Can a Bank Strategically Combine the Standardised and Internal Model Approaches across Different Desks?

Concept

The capacity for a banking institution to combine the Standardised and Internal Model Approaches is a direct, architectural feature of the prevailing market risk capital framework established by the Fundamental Review of the Trading Book (FRTB). Your question addresses the core of the system’s design. The framework explicitly moves away from an all-or-nothing application of internal models, instituting a more granular and operationally flexible system. This design grants model approval at the trading desk level, enabling a bank to operate a hybrid capital measurement structure.

Certain desks, characterized by liquid, well-understood risk factors and robust historical data, may qualify for and benefit from the Internal Model Approach (IMA). Concurrently, other desks dealing with more opaque, illiquid, or exotic risks can operate under the Advanced Standardised Approach (ASA).

This structural shift acknowledges the heterogeneous nature of a bank’s trading operations. It provides a mechanism to align the method of capital calculation with the specific risk profile and data availability of each distinct business unit. The framework is built upon the principle that a single, monolithic approach is suboptimal for a complex financial institution.

The ability to combine methodologies is the central strategic element introduced by the FRTB. It allows an institution to deploy its analytical resources and modeling capabilities where they yield the most significant benefit in terms of risk sensitivity and capital efficiency, while maintaining a robust, conservative standardized measure for portfolios where internal modeling is impractical or inefficient.

The Fundamental Review of the Trading Book framework is architected to permit a combination of internal and standardised models by granting approval at the individual trading desk level.

What Defines the New Market Risk Architecture?

The contemporary market risk framework, introduced under Basel 3.1, represents a complete overhaul of its predecessors. Its architecture is founded on a clear delineation between the trading book and the banking book, and it provides a multi-tiered system for calculating market risk capital requirements. This system is designed to enhance consistency across institutions and improve the risk-sensitivity of capital calculations. The core components of this architecture are the distinct methodologies available to banks, each calibrated for different levels of complexity and risk.

The primary approaches are:

• The Advanced Standardised Approach (ASA) This is the default, comprehensive standardised methodology available to all firms. It calculates capital requirements through three main components ▴ the Sensitivities-based Method (SbM), the Default Risk Charge (DRC), and the Residual Risk Add-on (RRAO). The ASA is significantly more risk-sensitive than previous standardised approaches but does not require the intensive model validation and supervisory approval process of the IMA.
• The Internal Model Approach (IMA) This approach allows a bank to use its own internal models to calculate capital requirements, subject to stringent supervisory approval. The new IMA replaces the old Value-at-Risk (VaR) measure with Expected Shortfall (ES), a metric designed to better capture tail risk. A critical innovation is the introduction of a framework for Non-Modellable Risk Factors (NMRFs), which mandates a specific capital charge for risks that cannot be reliably modeled due to scarce data.
• The Simplified Standardised Approach (SSA) This is a recalibrated version of the older standardised approach, available only to institutions with small trading book business, offering a less operationally complex option.

The Trading Desk as the Unit of Application

The most significant architectural change facilitating the combination of approaches is the shift in the unit of supervisory approval for internal models. Under the FRTB, permission to use the IMA is granted at the trading desk level. A trading desk is a well-defined group of traders or trading accounts with a clear business strategy and risk management structure. This granularity is the key that unlocks strategic combination.

A bank is no longer faced with a binary choice of using internal models for its entire trading book or not at all. Instead, it can conduct a cost-benefit analysis for each trading desk, deciding where the investment in developing, validating, and maintaining an internal model is justified by the resulting capital efficiencies and superior risk management.

This desk-level approval process necessitates a robust internal governance framework. Banks must clearly define their trading desks, document their strategies, and possess the infrastructure to manage P&L and risk at this granular level. The supervisor evaluates each desk’s model for approval, including rigorous back-testing and profit and loss attribution tests (PLAT) to ensure the model’s accuracy and conservatism.

