Fundamental review of the trading book (FRTB) along with the remaining Basel III reforms to other RWA (risk weighted asset) requirements, commonly referenced to as Basel IV, have been in development for a long time and introduce a paradigm shift in the market risk regulatory framework. They impose a complete overhaul of market risk capital rules across the globe with the aim of providing a level playing field in terms of how Banks calculate and report risk.
1 January 2023 seems so far away, but given the complexity of FRTB changes, the title of this set of regulation is not pre-fixed with “Fundamental” for nothing!
In terms of the potential effects of FRTB implementation, there are huge ramifications on bank’s business models with increasing constraints and rules that they have to adhere to.
FRTB will not just impact the regulated banking community, but will also have repercussions for all asset owners, as well as the broader capital market.
As a result, now is the time to begin preparations and identify solutions to mitigate their potentially dramatic impact on access to financing.
It is estimated that the European banking system will need to add an estimated average increase of 14% of additional Tier 1 capital to their capital buffers. Such increase in costs is likely to be recovered by increased fees to their customers, thereby reducing/eradicating returns to those entities that lend cash and security, or the removal of intermediation services altogether to some customers.
FRTB sets a higher bar for banks to use their own models for calculating capital; ensures banks are capturing tail risk events; and cements the boundary between trading and banking books
Industry experts believe that risk capital requirements could rise by anything between 1.5x to 2.4x from their existing levels as a result of implementation for some banks.
FRTB requires banks to completely overhaul the way that banks assess/measure and monitor market risk.
Trading and banking books will have to have clear boundaries, with clear mark-to-market and capital risk charges relevant to each. This has the advantage (from a regulatory perspective) of having exceptional clarity around a bank’s ability to move non-performing loans into and out of Bank and Trading books which clearly reduces the ability for regulatory arbitrage.
Banks generally use an internal model approach to monitor risk (IMA). However, FRTB requires adherence to a new standard expected shortfall (ES) measure which better captures tail risks and replaces VAR and stressed VAR (Standardised Approach-SA). The aim of this overhaul is to harmonise the treatment of market risk across jurisdictions, so it is unlikely that this international agreed standard will be assuaged in any way by national interests.
The aggregate output floor requires a bank’s risk weighted assets (RWA), using their own IMA approach, to be not lower than 72.5% of RWA as calculated by the Basel framework’s SA.
The new rules limit the ability of banks to apply internal rating models for RWA purposes.
Currently, many banks allocate a 20% risk weight to 000’s of unrated, but high-quality counter-parties like pension and mutual funds. The standardised rules state that unrated obligors will attract a phased in 100% risk weight allocation going forward.
RWA allocated for securities financing as a result of these changes will have to rise dramatically to meet current demand.
As RWA requirements increase, so too will bank balance sheet costs.
The increased cost of doing business for banks will invariably affect the cost of, and how much, balance sheet is extended to their clients post implementation.
Repo and securities finance costs are set to increase in the run up to, and certainly post Jan 2023 implementation.
The scale of the challenge for the securities financing industry in preparing to meet this new regulatory framework should not be underestimated. The industry should be looking at solutions ahead of its implementation or it could find that many of its current strategies and assumptions become uneconomical to operate.
Mitigating liquidity risk – secured finance.
Clients who require balance sheet intermediation will have to adjust to new bank internal return hurdles.
Some banks may limit to whom they offer Repo/securities finance services altogether.
Banks will increasingly seek to intermediate transactions via solutions that may reduce principal risk and therefore capital costs.
The need to mobilise HQLA is on the rise, whilst intermediary capacity (bank balance sheet) has generally fallen.
The markets continue to grow, whilst capacity continues to be challenged by on-going regulatory reform.
When volatility increases, the demand for intermediation could easily outstrip the supply of capacity available to market users.
How the market is acclimatising and reacting - new initiatives to help additional liquidity.
There has been a drive towards increased electronification of the whole market in terms of pre and post trade to reduce and seek to eliminate operational risk. Benefits of electronification include, increased transparency, automation of compliance and reporting obligations, reduction of settlement errors and fails and provision of better connectivity and communication between clients and counterparties.
Sponsored clearing has also become useful a tool for some buy-side firms.
How can ConneXXion Markets help?
ConneXXion Markets provides market participants with alternative and additional secured finance access from non-traditional channels. This increases our client’s liquidity pools, adding to their existing secured finance capacity, and enhances returns - not just in times of market stress.
We seek to increase your liquidity pool and are additive to your existing secured finance Bank capacity.
Notably, we provide benefits which can improve performance.
ConneXXion Markets aim to be at the forefront of innovation and productive solutions.
Additionally, we offer our customers:
Operational efficiencies: electronification of trade flows, processes.
Removal of complexity: simple, cost-effective, scalable “one-touch” documentation and operational on-boarding.
Futureproof compliance: we help our clients meet current and envisaged regulatory requirements.
connexxionmarkets.com - leading the way to liquid and accessible secured finance markets
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