Banks are facing a world in which they will have less discretion and more intense supervisory oversight of their internal risk models, if the latest proposals for the Fundamental Review of the Trading Book (FRTB) from the Basel Committee on Banking Supervision (BCBS), published on 31 October, are adopted.

This second consultation incorporates feedback from industry delivered since the original consultation in May 2012, and many industry observations appear to have been taken into account. However, as currently drafted, various aspects of the new proposals may still prove challenging for the industry to implement.

Some key themes that emerge from the consultation include:

  • reduced discretion in the treatment of the division between the banking and trading books;
  • increased role of the supervisor through more granular scrutiny of internal models,
    including stricter criteria for the definition of amenable risk factors and the use of models, more intrusive testing to make sure models remain robust, harmonization in terms of how internal models are approved and assessed  and reduced discretion for banks in their use and calibration of internal models;
  • increased methodology challenges. Banks will be progressively required to move to new risk metrics such as Expected Shortfall, include the modeling of liquidity risk through an additional charge proportional to the holding period and implement a new daily back testing framework at a more granular risk factor level; and
  • increased infrastructure and disclosure efforts. Not only will all banks have to calculate standardized capital charges in addition to using their internal models, but proposals for a revised standardized approach mean that banks using standardized models will also have to perform more complex calculations. In addition, banks will have to disclose the results of standardized calculations, information on desk structures of the firm and results of new back-testing requirements.

The impact on individual firms will clearly depend on the extent of their trading activities, their current use of internal models, and the general sophistication of their risk management frameworks. But as the name of the paper suggests, there are some fundamental changes being proposed. All banks should take note of them.

The BCBS is requesting comments by 31 January 2014. A quantitative impact study will also follow. The BCBS has previously indicated that it wants to complete its work on the trading book by the end of 2014, but the new consultation paper gives scant indication on possible implementation dates. 

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