What Are the Strategic Trade-Offs between the Standardised Approach and the Internal Model Approach under FRTB?

Concept

The decision between the Standardised Approach (SA) and the Internal Model Approach (IMA) under the Fundamental Review of the Trading Book (FRTB) is a defining one for any financial institution with a trading book. It is a choice that will have a profound impact on capital requirements, operational complexity, and ultimately, the profitability of trading operations. The FRTB framework, introduced by the Basel Committee on Banking Supervision (BCBS), represents a significant overhaul of market risk capital rules, designed to address the shortcomings of the previous Basel 2.5 framework that were exposed during the 2007-08 financial crisis.

At its heart, the FRTB provides two distinct methodologies for calculating market risk capital. The Standardised Approach is a regulator-prescribed methodology that uses a set of standardized risk weights and sensitivities to calculate capital charges. It is a one-size-fits-all approach that is relatively simple to implement and is the default option for all banks.

The Internal Model Approach, on the other hand, allows banks to use their own internal models to calculate market risk capital, subject to strict regulatory approval and ongoing validation. This approach is more complex and resource-intensive, but it has the potential to be more risk-sensitive and to result in lower capital charges for banks with sophisticated risk management capabilities.

The choice between the Standardised Approach and the Internal Model Approach under FRTB is a critical strategic decision that will shape a bank’s capital adequacy and trading desk profitability.

The allure of the IMA lies in its potential for greater capital efficiency. By using their own models, banks can better reflect the specific risk characteristics of their trading portfolios, leading to a more accurate and potentially lower calculation of risk-weighted assets (RWAs). This can be particularly advantageous for banks with complex and well-diversified trading books, as the IMA can capture the benefits of diversification that are not fully recognized under the SA. The IMA also offers a more granular view of risk, allowing for more precise capital attribution and a deeper understanding of the drivers of market risk within the trading book.

The path to IMA approval is an arduous one. Banks must demonstrate to regulators that their internal models are conceptually sound, implemented with integrity, and subject to a rigorous validation process. This includes passing a series of stringent tests, such as the P&L attribution test and back-testing, which are designed to ensure that the models are accurately capturing the risks they are intended to measure. The operational overhead associated with maintaining an approved IMA is also substantial, requiring significant investment in data infrastructure, modeling expertise, and ongoing monitoring and reporting.

What Are the Fundamental Differences in Risk Measurement?

The core distinction between the SA and the IMA lies in their approach to risk measurement. The SA is a sensitivity-based approach that uses a set of prescribed risk factors and corresponding risk weights to calculate capital charges. It is a relatively straightforward methodology that is designed to be easily implemented and consistently applied across all banks.

The IMA, in contrast, is a model-based approach that allows banks to use their own internal models to estimate the potential for future losses in their trading portfolios. This provides for a more tailored and risk-sensitive measure of market risk, but it also introduces a greater degree of complexity and model risk.

The SA calculates capital charges based on three main components ▴ the sensitivities-based method (SBM), the default risk charge (DRC), and the residual risk add-on (RRAO). The SBM is the main component of the SA and captures the risks associated with changes in the prices of financial instruments. The DRC is designed to capture the risk of losses due to the default of an issuer of debt or equity securities. The RRAO is a catch-all component that is intended to capture any risks that are not adequately covered by the SBM or the DRC.

The IMA, on the other hand, is based on the concept of Expected Shortfall (ES), which is a more sophisticated measure of risk than the Value-at-Risk (VaR) measure that was used under the previous Basel 2.5 framework. ES measures the expected loss in the tail of the distribution of potential outcomes, providing a more complete picture of the potential for extreme losses. The IMA also includes a default risk charge and a stressed capital add-on, which are designed to capture the risks associated with default and with periods of significant financial stress.

The Regulatory Approval Process

The regulatory approval process for the IMA is a rigorous and demanding one. Banks must submit a detailed application to their national supervisor, which includes a comprehensive description of their internal models, as well as the results of a series of validation tests. The supervisor will then conduct a thorough review of the application, which may include on-site inspections and interviews with key personnel. The approval process can take several years to complete, and there is no guarantee that a bank’s application will be successful.

One of the key requirements for IMA approval is the P&L attribution test. This test is designed to ensure that the risk factors used in a bank’s internal models are the same as the risk factors that are used to generate the daily profit and loss of the trading desk. If there is a significant discrepancy between the two, it may indicate that the models are not accurately capturing the risks of the trading book. The P&L attribution test is a major hurdle for many banks, and it has been a key factor in the decision of some banks to abandon their IMA plans.

