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Fundamental review of the trading book – Internal model approach: accelerating towards full adoption

Martin Gibbon
Sep 15, 2023

Accelerating FRTB implementation means more than being on the front foot with your business case: upskilling modellers, learning from peers, and having a realistic plan will pay dividends.

The Fundamental Review of the Trading Book (FRTB) is a comprehensive set of capital rules introduced by the Basel Committee on Banking Supervision (BCBS) – to be applied to bank wholesale trading activities.

As an international standard, it sets out rules governing the capital which banks must hold against their market risk exposures, therefore will influence trading activity decisions, pricing and ultimately profitability.

Capgemini have been working with many global banks supporting implementation, from a UK perspective, although fine details are yet to be worked through, the Prudential Regulation Authority (PRA) has confirmed implementation of Basel 3.1 – which includes FRTB – for January 1st, 2025.

Among the key changes introduced with Basel 3.1 include removal of existing Internal Model Approach (IMA) methodologies and replacing them with a new framework. Existing internal model permissions for market risk will become redundant, and current IMA firms will automatically move to the new Standardised Approach (SA) when the new rules are implemented, unless they have been granted a new IMA permission under FRTB.

Salient new IMA features include the introduction of the Default Risk Charge (DRC), Risk Factor Eligibility Test (RFET), Non-Modellable Risk Factors (NMRF), P&L Attribution Test (PLAT) and back-testing – all of which will be subject to greater in-depth reviews by the PRA as the implementation date moves closer.

Challenges experienced by firms that have already built business cases have typically included balancing tangible benefits with intangibles; for example, quantifying drivers including the ability to trade certain products or markets, capital and reputational imperatives.

Capital reductions under IMA are not guaranteed. Indeed, for some firms, capital requirements may possibly increase under IMA, in part due to the Advanced Standardised Approach (ASA) floor, complex instrument NMRF models and the DRC Probability of Default (PD) floor of 0.03%.

Early IMA adopters – those firms applying at least a year prior to the deadline of January 1st, 2025 – will be given priority, and firms applying later (for example, after June 2024) may incur delays significantly longer than a year to have their application reviewed. These waiver process timescales with contingency, will need to be built into project plans.

And expect regulatory scrutiny to increase, in particular the level of review where subjective assessments are used, for example, in the development and deployment of NMRF models.

Model developers will need to dial-up their learning and acquire new skills. Firms embarking on IMA have found the availability of relevant modelling skills, expertise and bandwidth to be a key constraint. Specialist experience is required to develop, validate, maintain and oversee the development and deployment of IMA-related models, and the quants will need to adopt new approaches. An example of this is not assuming stressed environments experienced historically will necessarily take place in a similar manner in the future when building Expected Shortfall (ES) models.

When it comes to implementation, firms will need to focus on:

  • Market Data – re-examining their use of feeds in support of the new models; some entirely new feeds may be required, for example, to support complex and exotic instrument NMRF modelling.
  • Infrastructure – more complex infrastructures will be required to address the advanced computation and monitoring demands of IMA; model back-testing, and in particular PLAT, will require enhanced risk infrastructure; DRC back-testing will need to use alternative approaches including stress testing and scenario analysis.
  • Operational Complexity – new models will need to run alongside pre-existing models, for example, ES and Value at Risk models (to perform back-testing).
  • Planning – unrealistic expectations regarding timescales, resourcing, scope and dependencies have led many mobilised programmes to over-run their initial estimates; in part due to regulatory uncertainties, scope creep driven by the parallel refresh of broader market risk infrastructures, and skills shortages, some firms have had to extend timescales and request additional funding; contention risk – in both infrastructure and modelling disciplines – has also been a driver of delays.

What accelerators can Capgemini bring to help firms improve their delivery cadence? Some examples include:

  • Wayfinder – mapping current to proposed future rules and regulations, providing searchable content, seeing at a glance the impact of proposed changes on products and businesses, tracking response deadlines and implementation dates, assisting in prioritisation, minimising interpretation risks and reliance on external counsel. Developed by leading law firm Simmons & Simmons – supported in business and technology implementation by Capgemini
  • Gap Analysis – aligning current business and technology features to a paragraph-by-paragraph view of the target state, driving a detailed understanding of proposed change impacts on policy, governance, organisation and process, application, data, infrastructure and non-functional requirements.
  • BizDevOps – bringing business, development and operational staff together into multi-disciplinary squads, tribes and chapters, championing the engagement of senior accountable executive sponsors, mobilising effective governance, reducing production of lengthy packs and supporting quick decision-making alongside effective quarterly review processes.

The above brief exposé of changes, challenges and solutions introduced by FRTB IMA shows how, with careful planning across many diverse fronts, successful implementation is achievable. Note however, that some aspects of success will be outside firm’s direct control and therefore will require careful guidance.

Martin Gibbon

Global Head of Finance, Risk & Compliance
Martin is the Global Head of Finance, Risk and Compliance at Capgemini Invent. He has successfully delivered large, complex, regulatory and business driven change at global tier-1 financial service firms – including leadership roles on FRTB and market risk programmes. Many of these initiatives have also included implementing significant cultural and behavioural transformation in challenging environments. Prior to joining Capgemini, Martin led financial risk transformation at HSBC, risk change at NatWest, risk technology at EY, and risk and compliance across all business lines at IBM.