Speakers at OTC Derivatives Summit 2016 tackle the complexities of global regulatory requirements.
International and regional banks conducting OTC derivatives business in Asia face new challenges in market risk measurement as well as additional capital commitments under global regulations such as FRTB (Fundamental Review of the Trading Book).
BCBS (the Basel Committee on Banking Supervision) issued a report late last year which said FRTB implementation could prompt an increase of 4.7 percent in banks’ capital requirements. Meanwhile, banks also face challenging requirements for measuring counterparty credit risk with the advent of stricter qualification requirements for the use of internal models and eventual move to SACCR (the Standardised Approach to Counterparty Credit Risk).
Speakers at the inaugural Regulation Asia OTC Derivatives Summit in Singapore debated these issues, among others. Addressing FRTB, Tim Clarsen, risk management specialist at capital markets platform provider Murex noted that although arduous, even eight years after the Global Financial Crisis regulation remains clearly framed against those events.
“FRTB is an extension of what was put in place after the financial crisis, when several shortcomings in internal models became obvious, including assumptions made in the value-at-risk framework,” he said.
The End of Internal Models?
According to Frankie Phua, head of credit and country risk management at UOB, banks in the region no longer have an option when it comes to models used to evaluate counterparty risk – the standardised approach will become a reality of life for even the most sophisticated institution.
“It is no longer an option to choose a standardised approach or an internal approach, regulators expect you to set a floor on your capital, so even if your internal approach is very sophisticated the capital will be too low,” he said.
The experience of the 2008 global financial crisis convinced regulators that they cannot believe in the efficacy of banks’ internal risk models and systems. Imposing FRTB and other standardised risk measurement regimes underpins regulators’ main strategy: to demand more capital to withstand financial shocks, end proprietary trading and restrict risky activities.
Clarsen added that the issue “throws the logic of having an internal model into question”.
Indeed, BCBS (the Basel Committee on Banking supervision) recently proposed that even the largest, most sophisticated banks use standardised calculations to determine capital levels, although FRTB theoretically allows continued use of internal models subject to more granular, desk-by-desk approval procedures.
For Yves Tomballe, Asia Ex-Japan head of market and liquidity risk at Bank of Tokyo-Mitsubishi UFJ, there was still a rationale for using internal models, although he acknowledged these would not be sufficient.
His main concern was variances in how FRTB will be implemented: “Our choice will probably be a mix of both (standardised and internal models). What concerns me more is how FRTB will be implemented locally. We are yet to know what different countries will bring as there is very large scope to the level of implementation.”
Yet the need for the right approach is not only to meet regulatory requirements, according to Bruno Campana, managing director of FTI Consulting, who said it was important for banks to aggregate desk risks effectively and reconcile these with their overall risk appetite.
“This is particularly important for banks with main trading centres that manage both banking and trading risks,” he added.
Complexity and Cost
Phua approved of SACCR for its greater risk sensitivity, but noted this would require substantial effort to implement.
“You need a lot of data, and systems, so it will be a major challenge,” he noted.
The implementation of FRTB will be similarly challenging, according to Brian Lo, managing director and head of market and liquidity risk at Singapore’s DBS bank.
“Banks will have to produce regulation-defined risk sensitivities and validate these. If you have any aspirations to move to a more advanced model, you will have to work desk by desk, and get it through back testing,” he said.
Executing FRTB demands a more full understanding of risk and a distillation of its quantitative elements in a way that extends beyond the trade. Understanding the risk taken as an asset class and what it means for a particular trading desk and how it interrelates to the rest of the book and ultimately the entire bank will pose serious challenges to system development.
“Banks need to understand the implications to decide which activities are justified.”
“I would warn Asian banks about the extra effort in understanding the data and making sure everything is understood by risk management staff,” added Campani.
Clarsen agreed: “You have to step through a number of calculations, and run simulation on the portfolio for a large number of risk factors, take all of these results – millions of P&L vectors – put them in one environment and then apply a regulatory formula.
“It has huge implications for infrastructure and technology.”
The Impact on Liquidity
Earlier this year, the International Swaps and Derivatives Association, Global Financial Markets Association, and Institute of International Finance issued a joint statement saying FRTB would require an increase of capital by about 40 percent, which could reduce market liquidity.
However, Tomballe noted that so far, more stringent requirements have not had that effect.
“So far we haven’t seen any disruption and liquidity remains ample. Once central bank easing measures are withdrawn, my concern is whether liquidity be sufficient when we see a series of regulations asking us to increase high quality assets,” he said.
Some regulators have pre-empted this potential disruption, according to Phua, citing the Monetary Authority of Singapore’s recognition of a wider range of collateral.