TheRiskWeightis0.1%fornon-exotic

underlying assets,otherwise1.0%

• TheSAisdesigned tobeacrediblealternativetointernalmodels, andtoformbasisformoreobjectivecomparisonofbanksrisks

• TheSAwillbecentralforutilisationoffuturecapitalfloors

• Disclosurerequirementsarestillpending.BCBS356indicateonlyhypotheticalportfolio figures tobepublished forpureIMAbanks

Example:• ADMBwillgiverisetoGIIRdelta+

GIIRvega +GIIRCurvature+CreditSpreaddelta+DefaultRiskCharge+ResidualRiskCharge

*Pureback-to-backpositionsnotincluded

TheInternalModelcapitalchargeistheabsolutesumof3elements

©MortenWeis2016

ExpectedShortfall(ES)

DefaultRiskCharge(DRC)

Non-ModellableRiskfactors

HistoricalStatisticalMetric• Calibratedtostressed

1Y periodduringlast10years

• Liquidityscaling• Highdatarequirements

CreditRiskMonteCarlomodel• Bonds,• Equities

StressTestingCharge• Lackof“realpricedata”• Atleastasconservative

astheESmodel

FRTBIMA– thenewExpectedShortfallModelconcept

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• 97.5%ESfor1Yperiodofstressoverthelast10yearsreplaceVaR +sVaR aspricevolatilityriskmetric

Liquidity bucketexamples:Riskfactorcategory nIR:EUR,USD,GBP,AUD,JPY,SEK,CAD+“domestic" 10IR:allothercurrencies 20IR:volatility 60FX: listofcurrencycrosses 10FX: residualcurrencycrosses 20Equity (largecap) 10

Credit Spreads:CorporateInvestmentGrade 40

• ContrarytoCRDIII,crossasset-classcorrelationsarerestrictedtoavoidtolargediversificationeffects

• Riskfactorsareclassifiedin5liquiditybuckets:10d,20d,40d,60d,120d.Allshocksare10-day

Example:a NOKswapforaDKKbank𝐸𝑆&' = (𝐸𝑆+,). + (𝐸𝑆+,).

• Exposuretoseveralriskfactors⟹thesametradeisrevaluedmultipletimesinthecalculationofES

FRTBIMA– Themainelementtobeawareoff

©MortenWeis2016

• Fullrevaluationisnotaformalrequirementasinconsultationversion,butpassingIMAtestswithoutwillbedifficult

• DifferencesbetweenFOandRiskvaluationmethodswillmakeIMAtestschallenging topass

• JointEquityandBonddefaultstobemodelled inDRC

• Significant increaseinCPU&storagedemands

• Theshift fromVaR &StressedVaR toESisassuchnotdifficult

• Themainproblem isIMAapprovalwillnowbedecidedonTradingDeskLevel

• Hardquantitativeandqualitativerequirementsareset:• P&LexplainalignmentFO– Risk• Backtesting• “Realprices”mustexist

• Thetreatmentofliquidity issimplisticandpenalising formanyexposures

• The“domesticcurrency”willhelpDKKbasedbanks

• ”Brokenhedges”willdrivecapitalchargesup

• Theminimummultiplier isreduced from3.0to1.5

FRTB:Whyarethelargebanksveryconcerned?

©MortenWeis2016

• CapitalplanninghardtopredictduetoautomatedIMAadmission tests

• LargecliffeffectsbetweenSAandIMA• Massiveinvestmentsinpeople,dataandIT

formetricshardtouseinternallyforownriskmanagement

• Negativeeffectson liquidityexpected• Maysignificantlyaffectinvestmentbanks

businesscomposition

• Industryassociationshaveledvoluntarysurveyacross21leadingbankson impactoffinalrules

• Whilethefinalrulesarelesspenalisingthanlatestdraftversion,marketriskcapitalwillstillincrease1.5– 2.5timesonaveragecomparedtotodaysrules

SAtoIMA*Interestraterisk 3.0Creditspreadrisk 2.0Equityrisk 4.1Commodity risk 2.9Foreignexchangerisk 6.6

*SAexcludingRRAO&IMAexcludingNMRF,18th April2016

FRTB– Whatisthetimeline?

