Fundamental Review of the Trading Book

Guest blog by the Banking and Financial Services Sector Advisory Panel

The Fundamental Review of the Trading Book (FRTB) is back in focus after the much-anticipated Basel “end game” proposal has been published by the US Federal Reserve. It’s an international standard that sets out rules governing capital banks must hold against market risk exposures.

How will the new regulation impact the control framework of financial institutions?

What role should internal audit play in preparing for the transition?

This review started over 10 years ago…understanding its history is important.

A subset of the Basel capital rules, FRTB is a set of rules to determine the market risk regulatory capital requirements. It was born out of lessons learned from the 2008 financial crisis, when banks found themselves short on capital and liquidity at a time of system instability and financial distress.

In July 2009, on the heels of the crisis, the Basel Committee on Banking Supervision introduced a set of revisions to the market risk framework, known as Basel 2.5. While those revisions went into effect relatively quickly, they were only intended as a set of short-term measures.

The first draft of a more comprehensive approach was published in May 2012 and finalized in January 2016. However, the implementation date, which was initially set for January 2019, continued to be pushed out due to industry feedback, significant operational and technology costs of implementations, complexity of modeling and methodology changes, and, finally, COVID-19 pandemic.

According to the US Notice of Proposed Rulemaking, the new capital regulations would be phased in over three years starting July 1, 2025, with many of the elements of the regulatory capital calculation expected to be in place upon the effective date of the rule. US regulators have proposed that the rule, in its entirety, be fully phased in on July 1, 2028.

Implementation of Basel “end game” rules, including FRTB, will draw considerable investment of time and resources over the next several years. Chief audit executives of impacted financial institutions should ensure that they allocate proportionate resource to provide timely assurance and advise on the topic.

To understand the significance and the scope of the changes introduced by FRTB, one only needs to look at the areas that are going to be impacted.

• A more prescriptive delineation of products allowed in trading and banking books, known as trading/banking book boundary will impact controllers, accounting, and financial functions.
• Modeling changes like introduction of new risk measures, revised standardized capital calculation approach, and new requirements to consider market liquidity and diversification, will not only impact modelers, but also introduce new data and technology requirements to support calculations.
• Increased capital requirements for non-modellable risk factors will require banks to introduce new processes and controls to collect and analyze scores of market data.
• Lastly, but most importantly, punitive capital requirements applied to illiquid and difficult to model products, combined with the desk level approval process to apply for the internal model approach, will drive changes in business strategy by incentivising vanilla products at the expense of the more complicated ones.

Addressing the challenges posed by FRTB requires involvement from a wide group of stakeholders in the business, technology, finance, risk and operations. Internal audit should employ a similarly comprehensive approach to stay on top of developments. Here are a few steps to consider -

• Connect with stakeholders: get involved as observers in program governance and key working groups; incorporate FRTB updates in business monitoring discussions with the key stakeholders.

• Coordinate across internal audit teams: FRTB implementation impacts different internal audit teams in the same manner as it impacts different groups of stakeholders. A regular working group within internal audit would help auditors exchange information and get a comprehensive picture of changes happening across the organisation.

• Stay abreast of industry and regulatory developments: Regulatory landscape continues to evolve. The firms are expected to adjust to the global FRTB adoption calendar, which includes regulatory applications in multiple jurisdictions, standard approach reporting deadlines, and other regulatory deliverables ahead of implementation dates. In many cases, regulators require an internal audit review of the documentation that has been submitted for their (Regulators) review.

• Perform FRTB governance audits: at this point, FRTB program management at the financial institutions is at a mature stage. Internal auditors could perform governance audits of the FRTB Steering Committees, PMO, and working groups to ensure that adequate representation, appropriate governance structure, and management reporting are in place.

• Assess impact on the future audit plan: in addition to a pre-implementation audit strategy, internal audit will need to consider the impact of FRTB implementation on the risk profiles of affected internal audit entities and update their risk-based audit plan accordingly.

Do you know how your organisation will be impacted?

What does the implementation plan look like?

How will assurance be provided?