FRTB compliance: Options for banks with small trading books in the United Arab Emirates

The Fundamental Review of the Trading Book (FRTB) is a flagship market risk regulation that is a game changer for financial institutions. For FRTB compliance, banks in the United Arab Emirates (UAE) have a choice between the Internal Model Approach (IMA) and the Standardised Approach (SA). Within the SA, banks can use the advanced approach based on risk sensitivities or a simplified standardised approach (SSA). The decision for FRTB compliance should be thought through carefully and banks should consider factors such as risk management sophistication, Risk Weighted Assets (RWA) impact, along with the costs and complexity of implementation and ongoing maintenance.

Whether using the IMA, SA or SSA, banks in the UAE should prioritise proactive action for the best chance of effective compliance. Spanning rigorous self-assessment of current models and processes, data governance and targeted internal FRTB education, banks in the UAE must scrutinise their current approaches closely. Thereafter, they should implement appropriate measures to address inadequacies that might compromise compliance. This article will outline what banks need to be on the lookout for and how they can implement beneficial changes for FRTB compliance.

The Internal Model Approach

The IMA encapsulates a more coherent capital framework calibrated to a stress period with liquidity horizons ranging from 10 to 120 days. Internal models are streamlined and rationalised, with Value at Risk (VaR) and Stress VaR replaced by Expected shortfall (ES). Further to this, a Non Modellable Risk Factors (NMRF) measure is included and the Incremental Risk Charge (IRC) and the Comprehensive Risk Measure (CRM) are replaced by the Default Risk Charge (DRC).

Using this approach, banks’ internal models must operate at the desk level with increased controls on performance, achieved through profit and loss attribution and back testing. IMA is more sophisticated, providing more accurate risk measurement and potentially significant RWA savings. However,  the complexity comes at a higher maintenance cost.

The Standardised Approach

For the SA, the total capital requirement is the sum of the Sensitivities Based Method (SBM), DRC and Residual Risk Add-on (RRAO) components. There is also a Simplified Standardised Approach (SSA) that is less complex and more accessible for banks with small trading books and less sophisticated risk management capabilities.

For the SSA, the Interest Rate Risk (IRR), Equity Risk (EQ), Foreign Exchange Risk (FX) and Commodities Risk (COMM) components are each multiplied by regulatory provided scalars and added together to calculate the total capital requirement.

Source: Consolidated Basel Framework: https://www.bis.org/basel_framework/

In the UAE, regulators can allow banks with small trading books who have limited market risk resources to opt for the SSA, if below criteria are met:

• The bank does not engage in complex trading activities (e.g., non-linear derivatives and structured products)

• Does not correlation trading positions

• Is not a globally systemically important bank (GSIB)

• Does not use the FRTB IMA approach for any of its trading activities

The advantages of the SSA compared to the more advanced SA are that it is simple to calculate using standardised regulatory parameters – it has a relatively low implementation effort with lower data requirements and computational burden. This approach provides a good entry point for minimum FRTB compliance. However, it does not fully capture the risk profile of certain portfolios and will still require significant effort from banks in terms of implementation, documentation, validation and ongoing maintenance.

Furthermore, the Central Bank of the United Arab Emirates (CBUAE) model management standards[1] and guidance published in December 2022 has implications for banks in terms of data management, model development, implementation, validation, use and performance monitoring. These standards are applicable to the FRTB SSA models, which form part of the bank’s overall model inventory.

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Challenges and the way forward for banks

There are a range of different challenges facing banks with small trading books to achieve FRTB compliance, but the industry can respond to address them effectively.

1. Banks should complete self-assessments against the FRTB SA Basel rules and CBUAE regulatory standards. Through this process they should identify any gaps in data management processes, model development, validation, management, regulatory reporting, performance monitoring and documentation. Banks should formulate effective roadmaps for timely gap remediation and socialise this with senior management. This will help in proactive communication with the regulator and will be key to achieving FRTB regulatory compliance in a timely manner.             

   
   

2. There is also increased regulatory scrutiny of banks’ data governance practices. For their FRTB capital models, banks should ensure they have identified critical data elements (CDEs) covering trade, market and reference data, as well as well documented data lineage with a clear linkage between FRTB capital numbers and CDEs. Additionally, there should be effective controls in place for ongoing assessment of data quality and Key performance Indicators (KPIs), including completeness, accuracy and timeliness.

   
   

3. The FRTB capital models will require robust documentation to be in place covering methodology, process manuals, procedures, business requirements and testing evidence. These should be embedded into the bank’s overall risk management policy framework. The documentation should stand the test of internal audit and regulatory scrutiny. An independent party not involved in the development exercise should be able to understand the model and perform an independent replication of the implementation.

   
   

Furthermore, high quality documentation, metrics and communication throughout the model lifecycle is vital to enable senior management to make informed risk management decisions concerning regulatory capital.

4. It’s also important for banks to ensure VaR models are validated by a team that is independent of the first line model development team. Once a bank develops its FRTB SA capital model, the model validator should evaluate whether the model is fit for use by assessing conceptual soundness, design, implementation, usage, ongoing monitoring, data management practices, documentation quality and the robustness of the control framework. There should be effective challenge of the model to ensure that remedial actions are taken by the first line and the validation documentation should stand the test of internal audit and regulatory scrutiny. Furthermore, the model with associated validation findings and remedial actions should be presented at a model oversight committee for approval.

5. Lastly, It is vital that there is a strong training programme in place to ensure that internal staff have a good grasp of market risk fundamentals, including FRTB regulatory requirements, measurement methodologies, risk management strategies and processes used to generate internal and regulatory metrics.

   
   

The challenge for senior management is often to understand the technical nature of FRTB capital models that drive strategic decisions. Without the appropriate technical knowledge some senior managers may simply fall back to managing the process. To address this requirement, banks will need to ensure that risk managers continually educate senior management through delivery of structured workshops to drive an understanding of key strategic levers and elements of model design, assumptions, limitations, implementation, usage and performance.

Tackling FRTB compliance presents banks with a number of distinct challenges and important decisions to take, particularly those with small trading books. Weighing up the SSA and SA  is critical, as each method comes with its own trade offs that banks will need to consider on a case-by-case basis. Compliance challenges stem from intense pressures on model governance, validation, risk sensitivity, and regulatory capital efficiency. To address these effectively, banks must take a meticulous approach to self-assessments, data quality governance and model validation. If banks can do this, alongside creating a continuous learning culture around FRTB, they will position themselves strongly in an evolving regulatory landscape.

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(The author is Client Partner & Head of Market Risk at 4most. Views expressed are personal.)