Basel 4 in January 2023, R U Ready?
This week, I was busy giving presentation towards market risk colleagues in Indonesia, coming from various local and multinational banks. The topic is about the new FRTB standards (Fundamental Review of the Trading Book), the foundation of the new minimum capital requirements for market risk within the new Basel 4 framework. It is expected to go live in January 2023, after one year postponement taken into account due to Covid-19. The new standards will go live together with other Basel 4 updated components, such as CVA and credit risk. While some banks have spent both time and resources to tackle this new banking standards, it is becoming more obvious that many aspects of the new standards are not well understood. This is however is due to the complexity of the subject that BIS (Bank for International Settlement) would like to address, however at the expense of quantitative language that general risk professionals from various backgrounds can easily understand. Though my sample size is small from geographic background in this training, with half participants coming from multinational banks and relatively senior from working experience aspect, I can relate to their confusion over the texts. Please let me express two of my findings over the new standards and perception from my training audience through this article.
Interpreting Basel 4 Texts Are Not for Everyone, Even Within Risk
Using FRTB original text from BIS as basis, the formulation of market risk minimum capital requirement of Basel 4 is quantitatively more challenging to interpret in comparison to the late Basel 2. Not only that the new standards are implementing more sensitivity-based measurement, the new standards also incorporating economic regime change through correlation parameters (directly relate to diversification benefit), more seriously than before. In this initiative there is not only one, but two sets of correlation parameters for all risk factors and risk classes need to be updated for all the 3 correlation scenarios (low, medium, and high correlations).
In addition, there are also multiple formulas that are interesting to examine from certain angle, for example the below curvature formula from BIS’s February 2019 Minimum Capital Requirements for Market Risk (page 24):
Reading this formula carefully with explanations, we may ended up wondering, what exactly is the new x with + and – symbols mentioned in the equation, what shocks that were applied? Now, try to compare it with the below re-arranged formula:
The second formula is what I have re-arranged, after comparing the CVR first formulas with explanation from various other parts of the document to get full understanding. Checking it with my understanding through years of explaining P&L reports, I understood what BIS would like to express here as CVR, is actually what we called in industry-wide terminology as:
full-reval and sensi-based P&L explanation differences, given that only first-order sensitivity is used
With this reworded definition, you can immediately speak to your trading system business analyst what exactly that you need. This is not the only thing that I found, there are actually quite a lot of such cases in the original document, where interpretation require not only quant-knowledge, but also some hands-on experience dealing with P&L data. Especially, since P&L Attribution is one of the key components, not only in internal model approach (IMA) of the new market risk capital framework, but also in SA method given how trading desk is the defined throughout the document.
No Silo-Based Approach on Credit Risk and Market Risk
Basel 4 also brings several new standards with converging credit risk and market risk dimensions, such as:
- Credit spreads sensitivity-based method under market risk capital charge
- Default risk charge under market risk capital charge
- CVA or counterparty value adjustment
To understand the difference between the three metrics, one need to understand what exactly the market scope or dimension that Basel is looking for in this new Basel 4 standards.
Since 2008 crisis, BIS has been focusing and making sure that no risk is overlooked in the new revised standards from Basel 2, which is why we can still that some root causes of 2008 crisis is still even regulated in Basel 4 documents (such as introduction of CTP – Correlation Trading Portfolio, which is more like legacy book of complex CDS trades). With this motivation, Basel 4 is designed to make sure risks with both credit risk and market risk components are well identified, assessed, evaluated, and controlled, given how Basel 2’s regulatory arbitrage were partly blamed in the last 2008 crisis. However, it is also important to note what kind of infrastructure challenge that a bank should face in dealing with this situation.
Even until now, most banks are working in a silo-based arrangement for their credit risk and market risk systems. Direct interface between systems from these two risk categories are considered odd or strange to develop, while the new standards require more interaction between the two domains. Imagine a CVA trading desk that needs to do a live calculation or pricing as swap desk was giving quotes to client, but the rating from credit risk system was not directly connected to have a flash/direct update. Such situation would create not only inefficient internal risk transfer for centralized CVA process, but may also lead to an incorrect figures charged between the desks. Unfortunately, it is very likely convergence of credit risk and market risk not well-planned by risk management system architecture team.
There are many other examples coming from FRTB texts what kind of problems may arise due to interface inflexibility between credit risk and market risk systems, but let’s not spoil them all in this article 😉
Conclusion
New Basel 4 standards have long-term consequences. Beyond reading and implementing the texts, there are also business implications (such as barrier feature, RRAO, and market-linked deposit bank’s profitability). With less than 2 years implementing Basel 4, may the force of capable implementation project manager be with you all. After one year postponement due to Covid-19, corona or not, clock is ticking. Tick.. Tock..
