The final Fundamental Review of the Trading Took (“FRTB”) text released in January 2016 marked a significant improvement on the previous versions and has taken into account many of the points raised by the July 2015 Quantitative Impact Study (“QIS”). The final FRTB text improved the calibration of many parameters and amended key charges such the Residual Risk Add-ons (”RRA”), and better defined the non-Modellable Risk factors (“NMRF”).
As a consequence FRTB’s impact has become more palatable for banks. But the benefits of the improvements are far from being uniformly distributed. Emerging Markets (“EM”) players are likely to experience out of proportion increases by this reform. This will have significant impact on the future development of Emerging Markets, and potentially create unintended consequences, such as segmentation of markets and reduced liquidity.
Modelling Illiquidity might create more illiquidity:
FRTB was designed to account for illiquidity in the Internal Model Approach (”IMA”), and it achieves this goal through the differentiated parameters set on “Holding Periods”. This, combined with the lack of granularity on credit rating (“IG” vs. “non IG”), availability of historical trade data (“Modellable risk factor” vs. “Non Modellable Risk Factor”) will have an outsized impact on firms using IMA for Emerging Markets.
Whilst some Emerging markets may be able to pass some NMRF (Non Modellable Risk Factors) and PLA (Profit and Loss Attribution) criteria, genuine “frontier markets” will be constrained to be on standardized rule for a very long time. The hurdle imposed by Non Modellable Risk Factor criteria (Cost, Data availability) and by the P&L Attribution tests (Cost, Stability of data) will therefore push many Emerging Market players toward the standardized rule, hence our interest for this methodology while reviewing the impact on EM.
Discontinuities in the Standardized Approach have a compounding effect:
The discontinuity of treatment of credit products visible in IMA are also seen in Standardized Approach (“SA”). The application of the worst of the 3 prescriptive correlation scenarii, the limited diversification at multiple levels are effectively compounding effects over and above the rating discontinuities. While none of these rules are inappropriately calibrated in isolation, the combined effects of all these discontinuities will disproportionately increase Emerging Markets capital requirements.
Emerging markets players are very aware of the limitation of their core markets and tend to hedge across asset classes, seeking “relative safety” and “relative liquidity” through their hedging strategies. As there is no diversification across asset classes, it is a penal regime.
The example below illustrates some counterintuitive outcome of FRTB under the Standardized rule.
|SBA Capital for 5y Generic Gov. Bond as a Percentage of Notional|
|Strategy||China (A+)||Hungary (BB+)||Prescribed Corr.||Use case|
|Outright Bond||10.0%||27.8%||High Correlation||Local EM Bank, IR not managed|
|Bond vs. local IR Swap||7.7%||25.1%||Low Correlation||Local EM Bank, IR managed|
|Bond vs. FX Swap||13.3%||31.1%||High Correlation||International Bank, IR &FX Managed|
The Capital Charge for BB+ rated Bond is 3 times more expensive than the A+ rated Bond. The non-investment grade Bond is penalised twice:
- On the Credit Spread stage (“CSR”), where the risk weight used to multiply the Bond risk factor sensitivity jumps from 0.5% vs. 3% for non IG:
- On the Default Risk Charge (“DRC”), the risk weight on Losses jump from 3% for A+ to 15% for BB+.
When considering hedging strategies under the Standardized Approach, results are even more counter-intuitive, as partial/limited diversification effects and change of correlation scenario influence the final outcome:
- A matching interest rate swap does not lower the capital charge significantly, as the prescribed “worth case loss correlation scenario” is changing from high to low, largely reducing the benefit of the hedging, by introducing more disallowance as more hedging is done.
- A Matching FX swap increases the exposure significantly, as the prescribed FX basis is charged and not fully diversified, thus breaking the level playing field between the various players, i.e., between those using FX Hedging strategies (typically offshore players) and those acting locally.
The impact of FRTB on Emerging Markets seems out of proportion to that on Developed Markets. A partial recalibration may be necessary.
At market level:
- Increase barrier entry, reduced access to EM
- Segmentation of markets, with Strong Cliff effects / lack of granularity
- Reduced liquidity
- Reduced diversity in the market players
At Bank level:
- Capital Cost increase of EM hedging strategies
- Cost of borrowing to be impacted by Capital Increase
- No Level playing field between participants
- Cross risk class strategies are punitive
- Some business models would require repricing
 The Lack of credit rating granularity produces strong Cliff effects in both methodologies: In Internal Model approach (“IMA”), any Sovereign debt dropping from investment grade would see a steep 50% increase capital requirement, as there is a binary change in the Holding Period from 20 days to 40 days. The impact is indeed more pronounced under Standardised Approach (“SA”), with over 150% increase on a similar case, as risk weight increases from 0.5% to 3% when switching from IG to non IG.
Article written by Sylvain Martinez. Sylvain will be presenting at the Fundamental Review of the Trading Book Summit set to take place over 19-20 April. ICBC Standard Bank will be joining UBS, Natixis, and BNP Paribas on a Panel Discussion to assess the implementation challenges surrounding the Fundamental Review of the Trading Book.
The views stated in the article are those of the author and not the Bank.