Data from the European Banking Authority (EBA) published this Autumn, assessing the potential impact of Basel III reforms on EU banks, underlined the importance of the EU’s forthcoming implementation of global regulatory standards on the capital banks must hold for certain activities. One of the most immediate issues, from the EU’s perspective, is addressing capital requirements for market risk through the implementation of the Fundamental Review of the Trading Book (FRTB). The impact of the FRTB is widely expected to be substantial, with the EBA’s assessment finding that it would require a 52% increase in Tier 1 capital held against market risks for the group of 38 large EU banks that were assessed.
The magnitude of this projected increase in capital required helps explain why the FRTB has been so challenging to put in place, and why EU policymakers have now decided to proceed with a multi-step implementation approach that will be much more complex than the international standards intended.
For banks active in the EU, this has profound implications for their FRTB work, but could also present them with a significant opportunity to pursue FRTB implementation in a way that better supports their strategic and business objectives.
Recent developments in FRTB implementation
In December 2017, the Basel Committee on Banking Supervision (BCBS) agreed to postpone the international target for implementing the FRTB to January 2022. The BCBS then re-opened the FRTB framework in March with a consultation on some of its elements in order to allow for a more proportionate impact on banks’ trading activities.
In the EU, where the FRTB had first been proposed as part of the second Capital Requirements Regulation (CRR2) in 2016, the BCBS’s delay and re-consultation happened while negotiations were ongoing in Brussels. Partly in response to these BCBS developments, EU negotiators chose to amend the market risk component of CRR2 to implement the FRTB initially as a reporting requirement only.
Although CRR2 has not been entirely finalised yet (some technical negotiations remain on other aspects of the legislation) the 4 December endorsement by EU Finance Ministers of progress made so far in talks with the European Parliament signals that the EU’s adoption of a FRTB reporting requirement is now the most likely outcome.
This approach, if given final ratification by both the European Council and European Parliament next year, will leave the full implementation of the FRTB for new legislation that the European Commission will not, in our view, propose until mid-2020.
How the FRTB reporting requirement would work
To operationalise the reporting requirement and to reflect any changes made following the BCBS consultation, the Commission will adopt a Delegated Act by end-2019 modifying the FRTB framework in CRR2. This effectively means that the Commission would use secondary legislation to complete the implementation of the FRTB in EU law as a fully functional capital requirement, but only to be used for reporting purposes until new legislation makes it binding.
Under the CRR2 text, banks would be expected to begin reporting revised FRTB market risk weights based fully on the new Standardised Approach (SA) one year after the adoption of the Delegated Act (potentially as early as January 2021, a full year ahead of the BCBS implementation target). Banks wishing to obtain IMA approval under the new reporting regime for certain trading desks could still seek to do so and could begin using these models three years after the adoption of the Delegated Act (i.e. in 2023). During this time, binding capital requirements for market risk would continue to be based on the existing CRR rules, so any reduction in risk weights resulting from newly approved CRR2 IMA models would not bring a capital benefit for the duration of the reporting requirement.
Banks that are eligible for the derogation for small trading books may be able to forgo the reporting requirement until a binding framework is put in place, but larger banks should now be planning for a two-phase FRTB implementation with many of the operational requirements for implementation potentially needed to be completed by 2021 rather than 2022.
What are the implications of putting the FRTB in CRR3?
To bring the FRTB fully into force as a binding capital requirement, the Commission will need to make a new legislative proposal to this effect. Our view is that this will happen by June 2020 as part of the ‘CRR3’ legislative proposal that the Commission was already expected to make in 2020 in order to implement the final parts of the Basel III framework, agreed in December 2017.
Although legislating the FRTB together with the other elements of the Basel III framework might make sense, it results in at least two significant challenges:
- Timing of future negotiations: for legislation of the complexity of CRR3, the European Council and Parliament will normally take two full years to complete political negotiations before it can become law (this is a relatively conservative estimate based on time taken to negotiate CRR and CRR2).
- Uncertainty over the scope of future negotiations: there is no guarantee that the Parliament and Council will not seek to modify the market risk framework as part of their CRR3 negotiations (i.e. beyond what CRR2 and the Commission’s Delegated Act will already have established by that point). Indeed, the Commission used a May 2018 Call for Advice to ask the EBA to evaluate the FRTB along with other parts of Basel III that it intends to include in CRR3, indicating that EU legislators are reserving the right to re-calibrate the framework before introducing it as a binding capital requirement. This could jeopardise some implementation work already done by banks and regulators around the CRR2 reporting requirement, although much of this work is likely to still be useful for banks in preparing for ‘Day 1’ of the binding FRTB regime
As a result – between the time that CRR3 will take to negotiate (ending in mid-2022 at the earliest) and the time that the FRTB is then likely to need in order to be implemented – it looks virtually impossible for the EU to be able to implement the binding FRTB standard by the BCBS’s January 2022 target. Rather, a delay of at least two years past this point now looks difficult to avoid.
What does this mean for banks?
Banks facing the growing likelihood of a two-phase introduction of the FRTB in the EU now need to consider what this means for their implementation planning. This will be a challenge, as banks operating in the EU may very well have to comply with an FRTB-based reporting requirement as early as 2021, but continue to face considerable uncertainty over the final shape and economics of the framework until well past the BCBS implementation deadline. Different implementation timetables, and approaches, between the EU and the rest of the world will be particularly challenging for internationally active banks.
One decision of particular importance will be whether banks seek regulatory approval to use IMA models under the new CRR2 regime during the FRTB reporting period. Banks that currently use IMA face the prospect of reporting significantly larger market risk weights during the first two years of the EU’s implementation when reporting under the SA will be the only option available to them. Nevertheless, given the expense and effort associated with IMA approval, this might be difficult to justify without any immediate capital benefit. As mentioned above, where new IMA models are built and approved for use under the CRR2 reporting requirement, banks will have to monitor how changes made to the framework in CRR3 negotiations could affect the continued eligibility of or capital benefit from using those models. This uncertainty may, however, be partially limited by the work banks will do to implement the FRTB SA, which combined with the forthcoming introduction of a standardised output floor, will allow them to assess what the maximum capital benefit from internal models could be.
Banks, however, will still have to remain vigilant to the risk that CRR3 could introduce the FRTB binding requirements with a short implementation period (particularly if CRR3’s changes to the FRTB are very limited in scope). Banks which do not seek IMA approvals during the reporting period may struggle to do so in time if they only begin their work after the CRR3 legislation is finalised, or may find themselves at the back of the queue for supervisors in their model approval work. A number of banking supervisors have indicated that the FRTB model approval process is likely to take several years. Keeping in mind the European Central Bank’s expectation that banks move away from back-to-back booking as part of ‘Day 2’ Brexit restructuring, an influx of banks booking more trades in the Eurozone in the coming years could lead to a larger number of applications for IMA approvals, resulting in even greater pressure on scarce supervisory resources.
Although the EU’s complex approach does inject some added uncertainty into FRTB implementation, banks should nevertheless seize the opportunity to make strategic use of the extra time they will likely have before binding requirements come into force. Aligning many of the risk and data infrastructure upgrades that the FRTB requires with a much clearer understanding of the stages in which the FRTB will be rolled out could allow banks to pursue implementation in a way that supports their broader strategic regulatory and business objectives. This may include the opportunity to leverage FRTB implementation to align Risk and Finance functions more closely, to monitor market risk better on a daily and intra-day basis, as well as to enhance operational efficiencies throughout the traded risk process.