At a meeting in December 2017, the Basel Committee agreed to delay the implementation of the Fundamental Review of the Trading Book – from 1 January 2019 to 1 January 2022. This was perhaps not surprising – it had been reported that several European banks had put implementation on the backburner due to a lack of clarity over the new regulations, and local regulatory bodies are significantly behind in developing their rules to translate the reform into law.
To act or not to act?
So, what does this change mean in practice? It is obviously good news for those on the receiving end, but can banks sit back and put their feet up, in anticipation of further delays? In our view, absolutely not.
Firstly, the regulations WILL come into effect – it’s a case of when not if – so delaying might feel like buying time but it’s a false economy.
Secondly, there is plenty of information to go on to start implementation. The overall direction and detail of the regulations is set and there won’t be wholesale changes. Several outstanding decisions were also confirmed in December, such as the flooring of capital requirement using the Internal Model Approach (IMA), which was floored at 72.5% of capital, calculated using the Standard Approach.
Thirdly, the internal changes required are extensive and current levels of preparedness are low, so using the extra time to get ahead makes sense.
Right now, banks should be designing the technical framework, developing new risk models, and working on data, none of which are quick fixes, and all of which require thorough testing.
To enable the required data flow changes, source data needs to be cleansed and validated. The increased modelling requirements for the framework changes necessitate an increase in calculation, greater automation and more complex algorithms. And systems need to be flexible enough to incorporate further changes in the future.
What does the future hold?
With such a dynamic financial environment, where regulations are evolving continuously, we expect significant transformation in the banking industry over the next 10-15 years, with our predictions for three key areas of impact being:
- Further shift toward favouring “asset light” businesses: Regulations such as FRTB will force banks to hold more capital, driving banks toward businesses which require less capital requirement or are asset light. Wealth management is one such asset light sector. Almost all the major banks have strongly ventured into the wealth management industry in the last 5-7 years. Goldman Sachs’s $1.2tn asset management division now accounts for 18% of group revenues, up from 13% a few years ago. At UBS, asset and wealth management represents around two-thirds of profits before tax.
- Decreased volumes of exotic derivative products: The scope for exotic trading will decrease. Banks will refrain from exotics trading because of the additional capital requirements. In the FRTB framework, these additional capital requirements can be attributed to two main factors – residual risk add-on charge and illiquidity charge. These charges depend upon the non-linearity of the products’ pay off and the liquidity of these instruments.
- Financial product innovation: Historically there has been a strong relationship between regulations and financial innovation. Since with any change in regulation, banks’ capital requirements generally go up, and to manage this, banks innovate. The securitisation process (creation of CDOs and CLOs etc) was partially inspired by the need to reduce the amount of regulatory capital a bank must hold. Putting it very crudely, the ‘risk’ was sold off to investors in the form of CDOs and CLOs. This reduced the ‘risk’ on the banks’ books and thus the amount of capital that banks needed to hold. The latest Basel document includes a substantial increase in the amount of capital a bank should hold. If history is any guide, we can expect more financial innovations in the sector.
In summary, the delayed deadline mandated by Basel has given banks more time to become compliant with FRTB, which beyond the regulations, will also enhance the very infrastructure upon which they are doing business.