IBM RegTech Innovations

Capital optimization for desk restructuring under FRTB

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Earlier this year the Basel Committee published its final of the final (until further notice?) review of the capital requirements for market risk regulations, namely the Fundamental Review of the Trading Book (FRTB). It becomes effective in 2022, but banks should now, more than ever, implement the proposed changes in order to meet the deadline for reporting their Pillar I capital under the new methodologies.

In reality, FRTB has taken much longer than expected, with more than two revisions and a few consultative papers being published for good measure. The deadline for the proposed effective date was pushed from 2019 to 2022, and local regulators around the world have still not mandated when or if FRTB will become mandatory for their respective jurisdictions.

Much of the debate and cause for concern has been a higher than expected increase to capital requirements and the effects that this increase can have on banks’ profitability and operations – especially for those that will not have the capacity to apply for internal models. The Standardized Approach under FRTB is highly punitive, more so in the first versions of the regulations, but even with the reductions of risk weights, banks wishing to report under SA will see a 30%¹ average increase in their capital requirements.

The second pain point of FRTB is perhaps one of the biggest proposed changes of the new market risk regulation: Banks need to apply, on a desk-by-desk basis, for IMA approval. And retaining IMA approval is even more difficult. A bank that wishes to report capital under IMA needs to pass a number of Model Assessment tests such as backtesting at the bank-wide (top of the house) as well as backtesting and PnL attribution for each candidate IMA desk.

The results of the model assessment tests are classified under green, amber and red. Green means that the desk can continue reporting capital under IMA. The amber zone acts as a buffer and there is a capital surcharge associated with desk’s capital falling into this zone. A red zone result means that the desk will lose its IMA status and must start reporting capital under the Standardized Approach.

After the first consultative paper of FRTB came out a few years ago, banks recognized that the implementation of FRTB will not only have a huge impact on their capital requirements, but also on their systems and internal processes and strategy. As such, banks have been revising their current systems readiness to cope with not only the new methodologies for calculating capital but also with their ability to cope with the ten-fold increase on computational requirements. The impact on banks’ processes and strategies is also huge as banks begin to assess how the trading and banking book boundary revision will affect their capital calculations. Most importantly they need to identify which desks will apply for IMA, if any.

This, however, can be seen as an opportunity for the bank to minimize the overall capital requirement by reviewing the structure of their trading desks. There is no diversification benefit allowed across the two approaches, as total capital is equal to the sum of total capital of IMA desks and total capital of SA desks. However, within the calculation of the two approaches diversification is allowed. This implies theoretically that there exists an optimal desk structure. Our focus for the rest of this article is to discuss how a bank can find this optimal strategy.

Brute force optimization cannot be employed to solve this problem. The possible combinations grow exponentially with the number of desks. For example, for a bank with 100 desks, there are 1.3e30 possibilities to be evaluated. Even if this bank was able to throw many resources at the problem and was able to calculate for a potential choice of desks the overall capital in a nanosecond, it would still take 40 trillion years (!) to find the optimal capital. In addition, this optimal solution can be very unstable. Brute force optimization doesn’t take into account long term model assessment approval and thus can result in capital volatility and the associated costs.

Banks are looking at the options of throwing hardware at the problem, using scalability and performance techniques such as Hadoop (Big Data), cloud-based calculations and even quantum computing to try to ease the hardware burdens.

Finding the optimal desk structure that minimizes bank capital might be a very difficult problem, yet banks can still devise a desk structure that reduces the overall capital and takes into account long term model assessment approval. They need the tools that enable them to assess potential desk structures’ capital on demand and at the same time indicate whether that candidate structure would still pass all model assessment tests.

Restructuring desks to lower the top of house capital is an excellent approach to ensure the bank’s trading operations run efficiently, and to ensure the bank frees up as much capital as it can.  Operationally, end users need to have all of the available information, and the ability to play out these scenarios using real, live data.  Banks need to explore desk structure changes that are possible – and how they can be optimized over a period of time.  This should be well in advance of the end dates for FRTB in 2022.

 IBM offers a number of solutions to help financial institutions manage risk and comply with the requirements of the Fundamental Review of the Trading Book, including Algo Workspace Analyzer.

¹Samuel Wilkes, “FRTB 2.0: lower capital but high running costs,”, 26 February 2019

WW Head of Financial Risk CTP Group, IBM Risk Analytics

Dimitra Bampou

WW Technical Sales Team Leader, Market & Counterparty Credit Risk, Watson Financial Services

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