Regulatory changes: the legacy of the crisis

Since the 2008-09 global financial crisis several regulatory changes have been implemented to increase the amount of capital required, particularly in the trading book. Recall that many of the losses incurred during the crisis came about because of a deterioration in the credit quality of exposures in the trading book impacting their mark-to-market (MTM) values, rather than outright defaults.

After the crisis, it became clear that such counterparty risk had been insufficiently covered for the stressed market conditions encountered. This led to a series of changes, beginning with the Basel II.5 regulations, which introduced the incremental risk charge (IRC) to allow for such counterparty credit deteriorations and defaults.

Basel III followed, including the credit value adjustment (CVA) capital charge, which capitalises the risk of future changes in CVA under stress scenarios due to changes in credit spreads. This, in turn, spawned a number of related value adjustments – debit valuation adjustment (DVA), capital valuation adjustment (KVA) and funding valuation adjustment (FVA) covering own credit, capital, funding risks and so-called XVA, comprising CVA, DVA, FVA and their interactions.

According to the usual norms, either a standardised approach or an internal models approach (IMA) may be adopted. The former generally leads to much higher capital charges, and the latter requires regulatory approval. The outcome is much higher capital charges in the trading book, with the impact being a reduction in over-the-counter (OTC) derivatives – i.e. arranged directly between two banks – to clearing via a central counterparty (CCP) clearing house, as the capital charges to the bank are then much lower.

These CCPs employ netting, margin calls and a variety of default funds to reduce the aggregate risks. Hence, two streams remain:
• Cleared derivatives via the CCP.
• Uncleared OTC derivatives.

Each requires the posting of initial and variation margin to either the CCP or the bank on the other side of the transaction. The nature of such a posted margin is, in itself, the topic of further recently published regulatory proposals from the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA).

Coming next: the FRTB

Continuing on this theme, further changes arose with the Fundamental Review of the Trading Book (FRTB) regulations. Set for implementation by the end of 2019, these address weaknesses in the Basel accords’ treatment of market risk and have far-reaching consequences, which remain the subject of intense industry debate. The underlying principle is to ensure a stronger boundary between the banking and trading books as well as to make transfers between the books much harder to justify. Such transfers, to reduce capital, were seen as a major contributor to the global financial crisis.

The FRTB also proposes significant changes to both the standardised approach and the IMA. For the former, the FRTB introduces a risk factor sensitivity-based approach (SBA) to make the standardised approach closer in its behaviour to the IMA, thus encouraging those using the SBA to have similar behaviours to those on the IMA. Banks opting to take the IMA now have much more rigorous risk modelling requirements, with models being approved at the level of trading desks rather than for the entire institution.

There are more onerous requirements for the volume and quality of data required for such models, and, where these are not satisfied, the FRTB introduces capital charges for non-modellable risk factors. The effect of this will be to partly negate the capital reduction achieved via the IMA. Due largely to scepticism in the wake of the 2008-09 crisis about the ability of models to perform at times of market stress, a certain proportion of the capital arising from the SBA is now used as a capital floor, even when a trading desk has IMA.

Turning now to the IMA modelling methodology, the previous value at risk (VaR) approach to assess the distribution of outcomes is seen as not properly illuminating events in the tail of the distribution – these being the very events which caused so many issues during the crisis. Hence, there is a move to expected shortfall (ES), the average of the tail of the distribution thus representing a measure of the impact of the more extreme events which may occur. Unlike VaR, back-testing of ES introduces further analytical challenges.

IMA approval also requires attribution of the profit and loss (P&L) and the justification for such (i.e., a determination of what is giving rise to the P&L – so-called explained P&L and unexplained P&L, as given by the pricing models). This is no trivial matter: rising levels of unexplained P&L and other IMA approval issues will lead to additional capital requirements and may lead to trading desks having to switch back to the SBA. A potential scenario arises of desks moving between regimes and different desks being on different regimes, thus necessitating further supporting IT systems, reporting and processes.

For those using the present standardised approach, the SBA of the FRTB is likely to see a reduction in capital; so the outcome is closer to those using the IMA. At this stage, it is unclear where the overall industry balance will settle – either with a huge increase in the number of companies applying for IMA or, once all factors are taken into account, many more resorting to the SBA as a simpler and lower operational cost approach.

The FRTB also introduces liquidity considerations to account for the different times to liquidate positions during stressed conditions. During the 2008-09 crisis, the illiquidity of positions worsened the situation. However, this is not so straightforward to solve as, at times of high stress and uncertainty, many usually liquid assets suffer from market seizure. In terms of the robustness of the overall institution, increased liquidity coverage ratios from Basel III provide a further layer of protection, allowing additional time for market conditions to stabilise and positions to be unwound.

The precise liquidity bucket into which a given exposure resides is likely to lead to some contention, given the significant impact on capital held, which then affects the viability of holding the position at all. Several changes to the FRTB regulations have already occurred based on industry feedback on the liquidity of certain assets, even under stressed times such as the crisis.

Unfinished business relating to the banking book remains. Interest rate risk in the banking book (IRRBB) must be better integrated into the overall regime, so that it better aligns to changes arising from the FRTB for the trading book. This has now reached the regulatory consultative stage and is likely to produce further operational implications for banks.

Up to the challenge?

All these changes, in aggregate, greatly increase the requirements imposed on data, systems, reporting and supporting business processes. Compare this to an industry still weighed down with legacy systems, myriad IT fixes, complex data models, data duplicates, inconsistencies and reconciliation issues. Many of the difficulties in properly and efficiently addressing the regulatory and business pressures reside within such operational matters. A key issue for the industry is how to transition efficiently, without introducing further operational risks from the abundance of changes during such a transition.

When it comes to the overall effect on capital, the many regulatory changes, taken together, significantly increase capital requirements, control measures and operational costs. The precise extent of the capital increase is unclear, but studies have consistently shown substantial increases of many times relative to that which existed before the global financial crisis. Having already increased capital via Basel II.5 and III, it was a stated requirement of the FRTB not to further increase capital but, rather, to reallocate it.

In practice, industry assessments of the impact of the FRTB suggest a capital increase of at least 30% for those presently using an IMA. Collectively, such capital increases lead to many market participants exiting certain business segments, as they are no longer economical. However, akin to the law of unintended consequences, doing so concentrates activity within a smaller number of participants, thus increasing concentration risk and reducing early warnings that can arise from a larger industry population that includes weaker members.

It also drives activity out of the banking system and into the less well-regulated world of asset managers, peer-to-peer (P2P) lending and a growing number of fintech firms with reduced transparency and, hence, rising complexity, with the associated difficulties in monitoring at the scale of the overall economy. Given this moving target in the industry, further regulatory changes and new regulations will remain a significant part of the landscape.


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