In addition to the P&L attribution test, banks must also pass a series of back-testing requirements. Back-testing involves comparing the daily VaR estimates from a bank’s internal models with the actual daily P&L of the trading desk. If the number of exceptions (i.e. days when the actual loss exceeds the VaR estimate) is too high, it may indicate that the models are underestimating the level of risk. The back-testing requirements under the FRTB are more stringent than those under the previous Basel 2.5 framework, and they have also been a major challenge for many banks.

Strategy

The strategic decision of whether to pursue the IMA or to default to the SA is one of the most significant challenges facing banks under the FRTB. The choice is not a simple one, and it requires a careful consideration of a wide range of factors, including the size and complexity of the trading book, the bank’s risk management capabilities, and its overall strategic objectives. The decision will have a lasting impact on the bank’s capital position, its competitive standing, and its ability to generate returns from its trading activities.

For many large, internationally active banks, the IMA has long been seen as the preferred option. The potential for lower capital charges and a more risk-sensitive approach to capital management has been a powerful incentive for these banks to invest in the development and maintenance of sophisticated internal models. The IMA has also been seen as a mark of distinction, a sign that a bank has the advanced risk management capabilities to be a leader in the global financial markets. However, the increased complexity and regulatory scrutiny associated with the FRTB have led many of these banks to reconsider their commitment to the IMA.

The strategic calculus for choosing between the IMA and SA involves a complex interplay of capital efficiency, operational capacity, and long-term business objectives.

The costs of implementing and maintaining an IMA under the FRTB are substantial. Banks must invest heavily in data infrastructure, modeling expertise, and ongoing validation and reporting. The P&L attribution test and the back-testing requirements are particularly challenging, and they have been a major source of concern for many banks. The risk of a model being de-scoped by regulators is also a significant consideration, as this would force a bank to revert to the SA, potentially at a time of market stress when the capital impact would be most severe.

As a result of these challenges, a growing number of banks are opting for a more pragmatic approach. Some are choosing to implement the SA across all of their trading desks, while others are adopting a hybrid approach, using the IMA for some desks and the SA for others. This allows them to balance the benefits of the IMA with the costs and complexities of implementation. The decision of which desks to include in the IMA scope is a critical one, and it requires a careful analysis of the capital benefits, the operational challenges, and the strategic importance of each desk.

How Do Institutions Weigh the Costs and Benefits?

The cost-benefit analysis of the IMA versus the SA is a complex and multifaceted one. On the one hand, the IMA offers the potential for significant capital savings, particularly for banks with large and complex trading books. On the other hand, the costs of implementing and maintaining an IMA are substantial, and there is no guarantee that the capital savings will be sufficient to offset these costs. The decision of whether to pursue the IMA is therefore a strategic one that requires a careful consideration of a wide range of factors.

The following table provides a high-level overview of the key costs and benefits of the IMA versus the SA:

The decision of whether to pursue the IMA will depend on a bank’s specific circumstances. For a large, sophisticated bank with a complex trading book and a strong risk management culture, the benefits of the IMA may well outweigh the costs. For a smaller, less complex bank, the SA is likely to be the more appropriate choice. Ultimately, the decision is a strategic one that must be made at the highest levels of the organization.

The Hybrid Approach a Middle Ground

Faced with the stark choice between the all-or-nothing IMA and the one-size-fits-all SA, many banks are exploring a hybrid approach. This involves seeking IMA approval for some trading desks, while using the SA for others. This allows banks to reap the capital benefits of the IMA where they are most significant, while avoiding the costs and complexities of implementing the IMA across the entire organization. The hybrid approach is a pragmatic solution that is gaining traction with a growing number of banks.

The key to a successful hybrid strategy is to identify the trading desks that are the best candidates for the IMA. These are typically the desks that have the most complex and well-diversified portfolios, as these are the desks where the capital savings from the IMA are likely to be the greatest. The desks that are less complex and have more standardized products are better suited to the SA. The decision of which desks to include in the IMA scope is a critical one, and it requires a careful analysis of the capital benefits, the operational challenges, and the strategic importance of each desk.