A desk that fails these ongoing tests will lose its IMA approval and must revert to using the Advanced Standardised Approach. This creates a dynamic system where the right to use internal models must be continuously earned through demonstrated performance.

Strategy

The decision to combine the Advanced Standardised Approach (ASA) and the Internal Model Approach (IMA) is a profound strategic exercise in capital and operational optimization. It requires a bank to perform a rigorous, desk-by-desk analysis, weighing the benefits of lower, more risk-sensitive capital charges under the IMA against the substantial operational costs and regulatory burdens associated with it. The core of the strategy is to selectively deploy the IMA for trading desks where the capital savings and enhanced risk insights justify the immense investment, while utilizing the ASA for all other desks.

This hybrid model allows a bank to architect a capital framework tailored to its unique business mix. For desks engaged in high-volume, liquid, and vanilla products, the data richness and predictability of risk factors make them prime candidates for the IMA. The development of an Expected Shortfall model for these desks can lead to a capital requirement that more accurately reflects the portfolio’s diversification and hedging, potentially offering a significant reduction compared to the ASA. Conversely, for desks trading in illiquid credit products, exotic derivatives, or markets with sparse data, the hurdles to achieve IMA approval are immense.

The risk factors would likely be classified as Non-Modellable Risk Factors (NMRFs), attracting a punitive capital charge that could negate any benefits of the IMA. For these desks, the ASA provides a clear, albeit conservative, capital outcome without the associated modeling and validation overhead.

The Strategic Calculus of Model Selection

Choosing the appropriate approach for each trading desk is a multi-faceted decision. It extends beyond a simple comparison of capital numbers. The strategic calculus involves a holistic assessment of both quantitative and qualitative factors. A bank must systematically evaluate each desk against a set of critical criteria to determine the optimal path.

The primary considerations in this strategic analysis include:

1. Capital Impact The most direct factor is the potential difference in Risk-Weighted Assets (RWA) between the ASA and IMA. This requires a quantitative impact study for each desk, modeling its portfolio under both methodologies. The analysis must consider not only the Sensitivities-based Method of the ASA but also the Default Risk Charge and the Residual Risk Add-on, comparing them to the IMA’s Expected Shortfall, DRC, and NMRF charges.
2. Data Availability and Quality The IMA demands extensive, high-quality historical data to model risk factors and pass supervisory tests. A desk’s access to clean, observable market data is a critical prerequisite. If a significant portion of a desk’s risk factors would be deemed non-modellable, the resulting NMRF capital charge could make the IMA economically unviable.
3. Operational Complexity and Cost Implementing and maintaining an IMA-compliant framework is a massive undertaking. It requires specialized quantitative talent, sophisticated IT infrastructure, and robust governance processes for model validation, back-testing, and P&L attribution. The bank must weigh these significant, ongoing costs against the potential capital benefits.
4. Business Strategy and Portfolio Nature The nature of the desk’s trading strategy is a key indicator. Desks with complex, non-linear products may face challenges in passing the P&L attribution tests required for IMA approval. Desks with stable, well-understood strategies are better candidates than those with rapidly evolving or opportunistic mandates.

A successful hybrid strategy requires a rigorous, desk-specific evaluation of capital benefits versus the operational costs and data requirements of the Internal Model Approach.

Architecting the Hybrid Capital Framework

Constructing an effective hybrid capital framework is an exercise in strategic segmentation. The bank must classify its trading desks based on their suitability for each approach. This segmentation forms the blueprint for the bank’s implementation project and its long-term capital management strategy. The following table provides a comparative framework for this segmentation analysis.

Execution

The execution of a hybrid market risk capital strategy transitions from strategic planning to a complex, multi-stage implementation project. It demands a highly disciplined approach, meticulous project management, and deep engagement between risk, finance, IT, and front-office functions. The execution phase is fundamentally about building the operational capacity to run two distinct capital calculation systems in parallel and to navigate the rigorous supervisory approval process for the selected Internal Model Approach (IMA) desks.

