Market risk: new reporting requirements to start in 2021
Frankfurt am Main, 12 August 2020
Financial emergencies such as the 2008 crisis and the ongoing market shocks from the coronavirus (COVID-19) pandemic highlight the need for banks to hold sufficient capital as a buffer against sudden losses from adverse movements in market prices. Following the 2008 financial crisis, the Basel Committee on Banking Supervision addressed some of the most urgent issues related to market risk. At the same time, it began a more comprehensive assessment of the market risk rules: the fundamental review of the trading book (FRTB). This review has led to sweeping reforms of the prudential market risk framework to make banks more resilient. The Basel Committee finalised these reforms in 2019, including two revised approaches to calculating the amount of capital that banks must hold to absorb losses from market risk: a new internal models approach and a new standardised approach. The latter will play a key role across all banks.
In the EU, the FRTB is being implemented in two stages. First, the revised Capital Requirements Regulation (CRR II) requires banks to report their capital requirements under the new market risk rules to their supervisor. Second, EU legislators have asked the Commission to submit a legislative proposal that will require banks to meet their capital requirements under the new rules.
Regarding the first stage, the European Banking Authority has now – in response to the COVID-19 outbreak – proposed making the reporting requirement for the standardised approach binding in the third quarter of 2021. It will be mandatory for all banks with trading activity above a certain level, regardless of whether they use the current internal models approach or the standardised approach. Around 70 of the 116 banks directly supervised by the ECB are expected to report based on the new standardised approach (FRTB SA). By contrast, the obligation to report on the basis of the new internal models approach (FRTB IMA) will only be applicable to banks that decide to apply for and receive permission to use that approach.
The FRTB SA is much more sophisticated and risk-sensitive than the current standardised approach and, as a result, is more aligned with banks’ risk management practices. It incorporates sensitivities to changes in market risk factors (such as interest rates and credit spreads) and sophisticated hedging concepts that banks use to manage their risks. It takes a holistic view of banks’ trading portfolios by considering not only risks of instruments in isolation but also any risk-reducing effects of diversification. It is also more closely linked to the way in which banks measure their trading losses because it largely relies on the pricing models that banks use for that purpose. Given its greater risk sensitivity, the FRTB SA can be used as a fallback for the FRTB IMA. This is why banks that use the FRTB IMA to calculate their capital requirements in the future will still be expected to report their capital requirements based on the FRTB SA.
This greater risk sensitivity comes with greater complexity and implementation challenges. The ECB, in close coordination with all national supervisors in the euro area, is closely monitoring the progress that banks are making and sent a stock-taking survey to all directly supervised banks in December 2019. Responses from the 70 or so banks that will need to report their capital requirements using the FRTB SA rules indicate good progress on average. However, there is a notable difference between, on the one hand, banks using the current internal models approach (typically large banks) and, on the other, banks using the current standardised approach (typically small banks). The former have made significantly more progress than the latter, probably because they have a more sophisticated infrastructure and greater resources. Feedback from some smaller and medium-sized directly supervised banks indicates that they may face some issues. 15% of these banks reported having made negligible progress in implementing the new rules. Furthermore, 10% already admit facing delays in meeting the 2021 reporting requirement, which would not be acceptable from a supervisory perspective.
Banks have identified the availability and quality of data and the development of IT infrastructure as the main operational challenges affecting compliance with the FRTB SA rules. Their primary methodological challenge is how to calculate the capital charge for curvature risk – using upward and downward stress scenarios – for instruments such as options. A less significant challenge reported is how to calculate the capital charge for the risk of instrument issuers defaulting. All banks, and particularly those institutions that are lagging behind, should closely monitor progress on these topics and devote sufficient resources to ensure timely implementation of the FRTB.
One of the core components of the new standardised approach is the use of pricing models to calculate the impact of certain shocks on the value of the trading portfolio. 90% of the banks that will need to report based on the new standardised approach say that they are already using pricing models for most or all of their trading portfolios, for example to calculate how changes in interest rates or credit spreads affect the market values of these portfolios. However, supervisors will need to assess the suitability of the pricing models and ensure that differences in these models across banks do not lead to significant unwarranted variability in risk-weighted assets.
Banks indicated that they do not plan to outsource the calculation of the FRTB SA capital requirement to any significant extent. 63% intend to carry out their FRTB SA calculations entirely in house, while 37% plan to outsource only some specific elements. The latter include most of the banks that have so far made only negligible progress in their FRTB SA implementation. While banks foresee limited outsourcing, many plan to rely on third-party software for their FRTB SA calculations. These software packages may facilitate implementation but they also create the risk of a “black box” for banks’ management. Banks should be able to demonstrate that this software closely follows the regulatory requirements and that their staff fully understand the mechanics and processes behind the third-party software tools.
The ECB’s supervisory teams will use the survey results to discuss any specific implementation challenges with banks in more detail and to continue monitoring banks’ progress in this area. The ECB calls on banks to pay attention to the need for timely implementation of the FRTB rules and to get ready for the upcoming reporting requirements.