• Quantitative Analysis The first step in developing a hybrid strategy is to conduct a quantitative analysis of the capital impact of the IMA versus the SA for each trading desk. This will involve running the numbers for both approaches and comparing the results. The analysis should also take into account the costs of implementing and maintaining the IMA for each desk.
• Qualitative Assessment In addition to the quantitative analysis, it is also important to conduct a qualitative assessment of each trading desk. This should include an evaluation of the desk’s risk management capabilities, its data infrastructure, and its overall strategic importance to the bank.
• Strategic Prioritization Based on the results of the quantitative and qualitative analysis, the bank can then prioritize the trading desks that are the best candidates for the IMA. The bank may choose to start with a small number of desks and then gradually expand the scope of the IMA over time.

Execution

The execution of the chosen FRTB strategy, whether it be the full IMA, the SA, or a hybrid approach, is a complex and challenging undertaking. It requires a significant investment of time, resources, and expertise, and it must be carefully planned and managed to ensure a successful outcome. The execution phase is where the strategic decisions made in the boardroom are translated into the operational realities of the trading floor. It is a critical phase of the FRTB implementation process, and it is one that many banks are finding to be a major challenge.

For banks that have chosen to pursue the IMA, the execution phase is particularly demanding. It involves the development and implementation of a wide range of new models, systems, and processes, as well as the training of staff and the establishment of a robust governance framework. The P&L attribution test and the back-testing requirements are particularly challenging, and they require a significant amount of effort to implement and maintain. The execution phase for the IMA is a multi-year project that requires a dedicated team of experts and a strong commitment from senior management.

Translating the chosen FRTB strategy into operational reality requires a meticulous execution plan, robust infrastructure, and a deep pool of quantitative talent.

For banks that have opted for the SA, the execution phase is less complex, but it is still a significant undertaking. It involves the implementation of the new SA methodology, which is more complex than the previous standardised approach, and it requires a number of new data and reporting requirements. The SA also requires a significant amount of work to implement, and it is important not to underestimate the effort involved. The execution phase for the SA is a major project in its own right, and it requires careful planning and management to ensure a successful outcome.

The following table provides a high-level overview of the key execution challenges for the IMA and the SA:

What Does a Successful IMA Implementation Entail?

A successful IMA implementation is a complex and challenging undertaking that requires a significant investment of time, resources, and expertise. It is a multi-year project that must be carefully planned and managed to ensure a successful outcome. The following are some of the key elements of a successful IMA implementation:

1. Strong Project Management A successful IMA implementation requires strong project management. The project should be led by a dedicated team of experts with a deep understanding of the FRTB and the IMA. The project team should have a clear mandate from senior management and should be given the resources and authority to make decisions and drive the project forward.
2. Robust Data Infrastructure A successful IMA implementation requires a robust data infrastructure. The bank must have the ability to collect, store, and process the large volumes of data that are required for the IMA. The data must be of high quality and must be available in a timely manner.
3. Sophisticated Modeling Capabilities A successful IMA implementation requires sophisticated modeling capabilities. The bank must have the expertise to develop and validate the complex models that are required for the IMA. The models must be conceptually sound, implemented with integrity, and subject to a rigorous validation process.
4. Effective Governance Framework A successful IMA implementation requires an effective governance framework. The bank must have a clear set of policies and procedures for the IMA, as well as a robust system of controls to ensure that the IMA is operating as intended. The governance framework should be overseen by a dedicated committee of senior managers.

The Future of Market Risk Management

The FRTB represents a new era in market risk management. It is a more complex and demanding framework than the previous Basel 2.5 framework, and it will require banks to make significant investments in their risk management capabilities. The choice between the IMA and the SA is a critical one, and it will have a lasting impact on a bank’s capital position, its competitive standing, and its ability to generate returns from its trading activities.

The trend towards the SA is clear, with a growing number of banks opting for the simpler and less resource-intensive approach. However, the IMA is still a viable option for banks with the scale, sophistication, and commitment to make it work. The hybrid approach is also gaining traction, as it allows banks to balance the benefits of the IMA with the costs and complexities of implementation.

Ultimately, the right choice will depend on a bank’s specific circumstances. What is clear is that the FRTB will be a major focus for banks for years to come, and it will have a profound impact on the way that they manage their market risk.

Reflection

The decision between the Standardised and Internal Model approaches under FRTB is more than a technical compliance exercise; it is a reflection of an institution’s risk appetite, its technological capabilities, and its strategic vision. As you consider the path forward for your own organization, it is worth reflecting on how this choice aligns with your broader operational framework. Does your current infrastructure support the level of data granularity and analytical rigor required for the IMA?

Or does the simplicity and certainty of the SA better align with your current strategic priorities? The answer to these questions will not only determine your approach to FRTB compliance but will also shape the future of your trading operations and your ability to compete in an increasingly complex and data-driven market.