By Lars Popken, Global Head of Risk Methodology at Deutsche Bank.
Ahead of the Fundamental Review of the Trading Book Summit 2017, Lars provides us with an insight into FRTB final rule and project planning with moving goalposts for rules and timelines.
At the FRTB Summit 2017, you will be speaking on your insight regarding – Reviewing FRTB final rule and project planning with moving goalposts for rule and timelines. Why do you believe this is a key talking point in the industry right now and what can risk professionals gain from this insight?
FRTB it is “fundamental” for many reasons. It is a key talking point in the Industry since it is not just a fundamental review of the methodology by which banks estimate their capital requirements, but because it requires a change in mentality within each institution and a revision of roles and responsibilities across the bank’s functions.
To succeed within the FRTB framework, the bank’s departments need to cooperate more than today and become more integrated, having Front office teams involved the capital calculations and in particular in the sourcing of data inputs into the risk model. This is true not only in the context of internal models but also for the standardised approach, where the capital charge is not simply from trade economics but uses risk sensitivities which are sourced from upstream systems managed by Front Office. FRTB raises the bar for each department, Front Office, Risk, Finance and IT. All these departments will need to work in harmony to tackle the challenges of new eligibility tests for internal models, the identification and quantification of non-modellable risk factors and the calculation of the Stressed Expected Shortfall and Default Risk Charges. Understanding the challenges but also the opportunities which FRTB provides is key for risk professionals.
What are the essential considerations that need to be made when developing with agility to accommodate change?
A simple question to a very complex topic. There is quite a lot of literature out there already, so I want to only discuss this briefly with an FRTB angle to it:
Agility is synonymous of flexibility, probably the most challenging aspect for big institutions who may at times have a very standardised and governance-heavy development approach. FRTB may pose quite a challenge here: the required changes are intrusive, they impact on the front-to-end information flow through the bank, they are calculation and data-flow intense and the interpretation and rule-set is still evolving despite BCBS having issued a final guideline in January 2016. In short, it’s a mammoth task with significant uncertainty attached to the requirements.
Key design principles should be to align as close as possible the capital calculations with Front-Office data and models: share trade data, trade manifest, pricing libraries, market data, reference data etc. Data quality is key, including for the many years of history for market data. Furthermore, ownership and responsibilities of information and information flow need to be very clear; and any issues arising need to be addressed at the upstream source rather than via work-arounds in the risk systems.
Prototyping can be very helpful to inform the required architectural design, and to test the early results from the strategic implementation – if the conclusion of a prototype was that the intended methodology does not work, then the earlier such insight is available the better.
Important here is to tap in the institutions change activities in related areas in order to leverage existing functionality or provide future value for other projects; in the context of FRTB this could mean, for example, to re-use the market risk stress testing framework for the calculations of the NMRF charge.
In your experience, how can financial institutions best manage potential phase in of capital requirements?
Undoubtedly, a key aspect in managing change is to have a good understanding about the new rules for capital calculation and their (capital) impacts. For this reason, a bank should invest time in engaging with regulators to build a common understand of the requirements and it should invest in running accurate impact studies.
First of all, the result of impact studies provides feedback within the regulatory engagement process regarding unintended consequences of the proposed rule (and may lead to subsequent amendments of the rules). Secondly, accurate impact analysis is necessary for planning purposes, shedding light on those products which may quickly become uneconomical, e.g. where capital demand is increasing. Finally, accurate tactical measures will provide useful information which paves the way for an effective strategic implementation, challenging stakeholder departments across the institution to start communicate and cooperate towards the challenging common goal which is FRTB implementation.
All of this background work builds the foundation for the phasing-in of capital requirements. A phase-in may give sufficient lead-time for capital-intense positions to be de-risked or capital hedged in a more efficient way, or they allow businesses to evolve more gradually over time rather than a big-bang. Phase-in is not a weapon of choice though for broader acceptance of a change in regulation, because often the market analyses the performance of an institution on a “full-loaded” basis, thereby ignoring the phase-in period.
Can you give an overview of the benefits of early adoption?
At the moment it looks like European banks might all have to be subject to an early adoption when compared to the rest of the world – at least the legal preparations are more advanced on the level of European Commission than what we have observed elsewhere in the world.
If this were to lead to an unsynchronised timing of the potentially capital impact from FRTB across the developed markets, then this would be detrimental to the principle of a level playing field. Any benefits of an early adoption are likely to pale against the significant handicap of an increased capital charge for selected but not all jurisdictions.
What, in your opinion does the future hold for market risk professionals, and how can they keep up with the increasing change?
I state this quite regularly: ever since I entered into the world of market risk methodology in 2009, I have never gotten bored. Even once the FRTB implementation is on a sure footing, there are new challenges on the horizon. For example, the increase in sophistication of stress tests will spill over to the FRTB charges and the CVA RWA charge is still awaiting finalisation.
More importantly though, it is important to go back to the roots and consider what the ultimate goal should be for market risk professionals. Instead of further sophistication of the capital measures, we should be spending more time on improving the risk management capabilities: Rather than focussing on risk reports based on standard settings, we should build more dynamic and automated risk identification tools which constantly trawl through the portfolio and search for risk concentrations and scenarios which would be having an adverse impact on the P&L of the bank. Risk managers also need to develop better tools for monitoring market liquidity and understand the drivers of that liquidity. Exposures need to be put into the context of liquidity so that the bank can obtain a more accurate picture of their risk. We will need market risk professionals leading and benefiting from such a shift in focus.
Please note: The insights provided in this article do not reflect the views of Deutsche Bank