The operational reality is that every bank, even one with extensive IMA approval, must have the systems and processes in place to calculate the Advanced Standardised Approach (ASA) for its entire trading book. The ASA serves not only as the primary methodology for non-IMA desks but also as the mandatory fallback for any IMA-approved desk that fails its ongoing validation tests. This dual-system requirement is the foundational challenge of execution. It necessitates an IT architecture and data infrastructure capable of feeding both the sensitivity-based calculations of the ASA and the stochastic simulations of the IMA.

How Is the Desk-Level Approval Process Managed?

Securing IMA approval for a trading desk is a demanding, resource-intensive process that requires a sustained, collaborative effort with regulators. The process is not a one-time event but an ongoing cycle of validation and performance monitoring. A bank must demonstrate not only the initial integrity of its model but also its continued accuracy over time.

The critical path to IMA approval involves several distinct stages:

1. Desk Definition and Scoping The institution must first formally define its trading desks according to regulatory criteria, establishing clear business strategies, risk management structures, and P&L reporting lines for each. This is followed by a rigorous scoping exercise to identify which desks are viable candidates for an IMA application.
2. Model Development and Documentation For each candidate desk, the bank must develop an Expected Shortfall (ES) model compliant with all regulatory specifications. This includes calibrating the model to a period of significant financial stress and incorporating the prescribed liquidity horizons for different risk factors. Extensive documentation detailing the model’s methodology, assumptions, and limitations is required.
3. Data Sourcing and Validation The bank must build and maintain a robust data infrastructure to source the historical data needed for the ES model and the identification of Non-Modellable Risk Factors (NMRFs). This involves establishing criteria for data quality, completeness, and observability.
4. Independent Validation An independent model validation function within the bank must rigorously test the model, challenging its assumptions, methodology, and implementation. This internal validation is a critical prerequisite for a supervisory application.
5. Supervisory Pre-Application and Application Banks typically engage in a pre-application dialogue with their supervisor to present their proposed model and implementation plan. This is followed by the formal submission of the application, which includes all model documentation, validation reports, and results from initial back-testing and P&L attribution tests.
6. Ongoing Performance Monitoring Post-approval, the desk is subject to continuous performance monitoring through daily back-testing and P&L attribution tests. Failure to meet the specified thresholds for these tests results in the desk losing its IMA status and reverting to the ASA.

Quantitative Comparison a Tale of Two Desks

To illustrate the practical execution of a hybrid strategy, consider a hypothetical bank analyzing two distinct trading desks ▴ a G10 Interest Rate Swaps desk and a Structured Credit Solutions desk. The bank’s objective is to determine the optimal capital approach for each.

Executing a hybrid approach requires building the capacity to run both ASA and IMA systems in parallel while navigating the rigorous, multi-stage IMA approval process for each selected desk.

The following table presents a simplified quantitative comparison of the potential capital requirements under both the ASA and IMA for these two desks. This analysis is central to the execution decision.

This quantitative exercise demonstrates the core of the execution strategy. The decision is data-driven. For the G10 Rates desk, the path is clear ▴ the investment in IMA yields a substantial capital benefit.

For the Structured Credit desk, the analysis reveals that the ASA is the more efficient and prudent path, avoiding a costly and ultimately fruitless IMA implementation. A bank would replicate this analysis across all its trading desks to build its customized, hybrid capital framework.

Reflection

The capacity to construct a hybrid market risk framework is a defining feature of the current regulatory architecture. The analysis presented here outlines the strategic and executional components of this system. The ultimate configuration for any institution, however, is a reflection of its own identity. It is a function of its market footprint, its appetite for complexity, its investment in quantitative capabilities, and its overarching strategic objectives.

What Does Your Optimal Capital Architecture Look Like?

Consider the composition of your own trading operations. Where does the value of precision outweigh the cost of complexity? Which business lines are defined by risks so unique that a standardised measure, however advanced, fails to capture their true economic substance?

The answers to these questions will define the blueprint for your institution’s optimal capital structure. The framework provides the tools; the final architecture is yours to design.