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FRTB: The Road to IMA

Traders Magazine Online News, January 11, 2019

Gil Shefi

“Buy the rumours, sell the facts” is normally a good trading strategy. It plays nicely to the human bias that the Roman senator Tacitus described as “omne ignotum pro magnifico est” or “everything unknown is taken to be magnificent. But deciding a bank’s overall trading book desk strategy based on the unknown does not sound magnificent at all. This is arguably the position many banks find themselves in today when making decisions related to the Fundamental Review of the Trading Book (FRTB).

The road to FRTB’s Internal Model Approach (IMA) is a complex one with many directional decisions to be made along the way. To avoid taking a misguided turn towards the Standardized Approach (SA), banks need to start using the biggest and best data available in the market (“facts”) and not rely on just their own data or data they collected from publicly available sources alongside “expert judgement” to fill the gaps (“rumours”).

Nevertheless, in meetings with banks, a common theme surfaces time and time again: in their modellability status reviews, banks are mostly leveraging their in-house data coupled with expert judgement. This means that fundamental decisions – including the most material decision of whether trading book risk should be computed on IMA or SA – are being made using hand-drawn maps and a good deal of guesswork.

Based on these limited data sets, a significant number of tier two and regional banks, as well as some larger ones, are seriously contemplating opting for SA, as their findings show the overall cost of IMA compared to the capital savings generated by this approach is not justified. This is typically due to high SES (Stressed Expected Shortfall) charges stemming from having too many non-modellable risk factors (NMRFs).

Studies show that data pooling can reduce the number of NMRFs when compared to a single bank view, whether that be from a global or regional institution. This is true across different asset classes, different instruments and different underlying assets, even the most liquid ones, as illustrated in Figure 1 below in the EUR swaption modellability picture.

Figure 1: Modellability analysis of a bank’s own transactions versus a pooling approach

Source: IHS Markit

Some argue that banks are talking up the option of going SA as simply a tactical ploy; part of a wider strategy to force regulators into relaxing the FRTB requirements, especially around the PLA test and NMRFs. 

A stronger argument for the move to SA is the operational running costs: it is easier and cheaper to run than IMA. FRTB has a long history of uncertainty around the go-live date, so convincing management to unlock substantial budget is difficult; there are usually bigger or more immediate fish to fry. 

In addition to the question of “Is IMA worth the investment?”, for larger banks there is a second (and often-ignored) question of “Can we afford NOT to invest in IMA?”

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