The Potential Pitfalls of Operating Under an Internal Models Based Approach

The Potential Pitfalls of Operating Under an Internal Models Based Approach

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Thomas, please tell our readers a little bit about yourself and your experience within market risk

In my work as a Lead Product Owner in Nordea I am tasked with ensuring that we cover and implement all the required changes mandated by the Fundamental Review of the Trading Book as part of an ongoing project (both in terms of infrastructure, process and business model change). Nordea currently has Internal Model approval for Market Risk and we aim to re-apply for Internal Model approval under FRTB.
Directly or indirectly I have worked with business and capital impact of financial regulation for most of my career and I have actively followed FRTB for the last 3 years. I spent the first 4 years of my career working with market risk control and reporting first as an analyst and later as a manager.

 

At our Risk EMEA summit you will be presenting in our FRTB stream. You will be looking into the potential pitfalls of operating under an internal models based approach. Why is this such a key talking point?

Because at this stage we can honestly say that it looks like it will be much more difficult to receive and maintain internal model approval than has previously been the case. And further that in the current form, several of the components of the IMA framework will require a lot of work both within individual banks and across the industry to translate into workable processes as well as economically efficient business models.

 

Without giving too much away what would you say are the ramifications of certain desks being bumped to standardised?

Clearly this is a capital issue. Interestingly though even for the small subset of desks for which the capital impact of this would be manageable there will be consequences. That is because the logic and economics of how to hedge market risks in a capital efficient way will be restrained by the netting opportunities of the standardized framework.

 

How can professionals prepare if internal models fail?

With the current design of the framework it is not unlikely that the model assessment triggers for IMA (especially the P&L attribution test) periodically can force individual desks onto the standardized approach. In practise that means that one needs to prepare mitigating actions for managing capital consumption for both IMA and SMA even if one aims for Internal Model Approval. I would therefore encourage all banks to develop comprehensive capabilities and understanding of the future standardized approach for market risks.

 

What key challenges do you believe lie ahead for the market risk professional over the next 6-12 months with the finalisation and move towards implementation of FRTB standards?

One of the most important challenges that I see is that we have limited or no visibility of how the set of principles in the final FRTB rules in practise will be translated into law – which will have implications for what must be built in terms of market risk infrastructure. At the same time it is my general understanding that most market participants agree that one must proceed with high urgency if one wishes to be able to have an Internal Model ready and approved by the indicated timeline in the final version of the FRTB rules as published by the Basel Committee for Banking Supervision. In practise this means that one must decide on a series of large investments before there is a clear picture of what exactly needs to be built. This is one of the main reasons why Nordea has chosen to follow an Agile project management approach to implementing our project.

On the methodological side I think that the largest challenge will be that we must move from risk models that are appropriately conservative to capture all material risks to risk models that with a fairly high degree of certainty can replicate actual P&L. This is not a trivial exercise.

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