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BaselstandardfinalJanuary2016

FurtherBaselrules:CVA,CapitalFloors,IRRBB,… during2016

EU process2016- 2018

BCBS:localregulationinforce01-01-19

BCBS:firstreporting31-12-19

Unknowns areplenty….DG-FISMA(EU)havejustlaunched consultation

considering lesserSAdemandsonthesmallestbanks

Unknowns areplenty..CVARiskChargeseemstobecomepartofFRTBSAwithnoIMAoption

FRTB– Whystartpreparingnow?

©MortenWeis2016

• Largeincreaseindataandcalculations

• SBArequirefullcapitalmarketsITplatform

• Highneedforautomation

• IMArequire fullsetofnewmarketriskmodels

• SArequiresfull-revaluationforoptionsincludingDMB's

• Highresourcedemands

• SAnolongerajobforFinance

• Hardtogetspecialistresources

• Cross-firmcollaborationtakestimetoestablish

• Marketdata• “realprices”• Tradeclassification

• Staticdata

data people

ITmodels

Anddonotforgettimeformodelvalidation,auditandFSAdialogueandapproval

FRTB– Whystartpreparingnow?

©MortenWeis2016

data people

ITmodels

• TwomainscenariosforDanishbanks:1) OwnITsystemdevelopment2) SectorbasedsharedITprovider

• Inbothscenarios,planning, fundingandexecutionwilltakeconsiderabletimeandrequire full-timeattentionbyownriskspecialistsaswellasyour ITprovider

CaseA:• InbothSAandIMAyouneedtohave

completecontroloftheclassificationofallpositions intheTradingBooktoknowwhatcalculationsarerequired• Highdemandondataprocessing

forhigh-volume products• Datamodelsmostlikelyneedto

beextendedtosupportFRTBclassificationoftrades

CaseC:• Riskfactorsensitivitycalculationsare

required forproductswherenotcommonlyused– e.g.forcreditspreadsensitivityofgovernment bonds

• Configuration ofriskcalculationstakeslong timedue tonumericalcomplexityandneedfornewdataloads

CaseB:• Cleverriskdataaggregation techniques

mayincreasethecapacityofyourITsolutionsignificantly

• Manyleadingbanksandvendorsapplyin-memory“cube”technologyasitiswell-suitedfornon-linearmeasuresasinIMA

• Highdimensionalityandlargenumberofnumericalcomputations

FRTB– Whystartpreparingnow?

©MortenWeis2016

data people

ITmodels

• ForbothSAandIMAbanks,datademandswillbeveryhigh• Positiondata• Instrumentdata• Marketdata• StaticData• Reportingdimensions

Marketdata:• SAandIMAbankswillneedthesamelevelof

detailedmarketdatatocalculateriskfactorsensitivities

• IMAbankswillneed toprovethathistoricalpricesare“real”tobeinESmodel

• SAbankswillneedmarketdatatheypreviouslymaynothaveseenneedfor,e.g.creditspreadcurvesforgovernmentbonds

Staticdata:• SAandIMAbothhavehigh riskfactor

dimensionality thatsethighdemandsonstaticdata

• E.g.marketcapofequitiesandsectorclassificationfittingFRTBrules

• E.g.issuerratingsonallbondsandequitiesandabilitytolinkequityandbond issuers

Reportingdimensions:• Disclosurerequirementsarestillnotfinal,

butBCBS356inhearingtill10th Junesethighdemands

• TheFSAmaysetadditional requirements• Expect:tradingdeskstructure,tradingdesk

strategies(detailed),granularriskfactorcontribution tofinalcapitalcharge,hypotheticalportfolio capitalcharges,….

SomepersonalexperiencetosharefromNordea

©MortenWeis2016

Key tohaveseniorFrontOfficemanagementinvolvement inFRTBproject- businessmodelsmaychangewithFRTB.Tradinginvolvement iskeyinmostofthedatawork:marketdata– instrumentdata– staticdata

UncertaintiesinfinalrulesfavouragilemodelandITdevelopmentapproach

IMArequirecloseintegrationofFrontOffice,FinanceandRiskIT

Thelargeinternationalbanksarenowrunning bigFRTBprojects,mostwithtwo-digitmillion EURbudgets

Youarenotaloneaboutthischallenge- sectorcollaboration,externaladviseandbenchmarking wasveryhelpful forgettingNordea'sprojectoffonagoodstart

©MortenWeis2016

Questions&

ThankYou