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Webcast: Risk Management Frameworks - Impact of the Fundamental Review of the Trading Book

Speaker: Dr Simon Acomb

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A course on this topic is available in London Time Zone, New York Time Zone and Singapore Time Zone

Webcast Agenda

  • Background: Regulatory capital and risk management failure
  • Summary of FRTB
  • VaR as a Risk Measure
  • Good properties for a Risk Measure
  • Expected Shortfall (ES)
  • VaR vs ES
  • ES for Regulatory Capital
  • Impact of changes and capital impact

Learning Outcomes

  • Understand the elements of the internal model approach for calculating market risk
  • Compare the internal model market risk calculation with best risk management practice


1. What will happen if the fair value of a trade is not posted to PL, how will it be treated?
A. Paragraph 11 of the standards document states: "Banks must fair-value daily any trading book instrument and recognise any valuation change in the profit and loss (P&L) account. "Further details may be required on why the fair-value is not being posted, but on this basis I would say that this trade should not be in the trading book.

2. Is it true that the liquidity horizon in the standardised approach is larger for index options (e.g. SX5E) than for large cap equity options?
A. A distinction has to be made between treatment of equity options in the standardised approach and treatment of equity options in the internal models based approach. For the internal models approach the liquidity horizon for equity price is 10 days for large cap (>$2Bn market cap) and 20 days for small cap. There is a separate liquidity horizon for equity volatility which is 20 days for large cap and 60 days for small cap.

The standards document released on 16th January changes the standardised approach from that announced in the consultative phase. The standardised approach is covered is detail in the 2-day course, but the basic idea is that deltas of trades are weighted by risk weights and then bucketed into 1 of 11 buckets. The exposures within and across buckets are then summed with some prescribed correlations to obtain risk capital requirement. There is no explicit liquidity horizon; however this is taken into account implicitly by the fact that the risk weights for small cap equities are larger than for large cap.

It should be noted that for index options, like SX5E, a "look-through" approach must be used (this is described in paragraph 69 of the standards document). The delta of the index must be split into deltas of the constituent equities and then the standardised approach applied to the individual equity names.

3. So will banking book trades be forced into the trading book world?
A. This is unlikely. More likely is the other way round - trading book trades being classified as banking book positions. The old criteria were particularly vague and based around an idea of an intent to trade. As the trading book capital charges are generally less than banking book charges, the temptation was for banks to say they had an intention of trading even when the instrument was illiquid and likely to be on the balance sheet until maturity. The new rules are based around concepts of ability to fair value daily. So for example, holdings in a hedge fund or a hedge fund derivatives cannot usually be fair valued daily (a hedge fund is often only valued monthly). So hedge funds and derivatives on hedge funds will now be in the banking book, even if there is an intention for the bank to trade these positions - there would be an exception to this if the bank could see and value the holdings of the hedge fund on a daily basis. The same would go for holdings in real estate which under the new rules would be banking book positions even if there was an intention to trade.

4. What role has changing accounting practice, including the concept of xVA, had on the fundamental review of the trading book?
A. After some debate the Basel committee designed to keep a separate treatment for CVA, which is at a consultative phase at the moment. My guess is that in 10 years’ time when we are talking about Basel IV, CVA will be recognised as part of market risk and will in the future be incorporated into market risk calculations.

5. So the separate capital treatment for CVA will include the hedges, do you think?
A. The first thing to say is the rules for CVA are currently at the consultative phase and so nothing is for certain yet. The broad answer to the question is: yes, it is likely that hedges will be included, but this will be subject to some constraints. For example, the consultative document states that to be eligible for the FRTB-CVA treatment a bank must have a CVA desk.

6. Which business lines will be most impacted and what changes in businesses do you expect?
A. There will be a clear impact on securitisation businesses. These have been singled out and will not be permitted to use internal models for calculating capital. There is a clear risk that the standardised approach may require more capital and so make this business line less economic. For people who stick to the standardised approach the new rules have been aligned with delta one products and vanilla options, this may result in additional charges for exotic options.

7. How will banks decide which trading desks to include in internal model calculations?
A. If a bank wants to use an internal model approach, it has to elect which trading desks should be included. The definition of a trading desk is somewhat vague, but it has to have a head trader, a strategy, limits and risk management at the trading desk level. The key thing is that validation of the internal model has to occur for each trading desk. The validation and backtesting is an onerous process, so having too many trading desks will add to operational costs and the same process has to be repeated time and time again. However, if a trading desk fails the backtesting and on-going validation, that trading desk (and only that trading desk) has to revert to the standardised approach for capital calculations (which is likely to result in more capital). If a bank has too few trading desks - imagine the extreme of the entire bank as a single trading desk - then a backtesting failure will result in a large increase in capital requirement across the entire bank as the entire bank has to switch to the standardised approach. Clearly a compromise has to be achieved between the two extremes. How to divide up an institution into trading desks and efficiently perform the validation required is discussed in some depth during the 2-day course

Thank you to those attendees who submitted their questions.

LFS offers the 2-day 'Fundamental Review of the Trading Book' programme with Dr Simon Acomb in London, New York, Toronto, Sydney, Hong Kong and Singapore.

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